Why the Present Depression Will Be Deeper than the Great Crash of 1929   (June 4, 2009)

Galbraith's conclusions about the causes of the Great Depression point to why the current Depression will be deeper.

Continuing our analysis of The Great Crash of 1929 by John Kenneth Galbraith: by understanding the causes of the Great Depression as elucidated by Galbraith, we can observe the differences between the present and 1929. These reveal why today's Depression will be even deeper than the 1929-1941 one and why today's policy "fixes" as pursued by that great student of Depression, Ben Bernanke, are fighting the last war--a Keynesian stimulus strategy doomed to catastrophic failure.

I hesitate to call this topic "important" because such announcements instantly cut my readership in half. Thus I am inclined to call this topic "edgy," "explosive" and "contrarian," all of which sound more interesting than "important" (yawn).

Galbraith begins his exploration of causes by noting that "economics does not allow final answers on these matters. But, as usual, something can be said."

First, he demolishes the notion that abundant credit caused a speculative orgy.

The long-accepted explanation that credit was easy and so people were impelled to borrow money to buy common stocks on margin is obviously nonsense. (page 169) On numerous occasions before and since credit has been easy, and there has been no speculation whatever. Furthermore, much of the 1928 and 1929 speculation occured on money borrowed at interest rates which would have been considered especially astringent.

Far more important that rate of interest and supply of the credit is the mood. Speculation on a large scale requires a pervasive sense of confidence and optimism and conviction that ordinary people were meant to be rich. (emphasis added, CHS)

Next, Galbraith looks to the wellspring of credit which has been virtually nonexistent in our current speculative boom: savings. (Or at least domestic i.e. U.S. savings.)

Savings must also be plentiful. If savings are growing rapidly, people will place a lower marginal value on their accumulation; they will be willing to risk some of it against the prospect of a greatly enhanced return.

Speculative excess is somewhat self-regulating--or should be unless manipulated by the very state which is pledged to protect the economy from such excesses. Galbraith notes:

Finally, a speculative outbreak has a greater or less immunizing effect. The ensuing collapse automatically destroys the very mood speculation requires.

Moving from the causes of speculative excess to that of Depression, Galbraith rejects a cyclical cause: "No inevitable rhythm required the collapse and stagnation of 1930-1940."

As for the business cycle--expansion of plant, credit and inventory once over-extended, requires a contraction to restore balance--Galbraith grants it viability, but he rejects it as the cause of the Depression:

In 1929 the labor force was not tired; it could have continued to produce indefinitely at the best 1929 rate. The capital plant of the country was not depleted. In the preceding years of prosperity, plant had been renewed and improved.

Finally, the high production of the twenties did not, as some have suggested, outrun the wants of the people. There is no evidence that their desire for automobiles, clothing, travel. recreation or even food was sated. A depression was not needed so that people's wants could catch up to their capacity to produce.

So then what did trigger the Great Depression? Galbraith sets aside the speculative collapse itself for a moment and digs for problems in the real economy. He begins by noting worker productivity rose by 43% between 1919 and 1929 even as wages, salaries and prices all remained comparatively stable. This enabled increasing profits, which due to the large income disparities of the era, flowed largely to the well-to-do.

What did the wealthy do with this new-found capital?

A large and increasing investment in capital goods was a principal device by which the profits were spent. (page 175) It follows that anything that interrupted the investment outlays--anything, indeed, which kept them from showing the neessary rate of increase--could cause trouble.

The effect, therefore of insufficient investment--investment that failed to keep pace with the steady increase in profits--could be falling total demand reflected in turn in falling orders and output.

As I understand this, the proximate cause was a vast income disparity which placed much of the prosperous era's profits in the hands of a small wealthy class, who then mal-invested the profits. If that isn't ringing some bells in your head, then please recall that income disparity, which fell from 1946-1970 or so, has been rising ever since. Bingo--profits flowed increasingly into the hands of a elite wealthy class who then squandered/mal-invested the vast profits, undermining the entire economy.

Galbraith then turns to the causal relations between the collapse of the speculative stock market and the ensuing Depression. Once again, Galbraith fingers income disparity: 5% of the populace garnered a full third of personal income.

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both. The rich cannot buy great quantities of bread. If they are to dispose of what they receive it must be luxuries or by way of investment in new plants and new projects.

