Thoughts on the political-economy and current crisis



Modern progressives face the same problem that beset Roman emperors, English kings, and French revolutionaries (among many others). They don't have the money to pay for their plans and projects. Worse, sufficient money does not exist The solution all have tried is to create more money. The next problem, then, is that the more money they create the more they need. The value of the new money and all the previously existing money decreases as the volume increases. Creating more money does not increase wealth. But it does facilitate the rulers' ability to redistribute it. Earlier rulers were limited to debasing their money - by clipping coins, for instance. The French revolutionaries printed paper money but it also failed as it drove good money out and had to compete with other forms of money and other countries. But today modern progressives have put the entire world on the same system of unlimited fiat money. This makes the expansion of any individual currency become relative to the others. Its expansion can potentially bring the value of money itself to zero. Lenin actually tried this in the Soviet Union by purposely printing huge amounts of money, as the Bolsheviks believed that they could eliminate money from use in society. They failed.
So after nearly a century of expanding dollar growth and depreciating value here we are at a blow-off of the credit crisis. To understand the current political-economic situation and policies being advocated by governments and others we need to understand money - its origin, nature and function. This means also banks, as that is where the money is (and where most of it is created). The control over the creation of money from ancient times was an element of sovereign power. It still is specified in the U.S. Constitution as the sole power of Congress. However, since the late middle ages and Renaissance in actuality banks, gold smiths, and similar groups have been creating money. Modern governments have delegated control of money to central banks. Other organizations and institutions have also become creators of money. But control remains a very controversial issue. There are really only two options - give governments control and watch the politicians manipulate the money for political purposes - or give private banks control and watch them struggle to remain independent thus preventing politicians from having it their way. The second has been found unacceptable all over the world. Jack Weatherford in his book 'The History of Money' points out that today there is a major conflict raging in the world over the control of money. This is discussed in more detail below.
In this essay I attempt to bring together ideas found in a variety of references, most of which are given in the bibliography.

Part I


What is happening now?
We are witnessing the blow-off of the fourth epochal inflationary period in world history since the 12th century and its resulting deflationary period. The current events circa 1995-2009 are very similar to those of the periods (1350 - 1400): (1660-1670); and (1815-1820). We are also witnessing the frantic efforts of bureaucrats world-wide whose livelihoods depend on their administrating the 'welfare state' and politicians whose power depends on their maintaining the votes of interest groups held in thrall by subsidies in the name of the 'welfare state'. The process will be described in Part IV.

Why Now?
Globalization has suddenly added a billion or more low wage workers to the world economy, thus driving down average wage rates, while technology has vastly increased productivity and reduced the cost of transportation and communications. As during the three previous rapid shifts from inflation to deflation, both wage rates and prices of assets have fallen and must fall to reach a new equilibrium. However, in contrast with conditions in 1350, 1660, and 1815 today labor unions in high wage countries and their subservient governments have power to attempt to prevent the decline of wage rates while also demanding 'full' employment.


