By Larry Allen
Looking back at previous waves of economic crisis, economic historian Larry Allen illuminates our global predicament by uncovering the interlocked economic processes that lay beneath the crisis.
A celebrated quote of the nineteenth century British Prime Minister Benjamin Disraeli goes: “Read no history: nothing but biography, for that is life without theory.”1 This quote hints that theories come at the price of some simplification and distortion, that exceptions disturb every generalisation. Today there are reasons aplenty to ask if economic theories hold out more promise than concrete benefits, if interpreting economic events through the prism of economic theory warps more than illuminates matters. To apply Disraeli’s quote to economics and finance we must turn his quote on its head and say: Read no economic theory, only economic history for that is economics without theory. Therefore let us take a look at the current economic distress in light of economic history.
We want to recognise the identical character in all economic cycles despite the changing variety and complexity of technology, laws, institutions, geography, etc.
We can start by asking if stretches of economic prosperity have always been precarious interludes between catastrophes, if current economic difficulties mimic past episodes of economic and financial crises. To do this we must take a long view, looking back well beyond a hundred years. The object is to lay bare here the unchangeable, underlying character of all economic cycles, a character that makes itself very directly felt as much today as a hundred years ago. We want to recognise the identical character in all economic cycles despite the changing variety and complexity of technology, laws, institutions, geography, etc.
II. Role of Commodity Prices
Since World War II the developed economies have suffered two separate decades of sluggish growth: the 1970’s and the first decade of the new millennium. Towards the end of the 1970’s a distinguished economic historian, Walt Rostow, diagnosed the sources of this sluggish growth. He laid the blame at the feet of surging commodity prices and the role these commodity prices played in long waves of economic activity. Rostow observed 50-year long waves in commodity prices with upswings from 1790-1815, 1848-1873, and 1896-1920, and downswings from 1815-1848, 1873-1896, and 1920-1936. According to Rostow:
‘The lags involved in responding to a relative rise in food or raw material prices, and the fact that the response often required the development of whole new regions, led to an overshooting of world requirements and a period of relative surplus. A relative fall in the prices of food and raw materials then followed … until expanding world requirements caught up with the excess capacity…’2
Today’s leading scholars in economics pay small attention to long wave theories in economic activity, but the subject goes on simmering. The theories behind the long waves have yet to compel wide assent, but the development of newer and improved methods of time series analysis keep the subject alive. Erten and Ocamps reported evidence of four past super-cycles in commodities ranging between 30 and 40 years.3 Their study makes use of a measure of non-fuel commodity prices. It uncovered four super-cycles. One wave spanned between 1894 and 1932 and peaked in 1917. Another wave spanned between 1932 and 1971 and peaked in 1951. A third wave spanned between 1971 and 1999, and peaked in 1973. The upswing of a new wave surfaced in 2000. A post-mortem on the current economic crisis begins with the key observation that the global economy entered a phase of booming commodity prices in 2000. These booming commodity prices put a brake on economic growth and leave businesses, including banks, acting on overly rosy expectations. An economic deceleration owed to tightness in commodity supplies begets an economy more exposed than usual. It does not unavoidably dictate a financial crisis. The global economy endured the 1970’s boom in commodity prices without a whiplashing financial crisis. On the other hand, if a financial crisis is in the cards for developed countries, it is likely to burst forth amid booming commodity prices. Contrarily, emerging economics typically come alive and flourish when commodity prices boom.
Falling interest rates forces banks to accept either higher risks or lower return. Leading up to the 2008 financial crisis, higher risks maintained rates of return in the face of falling interest rates. Banks came to rely more upon short-term borrowing as opposed to deposits.
III. The Enlargement of Banks
Another clue comes to light when we study developments in the banking industry. Ordinarily industries see growth in business as welcomed news. In some cases growth bears unwelcomed news. Astronomers say our sun will one day expand into a giant red star before shrinking into a dwarf star. In history cities and small states have grown into vast empires before collapsing, evoking an analogy with the giant red star. A rapidly ballooning banking sector sends a warning signal in an economy facing tightened commodity supplies and sagging growth.