As the stock market crashed, those with the most to lose--the wealthy--found their cashflow and capital massively crimped. Since the entire economy was dependent on them spending and investing freely, the economy crashed, too.

You see where this leads in terms of the 1990s-2006 boom. The stupendous profits skimmed in the great dot-com boom flowed disproportionately into a few hands, who then mal-invested the gains (in a macro context) in a completely unproductive burst of overbuilt housing and commercial real estate. The ensuing bubble drew in all those who in Galbraith's words believed they deserved to be rich and as those hapless speculators crashed they took the entire middle class of homeowners with them.

Galbraith also fingers two other causes of the Great Depression: Faulty corporate structure and flawed banking structure. The parallels to the present are achingly obvious; here's Galbraith's terse description:

The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, imposters and frauds. This, in in the long history of such activities, was a kind of flood tide of corporate larceny.

As gargantuan as the flood of corporate larceny was in the 20s, the present era certainly exceeds it by a large margin.

Here is Galbraith's trenchant comment about the banking practices of the 20s:

Since the early 30s, a generation of Americans has been told, sometimes with amusement, sometimes with indignation, often with outrage, of the banking practices of the late 20s. In fact, many of those practices were made ludicrous only by the depression. Loans which would have been pefectly good were made perfectly foolish by the collapse of the value of the collateral he had posted.

The same, I fear, cannot said of the present: millions of guaranteed-to-default mortgages made to impossibly unqualified borrowers were never good nor prudent. The same can also be said of millions of auto/truck loans, millions of credit cards, millions of home equity lines of credit, etc.

Even worse, of course, the banks of the present era achieved heights of leverage via off-balance sheet derivatives, the securitization of mortgages and other financial legerdemaine that even the greediest, most venal bankers of the 20s could not even imagine.

Lastly, Galbraith blames "the dubious state of the foreign balance," i.e. the imbalance of foreign trade and flow of funds. In 1929, the problem seems to be that the U.S. was a magnet for capital inflows even as it managed a trade surplus. That imbalance doomed the global economy. Now of course we face the opposite imbalance but the same result will follow: the U.S. continues to run a staggering, unprecendented trade imbalance even as it sucks up an unprecedented share of global capital/savings.

Galbraith concludes: "Had the economy been fundamentally sound in 1929 the effect of the great stock market crash might have been small. But business in 1929 was not sound; on the contrary it was exceedingly fragile. It was vulnerable to the kind of blow it received from Wall Street."

You mean like the evaporation of $12 trillion wealth we've just experienced in the U.S.?

But the present is far more fragile and vulnerable than the U.S. economy of 1929, for the following reasons. In 1955 Galbraith could not possibly have foreseen or anticipated these current conditions:

1. A Federal government which since the "Reagan Revolution" of 1981 (e.g. don't tax and spend, just borrow and spend) has borrowed during so-called good times on a scale once reserved for rare Keynesian stimulus to combat serious recession. Thus we find ourselves at unprecedented levels of debt (comparable in terms of GDP to the entire cost of World War II) and our current Depression has barely begun.

2. A corrupt-to-the-core corporate structure riddled with bogus accounting, reliance on financial trickery for profits and misdirected/worthless regulatory oversight.

3. A banking sector of such debauchery and fraud that the excesses of the 1920s are reduced to the pranks of slighty-naughty choirboys and girls.

4. A Federal system of entitlements (Medicare, Medicaid and Social Security) which has grown far faster than the underlying economy for decades and now threatens the very solvency of the government itself, so stupendous are the future obligations.

5. A global military hegemony which costs more than all the other militarys and intelligence operations of the entire world put together. The U.S. military consumes more oil than the nation of Sweden (9 million residents).

6. An industrial, transportation and energy infrastructure that, rather than being rebuilt during the past 26 years of debt-based "prosperity," has crumbled in a long decline. Rather than invest in electrical power grids and energy-efficient transport systems, the U.S. squandered the trillions of borrowed dollars on toys, gewgaws, electronics made elsewhere, malls and commercial towers with only transient value and millions of bloated, inefficient poorly constructed homes no one needed or could afford: "assets" which were not productive at all, "assets" which are now capital traps on a scale heretofore unimaginable

7. A paucity of U.S. savings (and thus of domestic capital) with only one historical parallel: the depths of the Great Depression when unemployment was 25%.