What else is unique and different this time?
The great inflation wave of 1896-1995 coincided with the creation of the 'welfare state'- the culmination of the process that created the 'nation-state' in the late 19th century. No such state existed in the first inflationary price revolution - 1180-1300. During the second price revolution -1480-1660 the modern state was created, but in its princely and kingly forms. Those governments did not have either the tools or interests of the populace. It was only with the creation of the nation state based on a legitimacy providing promise to care for its citizens that such concerns became paramount. The third price revolution saw the state transformed into the territorial state, one indifferent to the welfare of its inhabitants. But none of these constitutional forms had the desire or ability to manipulate as governments do today. Now governments have immense power to try to control the political economy. Nevertheless the 'welfare state' is doomed by the fiscal impossibility of it fulfilling the promises to the subjects on which its legitimacy rests. And the nation state itself is being transformed into a new constitutional configuration that may be termed a "market state." In this process we can see that the bureaucrats and politicians will stop at nothing to prevent wages and prices from reverting to their natural lower level. These promises of the controllers of the 'welfare state' - that of expanding entitlements to all types of welfare - most recently to 'affordable housing' as well as life-long medical care, and higher education rest on a regime of continually expanding credit=debt supported by gradual inflation and made possible by fiat currency. This is the feature of the 20th century inflationary epoch that differs it from the previous three periods. The past inflations in other words were not exacerbated by government demands, apart from those related to direct devaluation of coinage.
The phenomena has similar features in all the industrial (developed) countries. In the U.S. it was established in 1913 with the twin acts that created the Federal Reserve system to control credit expansion and the income tax to provide the financial back stop necessary to have confidence in this credit regime. Prior to this time in the U.S. local and then New York City banks alternately expanded credit via bank paper (until confidence evaporated) then suffered panics in which the whole economy suffered, and then embarked on a new wave of credit expansion. But these episodes were short and limited. Nevertheless the banking community desired for the U.S. to have an European (British) type of central bank. In the 19th century banks failed because they did not have assured backing. Only the 'full faith and credit' of the U.S. government could support a central bank system and that required that the government have unlimited taxing power. Thus the interests of the bankers and the progressives in government coincided and created the dual features of the 20th century. At the same time this meant that the government was delegating to this central bank system its Constitutional function - the creation of the nation's money supply. But the result has been to turn what formerly were localized and brief bank panics=failures into a full scale systemic financial failure. This is explained in a later section. But this was only the first step. There were several expansionary bubbles and subsequent contractions, culminating in the events of 1929-33. By then the shift to a totally fiat money had not been completed. It became apparent that credit could not be expanded indefinitely as long as the currency was tied to a fixed gold standard. Thus the abandonment of the 'barbarous relic' and the advent of fiat money was accomplished in two steps by Presidents Roosevelt and Nixon.
The end of the 'nation state' was described by Philipp Bobbitt in his essential book - 'Shield of Achilles' - The shift from a century of inflation to a period of deflation was described and predicted by David Fischer in his book - 'The Great Wave' - and the two together constitute a fundamental explanation for current events. They will be discussed below. But there are many other significant references, which will be listed below as well.
Returning to the initial question: We are not in a recession, we are not in a depression. Rather we are experiencing the much more traumatic features of a world-scale deflation after a century of massive credit expansion. And the trauma is being made all the worse by the desperate efforts of politicians and bureaucrats and their special interest groups to thwart - overturn - the normal working of the historical process. Rather than fight the problem, governments should be assisting every one to adjust to the new reality. This does not mean 'do nothing' as doctrinaire believers in the 'free market' advocate. There is no such thing as a 'free market' and never has been. What the public thinks of as economic activity has always been strongly influenced if not directly controlled by political activity. This is because in the real world individuals are not willing to accept the results for themselves that would flow from an unbridled economic activity of a 'free market. This also is described in a later part.

Part II

Let us step back and consider fundamentals.



What is the 'economy'? In theory, it is a process and a result of the process.
As a process - it is the non-coercive process in which limited goods and services having multiple uses are allocated ( rationed) in order to optimize the results for the benefit of society as a whole. The goods and services include material and immaterial things such as haircuts, iron ore, honors and glory, rice and everything one would expect. As a result it is the totality of transactions and their outcomes that we normally think of as economic plus many more.



What is politics?
It is a process and the resulting structure established to perform that process. As a process - it is the coercive process in which limited goods and services having multiple uses are allocated to achieve the objectives of rulers ( or leadership) of the political structure that is created to conduct the process. The purpose, then, of politics is to shift outcomes, distributions, allocations of goods and services from what they would otherwise be absent the application of coercive measures.
As one can see these two categories operate on the same thing - the allocation of goods and services. They are totally intertwined to the extent that in the real world it is politics that almost always governs the results and the results that might flow from 'economy' are theoretical. But the uttermost application of politics - its resort to coercion - cannot deliver outcomes that economic fundamentals cannot or could not provide. Thus the two sides of the same phenomena work continually together. In this sense politics is referred to as the 'art of the possible'.