The years leading up to the 2008 financial crisis saw bullish growth in banks. Signs of abnormal bank expansion came to light in rising values of bank assets relative to GDP, frenzied financial innovation, climbing debt to equity ratios for banks, climbing debt to GDP ratios for societies, and a climbing rate of bank borrowing from other banks. Between mid-2004 and mid-2007 total bank assets doubled for the ten largest U.S. banks. In 2008 UK banking assets stood at roughly 540 per cent of GDP. In 1990 that statistic stood at only 220 per cent of GDP, and in 1960 at only 40 per cent of GDP.4 Strangely enough, abuses of off-shore banking, the shadow banking system and regulatory havens, are not new. In 1837 the U.S. underwent The Panic of 1837, a financial crisis that sent the U.S. economy wildly tumbling into deep and prolonged recession. This financial crisis broke upon the scene following a spree of aggressive wildcat banking. Wildcat banks were set up in remote areas, even Indian territories beyond the reach of pesky regulators and infuriated customers. Wildcat banks went without the luxuries of buildings, offices, or furniture. They issued their own bank notes backed by bonds held in a state auditor’s office. It was not unheard of for bank investors to found a bank with only enough capital to buy engraving plats and dies, and pay for the costs of printing up banknotes. Bond brokers handed over bonds to state auditors, which in turn authorised the bank’s investors to print banknotes. The bank’s investors then paid for the bonds with freshly printed banknotes. Outrage over these practices moved the freshly-fledged Republic of Texas to outlaw banks in its constitution. The binge of wildcat banking hardly went unparalleled. In the 1700’s John Law‘s bank in France handed Europe a glaring case of economic catastrophe preceded by overdevelopment in banking.
If a financial crisis is in the cards for developed countries, it is likely to burst forth amid booming commodity prices. Contrarily, emerging economics typically come alive and flourish when commodity prices boom.
Inflated banks alone may not signal a budding economic weakness, but rather a higher degree of leverage in society. Banks are in the business of borrowing short-term to finance longer-term investments. A long trend of falling interest rates forces banks to accept either higher risks or lower rates of return. Leading up to the 2008 financial crisis, higher risks maintained rates of return in the face of falling interest rates. Banks came to rely more upon short-term borrowing as opposed to deposits. Generally deposits are less volatile than short-term credit. To dodge capital requirements banks launched off-balance sheet, off shore, Structured Investment Vehicles. A shadow banking system grew in regulatory havens such as the Cayman Islands.
IV. Saving Glut
Galloping strides in technological sophistication and financial innovation conjure up many new-fangled and unprecedented entanglements and convolutions that spawn new and unsuspected weak links in the financial system. These new weak links will no doubt hold a large place in many diagnoses of the 2008 financial crisis. This essay takes a different tact. It aims to lay bare similarities and parallels with past crises, patterns that are not new, that reveal more enduring characteristics of cycles and crises.
We can look for insights in economists contemporary with earlier cycles and how the trained eyes of those economists interpreted cycles. For comparison the 2008 financial crisis and its aftershock are often laid side by side with the Great Depression of the 1930’s. The leading interpreter of the 1930’s debacle was the famous British economist, John Maynard Keynes. Keynes deciphered the problem as savings racing ahead of investment, and a preference for money above less-liquid assets. He saw a way out of depression by running government budget deficits that gobbled up excess savings. As early as 2005 none less than Ben Bernanke, Chair of the Governors of the Federal Reserve System, brought up the “emergence of a global savings glut in the past eight to ten years.”5 High savings rates in fast-growing developing countries, and high savings rates in some developed countries, particularly Germany and Japan, bore the guilt for the savings glut in Bernanke’s verdict. Mounting savings rates lead to sinking interest rates. As interest rates fall investors take on higher risks to earn rates of return comparable to what was earned when interest rates stood higher.
