Does a Falling Money Stock Cause Economic Depression?

Mises.org ^ | April1 18, 2003 | Frank Shostak

[plusone]

Excellent post!. "When it became clear that the underlying values did not match prices, prices collapsed..." Sounds like the 90's, doesn't it?

[imawit]

You put it quite succinctly.

you reach a point where aggregate debt service by government, business and individuals consumes so much of periodic liquidity that the entity involved can no longer afford to make additional purchase commitments. Buyers disappear.

Not only this but the bubble and re-bubble going on by the FED cause dollar devaluation and with more bucks being lent out, lenders will want higher interest rates when they know they will be getting back dollars that buy less because inflation has set in. That $1 hamburger & fries is now $6.75. This added activity leaves the economy no where to turn.

[B4Ranch]

Could a boycott of Chinese products bring manufacturing, along with good paying jobs, back to the USA?

If we could get the government officials to even consider that American jobs were important then it might work. How do we change the Socialists in the government?

[AntiGuv]

Personally, I think it's critical that China be forced to alter its fiscal policies (esp. yuan currency appreciation) or otherwise become subject to protectionist measures. Unfortunately, I see minimal impetus in that direction so far as American policymakers are concerned...

[dalereed]

"How do we change the Socialists in the government?"

First you have to get a Supreme Court that believes in the Constitution.

If that ever transpires, you need someone with enough money and a smart attorney to sue the federal government to eliminate all programs that aren't authorized by the Constitution, including Social Security and Medicare!

[NYTexan]

That's a scarey thought!
It would diminish property values like a plague!

[Torie]

What all of this analysis misses is that money supply contracted after the stock market crash in 1929, and then protectionism ensued. In a global economy, and with a Fed that won't contract the money supply, I really don't see the analogy. Debtors are balanced by creditors, and the key is to let the money flow between them on a global basis. Granted, if loans are imprudent, there is economic waste, which must be paid for. But in the modern economic era, that need not lead to a depression.

[yankeedame]

How does debt result in deflation? Having read these words several times I find myself still puzzled by the wording/meaning of this question. Is the question: "How does deflation effect debt?"

Debtors of any class, government, business, or individual, have limited liquidity. That is why the debt (borrowed liquidity) was needed in the first place. Debtor liqudity may come from tax revenues, business earnings, or monthly earned income--but it is limited. First off, every thing in the universe is limited, however unimaginable those limits might be. Second, government revenues, business earnings, et. al. are indeed limited when speaking in context of the here and now. We borrow-- for a car, a house, whatever-- and the banks lend us money on the carefully considered assumption that we will be worth more tomorrow,or next year, than we are today. Businesses and governments borrow and are loaned money, via stocks and bonds, on basically the same assumption.

There is no reliable data on what the real limits are--how much of current income can be paid on residential mortgage debt, or credit cards or whatever without creating a deflationary economic environment. Speaking in the vast macro-economic sense, yes that is true; but, in reference to individual, business and, yes, even government "debtor liquidity" there are, of course, available,.e.g. Moody's, Morningstar, etc.

Point is that in the macro economy, you reach a point where aggregate debt service by government, business and individuals consumes so much of periodic liquidity that the entity involved can no longer afford to make additional purchase commitments... Again, this is based on the assumption of a static condition: That he who has $5 today, will have $5 tomorrow and $5 next week, maybe less but never than a penny or two more.

In the business environment, pricing power disappears and prices begin to drop; so do profits. True enough, to a point. Prices drop simply because they must in order to the company to maintain it's place in the market- but prices can only drop to a point. When profit derived from these lower, unsubstantiated price cuts (Spacely's Sprockets cut prices not because they found a better,cheaper way to make sprockets but simply because they had to) reach a certain point the company simply stops making the products. Only the federal government can continue to make something, be it goods or services, at a loss.

Deflation becomes imbedded--because new debt is incurred, not to buy additional assets but instead to make payments on existing debt. Which can not be lowered-either by fiat or allowed to drift downward. The cause of this is, in a word: contracts. No matter if it is in re: a union pay agreement, a purchasing order for a business, or a 30 year mortgage.

So we have skipped payments; interest only months; rising default rates and mortgage foreclosures. Monthly payments are made with additional credit card debt. A general decline in market prices is probably not too far ahead. This is because, as the old saying goes, "water seeks its own level". If, for whatever reason, real estate/housing prices are out of wack with reality the Free Market, if allowed to work, will bring them down (or raise them up) to their true level.