Market -
The market is the arena in which the allocation process takes place. The process:Man (generic) enters the market as both consumer and producer. He is a consumer first by necessity as he must have food, shelter and clothing; and second by choice as he can choose what other goods and services he may desire at any given moment. He is a producer first by choice as he can to a degree select what goods and services (if any) he wants to produce (restrained by such factors as geographical location and abilities); and second by necessity to the extent that he may be required to produce something to exchange for the goods and services he needs to consume. But note that there are people who do not need to produce much or anything in order to have all they desire to consume (South sea Islanders) and frequently, absent the necessity to produce in order to consume, there are individuals or groups in advanced societies who will opt not to produce. Many others find that they can produce all that they need for themselves so do not take the trouble and risk to produce extra for other people. For instance, this was the option taken by many peasant farmers in Russia in the 1920-30's which necessitated the Bolsheviks to employ coercion to extract produce for the city workers. Whole societies may be aculturated to accept both relatively low production and consumption of material goods in favor of expanded liesure. Man also enters the market, then, as both buyer and seller. He will want to buy at the lowest possible cost while selling at the highest possible price. This obviously establishes an inherent source of conflict. In a pure (that is non-coercive) economy buyers and sellers would reach consensus - cooperation and agreement - on the prices for sales and purchases. This is what Adam Smith meant by the 'hidden hand' at work.But very many men are not satisfied with the results they can achieve by this pure - non-coercive - economic process. This is where politics comes in. Man frequently also becomes either a debtor or creditor - -again, the debtor hopes to repay at least actual cost while the creditor hopes to gain the maximum possible from his loan. This also generates an inherent conflict and again, since so many are unwilling to reach an agreement, coercive politics enters the picture. The impact of this conflict is seen in the struggle over the supply of money. Since debts and credits have come to be expressed in monetary terms this has become a major factor.
The conflict between debtors and creditors also results in conflict over the money supply itself. Discussion of the roles of money will be deferred. But here one should note that deflation - that is a reduction in the amount of money relative to the demand for it in commerce - meaning the value of the money itself increases - results in debtors being hurt because they have to repay debts with more valuable money, thus they oppose it and favor inflation - while creditors (lenders) would like deflation in so far as they receive payments in more valuable money, But lenders don't like and will try to avoid so much deflation that their debtors actually default on loans. Debtors like inflation as they can repay debts with cheaper money. While lenders do not like inflation (unless they can institute a system to benefit themselves by control of the interest rates they receive for their loans). That is creditors may accept inflation if they can increase their return on the debts of others faster than the value of the debts themselves decline. Or they can leverage the debts they own their depositors into a sufficiently large number of loans.