The savings glut accounts for the sinking interest rates that herd famished investors into the arms of riskier investments. With investors chasing riskier investments to beat low interest rates, the economy is left floating on a thin film of confidence.
The savings glut accounts for the sinking interest rates that herd famished investors into the arms of riskier investments. With commodity prices turning upwards, banks escaping regulations in remote locations, and investors chasing riskier investments to beat low interest rates, the economy is left floating on a thin film of confidence.
Now we have identified three characteristics that the current global economy shares with past economic and financial crises. These are booming commodity prices, enlargement of banks, and a savings glut. The broad outlines of the crisis now stand clearer. High saving levels can only be counterbalanced by high investment spending or large government budget deficits. Business caught between weak demand and high commodity prices are in no shape or mind to launch the costlier investment projects. Banks recoiling from a phase of euphoric credit expansion tone down a once daring tolerance for risks. Government deficits help carry an ailing global economy, but a procession of foreign debt crises undermines the ability of governments to take an aggressive fiscal stance. Besides, it is a truism in economics that debtors benefit from inflation. High government deficits raise the fear that future governments will favour inflation, arousing inflationary expectations and rattling credit rating agencies.
We have identified three characteristics that the current global economy shares with past economic and financial crises. These are booming commodity prices, enlargement of banks, and a savings glut.
V. Déjà vu in Public Discourse
To underscore the shared traits of major economic contractions, it is enlightening and instructive to look at the historical parallels in the public debates sparked by these crises. To emphasise this point, let us take an episode in the far distant past and recall the commercial crisis of 1847 and 1848. In Germany, poor harvest in 1845 and 1846 launched a phase of rising commodity prices in Europe. In 1847 Britain suffered one of its worst bank panics. By 1848 the crisis had spread to manufacturing throughout Europe. As indicated above Rostow says the phase of rising commodity prices lasted between 1848 and 1873. In one of the more famous pamphlets published during this crisis can be found the following words:
‘Society as a whole is more and more splitting up into two great hostile camps, into two great classes directly facing each other…It has converted the physician, the lawyer, the priest, the poet, the man of science, into its paid wage labourers….In place of the old local and national seclusion and self-sufficiency we have intercourse in every direction, universal inter-dependence of nations….It compels all nations on pain of extinction to adopt the bourgeois [capitalist] mode of production…Independent, or but loosely connected provinces, with separate interests, laws, governments, and systems of taxation, became lumped together into one nation, with one government, one code of laws, one national class interest, one frontier, and one customs tariff. The lower strata of the middleclass…sinks gradually into the proletariat…partly because their specialized skill is rendered worthless by new methods of production.’6
These words are directly lifted form the Manifesto of the Communist Party, written in 1848 by Karl Marx and Friedrich Engels. These words sound a familiar tone, echoing criticisms currently lodged against global capitalism. Today it is easier to shrug off the words of Marx and Engels because global capitalism has proven its value. Where foreign trade is concerned, the verdict of history stands sparkling clear and final. Countries welcoming foreign trade have outlasted countries that shunned it. What we are interested in here is that similar underlying economic realities evoke similar human thoughts. Our own time has seen a rising chorus of leading economists singing a panegyric to free markets. Maybe free markets deserve these accolades, but this revival of free markets came after the global economy endured three decades of inflation. Inflation means that market participants find it easier to resell goods in the future for more than they pay for them now. Naturally businesses and households love free markets if they help them to buy products today and resell them for higher prices in the future. Whether this renewed confidence in free markets can weather a wave of deflation remains to be seen. Deflation makes it harder to resell goods at higher prices.