8. A huge reliance on financial leverage, debt, borrowing and trickery for corporate profits; the U.S. exports soybeans, increasingly worthless dollars and "financial innovations" which are now exploding in economies from Ireland to India with the destructive force of superweapons. In exchange for this dubious paper, we have accepted actual tangible goods from the rest of the world.

They are now slowly waking up to the fact they've been conned on a scale few can grasp.

9. Globalization has reworked the global supply chain in an astonishingly brief period of time. As a result, the arbitrage of currencies (foreign exchange a.k.a. forex), wages, governance (less is more profitable) and environmental regulations (zero is the most profitable) have all placed advanced post-industrial economies like the U.S. at great structural disadvantages.

10. The U.S. claims to be competitive but much of this competitiveness is highly selective and thus illusory. Everything in the U.S.--labor, goods, buildings and taxes--is high-cost, overregulated (except for finance, banking and governance) and vulnerable to unpredictable lawsuits and officially sanctioned looting. Other than recent immigrants, non-U.S. employers find the workforce is often surly, unappreciative, narcissistic, entitlement-obsessed, unhealthy, poorly educated, unmotivated and more inclined to get-rich-quick schemes than actual enterprise or productivity.

The middle management labors under impossible demands to enrich stockholders next quarter and heavy turnover insures few stay in any job long enough to learn it effectively. Team cooperation is a doublespeak fraud imposed by "facilitators," creating a phony work environment where employees and managers alike pretend to care. This bogus environment breeds a looting, game-the-system mentality in which everyone is grabbing for all they can before retirement, restructuring, reassignment, resignation or getting fired.

A "quarterly profits are God" mentality reduces the workforce (even the good workers) to units of input which are pared back or hired without regard to morale or loyalty. This managerial and cultural pathology makes a mockery of worker loyalty and breeds the very qualities of distrust and "I got mine" attitude which undermines both productivity and workplace happiness.

11. Last but certainly not least, the U.S. economy is highly depedent on cheap, abundant fossil fuels--the very fuels which are in the global depletion phase, happy stories about unlimited natural gas and tar sands to the contrary.

For all these reasons, we can anticipate the Depression currently unfolding will be deeper, longer and more destructive than the Great Depression.

Let's recount the chain of events which partly parallel the Great Depression and partly diverge in meaningfully more destructive ways from that previous era:

1. The postwar income convergence (i.e the rise of the great middle class, the reduction of poverty and the relative reduction of the Plutocracy's share of national income) reverses in the early 1970s as the "true prosperity" of the postwar era ends and is replaced by income flowing increasingly to the top as stagflation, globalization and the decline of dollar gut the purchasing power of the middle class.

2. The rising productivity of the 50s and 60s slips to the flatline through the 70s and early 80s, only picking up again as computer software and hardware revolutionize the back office, sales, manufacturing, just-in-time shipping/production, etc.

3. Concurrent with this gradual return to productivity is the rise of finance as the key profit-center of corporate America. As income skews ever more heavily to the top 1%/5%, then capital (productive assets) become ever more heavily concentrated in the hands of the financial Plutocracy. The top 1% now owns some 2/3 of the nation's entire productive wealth.

4. As profits rise (from rising productivity) then the profits flow not to wages (which remain flat to down 1975-2009 for all but the top 10% professional class) but to those who own the capital.

5. As the middle class experiences a decline in their income and purchasing power (for reasons cited above: declining dollar, rising income disparity, and wages falling due to global wage arbitrage) then they turn more and more to borrowing and ever greater debt to fund what they have been brainwashed by the media to believe is "the American dream" of imported luxury goods, bloated homes, vacuous cruises, etc.

The only other mechanism available to the middle class to increase household income is for Mom/Aunt/Grandmom to enter the workforce, which she does in the tens of millions, with sociological consequences which are still unfolding.

6. This advert/media-driven desire to borrow to fund the "good life" is hugely profitable to the money-center banks, which expand rapidly into mortgage securization, derivatives and consumer credit to the point that they come to dominate corporate profits.