So banks are both debtors and creditors - they borrow money from depositors or from other investors (bonds) and lend to individuals or businesses. To make a profit, obviously a bank must have lower payments for its debts - the interest it pays on deposits or on loans obtained - than the funds it receives from interest being paid on its own loans. There are two ways this can be accomplished - one is to borrow on short term at lower interest cost and lend on long term at higher interest received. This can be successful but it is dangerous. It may be made more secure when government by law sets a maximum rate on interest banks will pay (such as S&L banks prior to the 1970's) A better method is to leverage - that is use the funds borrowed (deposits or bonds) as a basis for then lending at multiple amounts to the sum borrowed. This was the insight first recognized (as far as we know in Western history) by the gold smiths and family banks of the late Middle Ages and Renaissance. Commercial banks that take deposits from the public normally are allowed in the order of 11 to 1 leverage - they loan out 11 times as much money as they have borrowed (including deposits). This way they can make money even if the interest rate they are paying on the small borrowed fund is somewhat higher than the interest rate they are receiving from the larger quantity of loans they have made. In other words banks also can profit in inflationary times but not so well in deflationary times, if the extent of the deflation forces bank debtors to default. But in recent years many organizations (- investment banks - GSE's - hedge funds - commercial companies like GE and GM) have been able to leverage at 30 or more to one - even sometimes up to 50 to one. At 50 to one a very small decline in the interest received versus the interest being paid can result in bankruptcy. The result of all this banking - financial institution - operations is that they are critically interested in both interest rates and inflation - deflation of the money supply. Their interest of course results in political efforts to manipulate both. Thus the struggle over the money supply is added to the other intrinsic conflicts mentioned above. Banks have always lent to governments, thinking that such borrowers would be more stable than individual borrowers. But to their chagrin medieval and even modern banks found out otherwise when sovereign borrowers defaulted. This is why when the banks created the Federal Reserve system they demanded that the U.S. government also institute an income tax, thereby establishing the fail-safe connection between government bonds and the taxation of the public.
Thus the proper name for the total production-consumption, buying and selling, activity is the political-economic sphere or area. And this was the name given to it by the classical philosophers and authors. Unfortunately of late the name has been shortened to 'the economy', but this seriously obscures at least half of the full process and leads the public to fail to recognize the very significant political component in all human activity. One might relate this to the academic specialization that has created separate departments of economics and political science in our leading universities. It also leads academic specialists to focus either on 'the economy' or on politics. It is the basis for so much application of mathematics and statistical analysis to the 'economy' as if it were in reality that theoretical model I noted above - as if results were not in fact so largely the result of political activity rather than a pure - non-coercive transactions. Thus a key element in the functioning of the 'economy' is outside the pervue of the econometricians' models.