VI. Short-term Failure in the Automatic Correcting Mechanisms.
A thoroughgoing proponent of free market capitalism stands undiscouraged by these messy difficulties. Since Adam Smith, renowned schools of economic thought have stressed the self-correcting nature of free market capitalism. If unemployment stands unacceptably high, competition among unemployed workers pushes wages down, boosting the profits earned from hiring extra workers. Unemployment arouses market forces that combat unemployment. This logic sounds rock-solid, but the self-correcting mechanisms fall short of bullet proof. What if booming food and energy prices persuade workers to doggedly resist wage cuts? If wages fail to fall, the economy must count on the interest rate mechanism. To be sure, a glut of savings should push down interest rates to tantalisingly low levels. Businesses should undertake more capital projects when interest rates sit at bargain-basement levels. This self-correction force, however, can hit a snag. What if booming raw material and energy prices neutralise the sweetener of rock-bottom interest rates? Higher energy and raw material prices subtract from the profits earned through the utilisation of capital. If that happens, the economy is robbed of the added impetus that tantalising interest rates invite.
The reasons for a sluggish rebound from the 2008 crisis now sharpen into focus. Firstly, countercyclical government spending policies lie unavailable at full strength. Secondly, booming commodity and raw material prices undercut the normal self-correcting mechanisms.
VII. The neutralisation of monetary policy
One more tool in the tool kit of economic policy cries out for attention. It has to do with the link between commodity prices and monetary policy. Often the blame for price surges in one commodity is cast at the door of one-time natural events, such as mad cow disease, avian flu, hurricanes, freezes, droughts, or wars. A worst-case scenario contends that the global economy owes the generalised boom in commodity prices to lax monetary policies. The most direct linkage between monetary policy and economic activity travels via interest rates. Easy money depresses interest rates, strengthening the drive to economic recovery. If monetary policy contemporaneously inflates commodity prices and lowers interest rates, then climbing commodity prices dilute the investment incentives of sinking interest rates.
To show how monetary policy can fail we must take a detour into monetary theory. Monetary theory in its most basic form contends that on average prices change proportional to changes in the money supply. If the money stock doubles without a change in GDP, then prices must more or less double. If GDP grows three per cent, then on average growth in prices equals growth in the money stock minus three per cent. In the case of unchanging GDP, the doubling of prices is an average price adjustment. Some prices may even fall, and other prices more than double. It happens that between December 2008 and December 2012 the U.S. Producer Price Index (PPI) for commodities grew 18 per cent, the U.S. Consumer Price Index grew 9 per cent, and the U.S. PPI for capital equipment eked out a mere 4 per cent growth rate.7 The U.S. PPI for durable consumer goods grew 5.6 per cent. This incongruity in price growth may only mirror differences in short-run price flexibility between goods and therefore be short-lived. Nevertheless, short-run rigidities and maladjustments can derail policies and self-correcting mechanisms. These wide incongruities in price inflation merit a hard look. In the data above, prices of commodities, which are less dependent upon credit, surprisingly receive a stronger spur from lower interest rates than costly durable goods whose buyers often count upon the availability of credit. According to these numbers, the prices of capital equipment and durable consumer goods benefit least from cheap interest rates.
The habit of commodity prices exhibiting enhanced sensitivity to money stock growth has not gone unnoticed. It goes back at least to the nineteenth century.
The habit of commodity prices exhibiting enhanced sensitivity to money stock growth has not gone unnoticed. It goes back at least to the nineteenth century. John Cairnes (1823-1875) observed this tendency in comparing the prices of crude materials with the prices of finished manufactured-good prices.8 Germany’s post-World War I episode of hyperinflation casts up more evidence along this vein. According to Frank Graham (1890-1949), raw material prices during German hyperinflation leaped ahead of finished-goods prices.9 Michael Bordo, writing in the later 20th century, reported the tendency of brisk money stock growth to unleash a surge in commodity prices.10
Even critiques and analysis induced during the recent cyclical somersaults parrot to a surprising degree words written during past cycles. From an economic point of view, we might even say that a person who has studied one economic and financial crisis has studied them all.