7. The financial Plutocracy, observing that actually producing goods is not very profitable unless you can fix prices as per ADM (Archer Daniels Midlands) or gain government subsidies and tax giveaways (oil lease depreciation, etc.) sinks its capital into the FIRE economy (finance, insurance and real estate), eschewing real-world investments as comparatively unprofitable.

Though rarely noted, this is a longstanding trait of capitalism stretching back to 1400-era Venice. When trade became less profitable than mainland farmimg, the Venetian Elite stopped funding trading and bought farms on the mainland. As a side effect, Venice ceased to be a military and trading power. But the Elite remained immensely wealthy.

8. As the tech bubble expands, middle-class investors see the Plutocracy (those with enough capital to qualify as angel investors and vulture, oops, I mean venture capital) reaping huge gains, and they enter the dot-com stock bubble buildup with a vengeance.

9. In a happy accident, the Soviet Empire collapses just as productivity begins its computer-fueled rise in the U.S. In a so-called Unipolar World in which U.S. military, political and financial influence is unrivaled, non-U.S. investors seek the relative safety and high returns (based on appreciation of the dollar) of U.S. financial instruments.

10. The dot-com bubble implodes in a speculative meltdown (dot-bomb), and retail investors (a.k.a. the middle class 401K investors) are devastated. The ephemeral wealth they once possessed, however briefly, fuels their speculative desire to get into the next get-rich-quick game, which just so happens to be "something everyone understands:" real estate and housing.

11. Having exhausted the dot-com play, Elite capital is seeking a new high-profit home. The miracles of derivatives (CDOs, credit default swaps, etc.) and securitized debt (mortgage tranches, etc.) open up vast new opportunities for leverage, off-balance sheet shenanigans and outright fraud/debauchery of credit. As chip wafer plants disappear from Silicon Valley (too dirty, too costly, etc.) then they're replaced with paper: mortgage-backed securities.

12. Sniffing gold in them thar exurban hills, the under-capitalized and over-indebted U.S. working class and middle class reach for the chalice of easy-money gold: leveraged real estate.

13. With the Federal financial regulatory agencies in a Republican/Democrat-enforced somnambulance, the coast is clear for brigands, shysters, fraudsters, con artists, liars, cheats, and assorted riff-raff in the realtor, mortgage and appraisal businesses, who all feed the ravenous maw of the money-center banks' apparently limitless appetite for real estate assets to securitize and leverage in exotic and highly profitable ways.

14. For a wonderful five years circa 2001-2006, the game is afoot and no-down-payment Jill and $100 million bonus Jack are immensely enriched. Meanwhile, the underlying real economy is becoming ever more imbalanced and ever more fragile as real production and real productivity plummet as everyone rushes to the speculative riches of exurban McMansions and malls.

15. This last best speculative leveraged bubble pops, gutting a Wall Street which had grown utterly dependent on leverage, debt, gamed/fraudulent accounting and bubbles for its rising profits.

16. Doubly devastated by the implosion of housing and their stock investments (mostly in retirement funds), the middle class faces the terrible consequences of its 26-year stupor of ever-rising debt and leverage. Alas, the Emperor's clothes are revealed as remarkably transparent.

17. Just as in the Great Depression, to its great surprise, the Elite has also suffered catastrophic losses and declines in capital and income.

18. Having borrowed and squandered trillions of dollars since 1981 on unaffordable entitlements, military misadventures and assorted worthless bridges-to-nowhere pork spending, the Federal government (The Fed and the Treasury) finds that its ability to borrow its way out of its current debt hole somewhat annoyingly limited. The rest of the world has finally caught on to the con, and Chinese university students are openly mocking Treasury Secretary Geithner's Orwellian claim of "we support a strong dollar." The miracle is that he was not pelted with tomatoes and tarred and feathered for making such absurd statements.

19. With the global media concentrated in a scant few corporate hands (less than 10), this pulling away of the curtain is deleted/excised from media coverage in a ruthless campaign of pure "green shoots" propaganda.

20. As the wheels fall off the U.S. economy and the bubbles cannot be re-inflated, fruitless attempts at holding back the tide with incantations (stop, tide, I am Obama/Geithner/Bernanke!) and loopy sand castles (the bottom is in, buy now! Green shoots are sprouting everywhere except in the real economy!) abound. Unresponsive to propaganda, the real world grinds down into a global Depression without visible end.

Is this "edgy" enough to be worthy? I hope so.

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