This is the sum total of the political structures created to apply the coercive measures necessary to alter the outcomes of political-economic processes in favor of some and in disfavor of others. It should be noted that the government itself is composed of individuals who have their own preferences as to the outcome of the political-economic process they are entrusted to conduct.
"Free market':
The 'free market' is that arena that would exist in theory as described above in a purely economic process - that is one absent coercion. Do we have a 'free market' today? NO we do not - nor has one ever existed except possibly for some very narrow good or service in which there is little individual interest - nor is one likely to exist in the future. The reason no 'free market' exists is because so many people - maybe the majority - do not want it to exist with respect to those goods and services that they consider important. As I pointed out above they are unwilling to abide by the results a real 'free market' would deliver.
Adam Smith coined the term 'hidden hand' and described its potential working in a 'free market'. But his book is of the genre of 'utopia'- philosophical works - like Thomas More's "Utopia". Adam Smith was showing that the then existing political-economic regime - 'mercantilism' was faulty. Many people recognized this and bought his arguments - but when it came to incorporating them into real life, most people declined to do so. (or at least those having political power refused). Adam Smith and his generations of philosophers thought and wrote in terms of political-economy. In 'Wealth of Nations' Smith posited political, cultural, social conditions that would make it possible for the 'free hand' to exist. But they do not.
Today we have politicians and public speakers who claim to want a 'free market' and we have others who claim that the 'free market' has failed and that government intervention is necessary to 'fix' the situation. But both groups are wrong. The one does not really want to abide by the results of non-coercive economic processes, while the other refuses to admit that already from the start it has been government - instituting the coercive political agendas demanded by various groups - that has prevented the 'free market' from existing. The 'free market' has NOT failed, it has simply not existed. So much of the learned discourse on the issue is beside the point and confuses the public. Now whether or not the government - that is political -interventions that distort the potential results of a true free market are 'good' or 'bad' - that is favorable or not - is a political and not an economic issue. Obviously the same outcome will be favorable to some and injurious to others, which of course is the point of the political intervention. But from a pure 'economic' point of view the politically created distortions can only reduce the total results otherwise obtainable. Note also, that if a 'free market' did exist, then government would be unnecessary - a source of inherent conflict of interest. Lenin grasped this fact when he described the social environment that would achieve the 'withering away of the state' - namely 'from each according to his ability to each according to his need'. (See State and Revolution)
Further, we might note that at any given instant in time the total productive capacity of a social system is fixed by the quantity and quality of the factors of production. (Land, labor, capital, ). Government can do nothing to increase this instantaneous capacity. The rate at which this productive capacity can grow is also fixed by the natural growth in the quantity and quality of these factors of production. Government can and often does influence this growth process by its use of coercive measures to divert parts of the factors into alternate uses. This also is a political process. The result will appear favorable for some segments of goods or services, but at the expense of others. The result is that political intervention can twist the outcomes of economic activity but cannot increase them beyond what non-coercive economics would otherwise produce. And the net effect of this government intervention is negative.
Now, back to the debtor -creditor relationship. Since government is itself usually the largest debtor, it favors inflation - in fact over the centuries it has been government that has engineered - created - inflation by debasing its own currency (changing the metal content of coins - increasing the printing of paper money). Governments have always suffered - even been overthrown - when deflation could not be prevented. David Hackett Fischer in his book - 'The Great Wave: Price revolutions and the Rhythm of History' - describes the alternating waves of inflation and deflation that have swept over Europe since the 12th century.