In effect monetary policy may bear responsibility for the booming commodity prices at the root cause of the short-run problem. Thus we find that the economy cannot count upon the short-run effects of monetary stimulus to operate at peak efficiency. This does not mean that these easy money policies go without merit. Booming commodity prices bring the hope that high prices will eventually bring forth greater supplies. In time abundant supplies of commodities straighten the path for a new economic recovery. Given the current state of the global economy, waiting for extra supplies of commodities holds out the best hope.
VIII. Concluding Remarks
The eye-popping technological and social changes of the last two hundred years lead one to wonder if the global economy of today might oscillate quite differently from the global economy of a hundred years ago. In reality the broad outlines of recent cyclical experiences appear in economic cycles going back at least to the nineteenth century. Savings gluts, bloated banks, booming commodity prices, stalled recoveries, and neutralised monetary policies predate the current age of exuberant financial innovation and computer networking. Even critiques and analysis induced during the recent cyclical somersaults parrot to a surprising degree words written during past cycles. From an economic point of view, we might even say that a person who has studied one economic and financial crisis has studied them all.
The current demand side stimulus policies evolved from the experiences of past cycles, but the outcomes fell short of satisfactory.
Now that we have studied the crisis through the lens of economic history, it is time to zero in on a key question: In the course of these bubble-driven recoveries, do the delicate processes of supply and demand lose the supply-side foresight that is needed for a stable market economy? If there is any merit to this question, the next question is how to improve the supply-side foresight of the global economy while remaining within the framework of free market capitalism. Perhaps governments should do more to furnish the private sector with the information and incentives it needs to prevent bottlenecks in energy and critical raw materials.
The current demand side stimulus policies evolved from the accumulated experiences of past cycles. These policies were founded in convincing logic, but the outcomes fell short of satisfactory. Between 2001 and 2007 the added stimulus of these policies accrued to the housing industry. Houses were the one capital good that bore the nearest kinship to finished consumer goods. In hindsight investment in crude raw materials and energy loomed more critical in 2000 than housing for the future growth of the global economy.
Larry Allen is a Professor of Economics at Lamar University in Texas. In 1978 he earned his Ph.D. after writing a doctoral thesis entitled: An Econometric Model of Manufacturing in Arkansas. After teaching economic theory and conducting econometric research for over twenty years he came to appreciate the insights that come from studying pure economic history. His most recent book is The Global Economic Crisis: A Chronology, published March 2013. Words such as “rich”, “insightful” and “informed-detachment” have been used to describe his work. See his most recent book at: http://press.uchicago.edu/ucp/books/book/distributed/G/bo15582892.html
2. W. W. Rostow, Getting from Here to There, (New York, NY) McGraw-Hill Book Company, 1978, pp. 22.
3. Brian Erten and Jose Antonio Ocampo, “Super-cycles of commodity prices since the mid-nineteenth century,” DESA Working Paper No. 110, United Nations Department of Economic and Social Affairs, February 2012, pg. 23.
4. David T. Llewellyn, “The Global Banking Crisis and the Post-Crisis Banking and Regulatory Scenario,” Research Papers in Corporate Finance, University of Amsterdam, June 2010, pp. 39.
5. Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” Remarks by Governor Ben S. Bernanke At the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia. March 10, 2005. Governor Bernanke presented similar remarks with updated data at the Homer Jones Lecture, St. Louis, Missouri, on April 14, 2005.
6. Karl Marx and Friedrich Engels, Manifesto of the Communist Party,(1848), (Chicago, 1952).
8. John E. Cairnes, Essays on Political Economy: Theoretical and Applied, 1873. Reprint (New York, 1965).
9. Frank D. Graham, Exchange, Prices, and Production in Hyperinflation: Germany 1920-1923, (Princeton, N.J, 1930).
10. Michael D. Bordo, ‘The Effects of Monetary Change on Relative Commodity Prices and the Role of Long-Term Contracts,’ Journal of Political Economy, LXXXVIII/6 (1980), pp.1088-1109.