Wednesday, August 1, 2012

Lies, Damned Lies, and Definitions, XXV: The Crash

Irving Fisher, according to Milton Friedman the greatest economist America ever produced, believed in 1929 that the stock market would continue to go up, and that this was a sign that permanent prosperity had been achieved. A few years later (after being bailed out by Yale University to the tune of millions), Fisher was calling for "reflation," what today we call "quantitative easing." The idea was to get prices back up to their pre-1929 level. This would allow the rich to make more profits, which would allow them to save more. If the rich saved more, they would have more to invest, which would create jobs for the non-rich.

One of the main causes of the Crash of 1929 was massive money creation during the 1920s for speculation on Wall Street at the same time that new capital formation didn't seem to be suffering. This baffled the experts who looked at things from a past savings perspective. As far as they knew, the problem was that money that should have gone into genuine investment, that is, into financing the formation of new capital, was instead going into stock market speculation. At the same time, there didn't seem to be any dearth of money for new capital investment.

The thinking was that during the short term there is a fixed amount of production that can take place in an economy — the "production possibilities curve," determined by the amount of existing savings, the "supply of loanable funds." This is because many of the experts believed that new capital investment is impossible unless consumption is reduced first and money savings accumulated; you cannot invest unless you have first saved. If more money is created than there is wealth in the economy, the value of each unit of currency declines and prices rise to that degree.

In the late 1920s, however, while the money supply was increasing rapidly and prices on the stock market were definitely rising, the currency seemed to be maintaining its value. The price level as a whole was not rising. So, the experts concluded (just as they do today), the rise in stock prices means that real wealth is being created. This is how Irving Fisher, who developed the Quantity Theory of Money equation, M x V = P x Q, could conclude that the U.S. had reached economic utopia.

In reality, of course, real wealth was not being created. What was rising was not the present value of existing marketable goods and services, but the present value of future marketable goods and services. As long as people had confidence that stock prices would continue to rise, it would not matter for the general price level as long as the rate at which new money was being created did not exceed the rate at which stock prices increased. If more money had been created than gamblers were willing to put into the market, they would have spent it either on new capital directly (driving up the price of capital goods) or on consumption (driving up the price of consumption goods).

When people realized that stock market gains did not create any new wealth, prices plunged. This also caused massive and almost instantaneous deflation due to gamblers defaulting on the huge number of margin loans. There were demands that the Federal Reserve start printing money to bail out the gamblers, but the chairman refused to violate the system's charter and engage in open market operations in speculative or non-productive securities.

As the value of businesses dropped drastically, both their creditworthiness and the value of the existing assets also plunged. Bills of exchange (backed by the present value of future marketable goods and services) and mortgages (backed by the present value of existing marketable goods and services) lost most of their value. Collateral was wiped out, and banks stopped lending for productive purposes just as they had for speculative purposes. Workers were laid off, people stopped consuming, and the economy went into a tailspin.

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