There are three functions that money should perform - the physical or notional item that serves as money can be anything, sea shells - wampum - great stones - iron bars, cattle, whatever, even pieces of paper. Money is used as a measure of account - that means book keeping of the accounts for transactions of buying and selling are recorded in a unit called money - this unit need not be used in actual commerce - for instance the British pound sterling was a unit of account while no such pounds were in circulation. Money is a facilitator of actual transactions - rather than using barter methods when goods and services are exchanged, money is a convenient representation of the values involved and can be more easily exchanged. Money is a store of value - this important function is the one most fraught with peril. Through history there have been exceptional units of money - Athenian, Venetian, Florentine - that kept their value due to the rigorous attention of the monetary authorities. These coins were famous because they were so unusual. But more frequently the monetary authorities - the rulers - sovereigns - finding themselves short of the quantity of money they needed, would debase it - increase its quantity by reducing its quality. Debasement of coins involved reducing the content of the precious metal (silver or gold usually). But history shows that it is paper money, especially when not strictly connected to a standard in precious metal, that has always been debased by the issuance of increasing quantities and often in larger and larger denominations. (Imperial Rome - Weimar Germany -Zimbabwe - Continentals in American colonies and Confederate money - medieval China)


Part III

Some historical background:
In 1996 David Hackett Fischer published "The Great Wave'. He predicted that the inflationary wave of the 20th century was ending and that the 21st century would see the beginning of a new deflationary era. Inflationary waves are characterized by increasing prices and expanding money supply, while deflationary waves see declining prices and shrinking relative money supply. Fischer's description of the chaotic conditions that exist during the late stages of the inflationary wave has come to pass since 1995.Sure enough 2000 came with three characteristic causes of deflation - vastly increased productivity (more cheap goods) massive decrease in transportation and communications costs, and entrance of billions of new workers at lower wages into the labor market.
As noted above, inflation favors borrowers and deflation favors creditors since debts may be paid off in inflation with cheaper money. In the past the governments resorted to debasement of coinage - clipping and changing metal alloy. Later they expanded the money supply with devalued paper money. Banks too, even though they are lenders, generally favor inflation if they can lend more money at higher interest rates. But they dread the bankrupt default of their debtors; something that happened repeatedly in history when sovereigns simply defaulted on their debts. The last half of the 19th century was a time of deflation, as greatly increased agricultural and industrial production, and expanded and cheaper transportation drove prices lower and lower, hurting debtors and 'crucifying them on a cross of gold."
.Something had to be done. Great Britain seemed to have created a solution already in the early 18th century will the Bank of England. But no similar financial institution existed in the United States. A group of leading bankers with European banking experts and key politicians met secretly at Jekyll Island, Georgia to devise a scheme. Out of this meeting was created the Federal Reserve Bank system and the Federal Income Tax. The bankers applauded silently while the politicians feigned ignorance.
The two developments were linked essentially. The purpose was to create a system that would protect the big bankers and enhance their profits. while preventing deflation by creating a steady inflation. Although progressives regularly denounced 'big banks' they saw their objectives furthered by the same system. The system works this way:
The U. S. government will borrow from the banking system. Prior to that the U.S. government did not have much if any debt and its expenditures were met by tariff and fees. It did not need much debt as its role in society did not require much expenditures. The controversy over banking and a potential central bank began with Hamilton and Jefferson and continued with Jackson and Biddle. Banks take deposits from individuals and offset this expense by lending multiple amounts. But the banking system relies on the Federal Government debt, as a solid basis for its capital on which it can leverage more loans. For instance during the battle between President Jackson and Biddle, the ability of the President to designate which banks would receive Federal deposits was critical. At the same time (1913) the new Federal Income tax provided the government with a potentially unlimited source of funds with which to repay any debts to the banks. This effectively solved the perennial problem of a sovereign defaulting on its debt to the bankers. The bank loan to the government is in exchange for a bond paying the bank an assured long term interest profit. But this is only a small sum. The bank then uses this new asset (government bond) as the basis for lending 10 - 11 times as much capital to other borrowers. Banks could and did use the deposits of their individual customers as the basis for leveraged loans, but those deposits were unstable and could be called back at a moment - forcing banks to call in their loans or default. But the government bonds need not be called, and in fact can be expanded if private deposits are withdrawn. The government itself and the other borrowers spend the newly created money. When the volume of the newly created money exceeds that amount necessary for daily commerce its value declines - ergo inflation - cost of goods rises.The government and other borrowers can pay back their loans (bonds) with less valuable dollars. But the bank is not hurt because the payments will be for 10 times as many dollars as it originally had. As long as the rate of inflation is kept lower than the interest differential the bank receives from its loans versus payment on its deposits all will be well for the banks. As part of this system, also the government by law set a very low interest rate depositors could receive on their money at the bank.Of course society finds that the role of the dollar as a store of value - savings - is declining. But in those days people could do little about it. But when the opportunity to invest and the prospect was published that investments would return interest greater than the loss from inflation more and more people flocked to buy those investments (the new money market funds) . Of course this channeling of depreciating dollars into a narrow range of stocks created inflation in their nominal value.