This is a fair summary of the current economic environment. As Shostak points out, the historical experience is that additional lending has been counterproductive No doubt, no doubt, but then you come to the sticky question of "additional lending", according to whom? by whose standards? By whose defination?" etc., etc., but that, as they say, is for another day.

How do we get out of this mess? Well you have to see how people get additional liquidity other than through the debt process. You have to expect new jobs to be created and employment to go up; compensation has to go up; business income has to go; tax receipts must go up. If anybody sees any positive signs on any of these items, or if anybody can see any reason why any of these things might happen, they should post immediately. I don't. IMHO, it's call "politics". Elections are not too far off and it is to the benefit of not a few to make sure the kettle stays hot and well stirred

[antidisestablishment]

Ditto to everything you said. And I believe the mortage mortgage market is even more ripe for a fall. Beyond the gross inflation, freddie and fannie are neck deep in derivatives and the growth rates simply cannot be maintained. It appears that the entire country forgot the lessons of the depression:

1. Don't trust banks (or government)
2. Anomalous growth is never real or sustainainable.

The collapse of the world economy will not be quiet.

[okiesap]

If Wal-Mart were to implement a MADE IN USA only policy, would the American consumer be able to afford the goods? I look around my house and I'm hard pressed to find much made here. I'm an average Joe who buys the best product at the best price.

By the way, I don't see the economic slowdown at my local Wal-Mart supercenter. Shopping there can be a hellish experience due to the large crowds.

[B-Chan]

I don't think Wal-Mart deciding to buy only American-made goods would have much effect on the unemployment rate in this country.

[STONEWALLS]

"If Wal-Mart were to implement a MADE IN USA only policy, would the American consumer be able to afford the goods?"

...that's a good point, and the corollary to it is...If Wal-Mart were to implement a MADE IN USA only policy, would the American economy be able to keep them supplied?.....for example, I'm not sure there's enough textile capacity left in this country to keep Wal-Mart in soft goods.....

Good luck to everyone!

Stonewalls

[Tauzero]

" It's certainly not the same as 29 with this factor."

The details are never exactly the same. This fact facilitates bullish rationalization, guaranteeing the gross mistakes will be the same.

[Unknown Freeper]

Bump for later read.

[A. Pole]

Despite the aggressive lowering of the federal funds rate target from 6.5% in December, 2000 to the current level of 1.25%, U.S. economic activity remains subdued.

Yes, but what was happening BEFORE "December 2000"? The Fed was tightening the screw to fight imaginery inflation even after the shares started to fall.

[A. Pole]

Deflation becomes imbedded--because new debt is incurred, not to buy additional assets but instead to make payments on existing debt.

Bump

[meadsjn]

Great article. I wonder why the Fed rate was raised to 6.5% just six months before the 2000 election, after the spigot had been open most of Clinton's two terms in office.

That must have been just the whiplash needed to start the next presidency off with a record economic slump.

[imawit]

Did some more thinking about this over the weekend.

Let's say the article was correct on the reasons and influences for the 29 crash.

There is a really big difference today from that. That episode was caused by financial and monetary frailty and mismanagement. Many of those factors are extant today. The major difference being that loans were margin and the equities behind those margins tanked

Today there are more loans and debt against equities such as real estate. This equity will not tank as fast as stocks will. The 29 crash was a series of daily crashes which in the end had a snow ball effect and a stampede. This won't happen with housing.

Housing takes a while. Not everyone will need to sell right away nor can houses be sold right away. Even defaults take a while. Should this happen, the mortgagees then have some equity of some value also and not everyone will have to sell either or default either.

Looks to me like the financial side of mortgages will suffer first and collapse before the mortgagors will. And, should the mortgagees take their equity in the form of homes, this will collapse but there will still be those who can hold on to their homes and live in them while the mortgagees have much reduced equity.

Interesting scenario. Any further factors or actions resultant thereby ?

[zechariah]

I'm beginning to come around to your position: employment is the key.

I think you could have a stock market crash without it necesarily taking the economy into recession. So I think that even if employment picked up, I'm not so sure that the stock market would immediately turn around.

I note also that there was a big round of tarrif hikes in 1929/30 that was effectively a tax on business. Plus government deficit spending was competeing with business for capital. So it looks like you had several factors holding back new job creation in the 30's.

[z]

[arete]

Excellent analysis as usual.

Richard W.