Part IV

Inflation and deflation in the United States in the 20th century:
Both John Mauldin and Martin Weiss have web sites at which they publish volumes of information on this subject. Several of the reference books discussed below also explain modern inflation and deflation. The basic concept is that change is taking place irregularly but continually - things are either getting better or worse, greater or smaller, et cetera. The world has seen waves of inflation alternating with deflation - inflation means prices rise - money supply increases more rapidly than productivity supplies more goods, thus the value of a unit of money is reduced (prices rise) Deflation means money supply is not rising as fast as productivity and may in fact be falling relative to the sum of goods on the market. thus prices fall as money itself increases in value .
The last third of the 19th century was a period of rapidly expanding production - in both agriculture and industry - and decreasing cost of transport - leading to expansion of the world market - but money supply was not growing over all (only occasionally as a result of several spectacular gold rushes). Hence the deflation that William J. Bryan called 'crucifixion on a cross of gold" - Bank deposits and the loans banks issued on their basis varied but in general were insufficient to create enough money. The last third of the 19th century also saw the shift from the structure of the 'state-nation' into the 'nation-state', which developed into the 'welfare state' as initially formulated by Bismark in Prussia. The claim to legitimacy of the 'welfare state' rests on its promise to provide for the 'welfare' of its citizens. They in turn are increasingly pressured to swear their allegiance to 'the state' above all other claims to their support.
The European states led by Great Britain (which had established a central bank in the 1690's that was crucial in financing Great Britain's wars) expanded their financial systems necessary to fulfilling the promises of the 'welfare state'. But as of 1900 the U.S. did not have a central bank. The periodic bank panics resulting from alternate expansions and contractions that reached a height in 1907 were cause for increased pressure on the U.S. to move to the European state model - that is create a central bank. The promises of the 'welfare state' rest and rely on 1 - redistribution of wealth from those who create it to the larger public that does not, but there is not enough wealth being created to supply the demands of the politicians for largess to their supporters. This leads to 2 - a gradual inflationary financial system that will enable to state to pay its promises in money of reduced value. For both an Income tax is essential - 1 it is part of the engine for redistribution of wealth and 2 it is critical for support of the central bank and the creation of government debt. The tax was and is considered critical due to the history of so many sovereigns simply canceling their debts at the cost of the banks. But taxation cannot fill the need for more wealth to distribute. To fund all this requires a continual expansion of the money supply - and that is not dollar bills, but rather credit founded on leveraging debt. This is the function of the Federal Reserve System and the banks. But as the 20th century demands for more and more credit expanded many non-banks were enlisted in the credit creating process.
The central bank (FED RESERVE) loans money to the government in exchange for bonds - in other words the government not only incurs debt to pay for expenditure programs (transfer payments) beyond those paid for by taxes, but also to provide a solid asset to the central bank. The central bank is authorized to issue money based on the full faith and credit of the US government - Historically banks were always in danger of the case when the sovereign power was their debtor and simply cancelled the debt. But the Income tax insures that the U.S. central bank can lend to the U.S. government with full assurance of repayment. This assurance is critical to enable the government to obtain loans - that is sell bonds. Meanwhile the central bank uses government debt (on which the government is paying interest) to fund loans throughout the society (in the past via banks) on which it also receives interest. This system then is propagated throughout the banking system. The key to understanding is that the U.S. government and whole banking system rests on debt=credit and that this REQUIRES continual inflation - but inflation at a slow rate so as not to cause reaction by the public. A low rate of inflation is essential. It must be below the interest rates the banks can obtain from long term loans (bonds). In the 1970's the American public became so alarmed by continual government created inflation that it demanded that Congress index its many benefits to inflation. This defeated much of the government inflationary agenda, but alternatives were found. After 1913 came World War I, then short cycles in reaction to it of excessive inflation and deflation (triggered largely by changes in agriculture, then by expanding industrial production - and all disfigured by the reparations bill from the war. The final inflationary phase grew until 1929, fueled by a large expansion of the number of individual investors who didn't know any better. And by a banking - brokerage system that flooded the market place with credit=money. But eventually a climax was reached when there were no more buyers ready to purchase from the sellers.
But the big problem came after the initial phase of a decline in value of stocks. The Fed Reserve and government did the opposite of what they should have done. Faced with a deflation in the effective money supply due to the initial contraction of credit, they constrained it further, reducing credit rather than expanding it. The new FDR government then used the crisis of the Depression to institute further controls over the economy and financial system. Skipping over World War II and its results we come to the post-war period. Now the Fed government and FED reserve are back in sync and trying to maintain a financial system based on slow and steady inflation. They try to match increases in productivity with just the right amount of increases in the money supply. Among the regulations is that individual savers in banks and S&L accounts can only receive a very small rate of interest relative to the rates banks charge and the rate of inflation. Throughout the period the government thus was able to confiscate more wealth from the public via inflation than it took from income taxes and use it to maintain not only immediate transfer payments but also the appearance that its future promises could be paid. But the result of all this was a credit cycle during which there were 'bull' and 'bear' markets as credit and money expanded or contracted even to a relatively minor degree. Since the 1920's the economic basis of the US has been expanding consumption. The GDP itself increasingly is made up of consumption rather than production, but consumption is essential to generate production, otherwise there will be unemployment . The CPI is fudged to indicate lower than real inflation. And the government is expanding its promises (Social Security, Medicare, low cost housing). But the 'welfare state' government also had the mission of providing 'welfare' that is attempting to insure employment, lower cost housing, increasingly health care, and the like. All this also cost money.
Much the same activities were taking place throughout the developed world.
So we come to 2000 - 2001. The FED has just engineered a huge expansion of money in fear of Y2K and then a contraction of money when that proved unfounded. But more significant - we now have a newly developing world-wide political economic structure. The classic origins of deflation are rampant - greatly expanding productivity, rapidly decreasing costs of transportation and communications, and a vast new several billion strong labor force that works for minimum wages. In 1996 David Hackett Fischer predicted that the era of inflation was ending and the 21st century would start with a renewed era of deflation. (But governments cannot stand deflation).
Meanwhile the US public is urged to buy and spend - increase consumption at expense of savings. The consumption is fueled by expanding money supply which is being used to pay foreign producers for finished goods and energy. The FED alone can hardly expand the money supply by itself. The entire banking system must generate credit (based on debt) to stave off deflation. The leaders of the welfare state push to expand its entitlement programs and increase the volume of wealth transfers, which requires more credit expansion. Then we have a reversal in the commodity segment of the economy. The rapid expansion of productivity is now requiring more and more use of raw materials and energy by the foreign manufacturing countries. The foreign labor force is gaining wealth and expecting higher living standards based on increased consumption also. Record amounts of U.S. dollars created by the monetary expansion engine are being held by foreign central banks. The world-wide supply of money is becoming insufficient. That means deflation again became a likely outcome. More monetary expansion is necessary.
In past centuries no one had the monetary power to maintain an inflation and block deflation, and of course no one knew the causes of what was going on anyway. But now at least the monetary authorities know what is going on. Unfortunately when inflation is fueled by monetary expansion via credit and debt the system constantly needs more and more credit in order to keep the expansion going. The excess liquidity is creating problems for investment houses - hedge funds, foreign governments, and investment banks and all - they need a place to invest this paper capital. This fits neatly with the government program to expand home ownership including ownership by low wage families that cannot afford normal purchase requirements. So standards for mortgage loans are reduced - clever, crooked brokers get into the act, just like they did during the South Seas Bubble. People are urged to borrow on terms they do not understand. The foreign banks that have excess U. S. dollars also 'invest' in these mortgages. The government sponsored lending institutions, GSE's, begin loosing market share even with their favorable tax and borrowing standards so they also proceed to fund faulty mortgages with the credit they obtain by borrowing. But there is an inherent conflict - the more buyers enter the market for homes the higher the prices, but the price increases make it more difficult for the more buyers to qualify for loans. So the loans become more and more risky. Then the financial institutions create another level of risk. They sell insurance that is claimed to pay off to the lender if a borrower defaults on a loan. The insurance company collects a premium as usual. But it calculates its risk on the same basis as for instance fire insurance - the more policies it writes to spread risk the better since it is not likely that many houses will burn at the same time. But it is indeed likely that if any mortgage loans default then many will. The insurance companies don't have enough capital to cover their losses. Of course the home building industry also sees great profit potential and builds 3.5 million more new homes than normal growth would require. As occurs in every inflationary bubble, at some point there are not enough new buyers, even at reduced quality, to continue to pay more for homes at the inflated prices. The bubble bursts just as the tulip bubble burst in Holland. Now everyone is in trouble. The total amount of the credit instruments is in the multiple trillions of dollars - and no one knows whose assets are covered by whose liabilities and reverse. A credit freeze is created as lenders are afraid to loan to anyone. This quickly includes also consumer credit - car loans - commercial and business loans and more.

Part V

Bibliography and comments:

David Hackett Fischer - The Great Wave, 1996
Fischer was more interested in study of the forces that created the 'great waves' and their results than in the detailed study of their subsequent deflations and equilibrium periods. Therefore he described and evaluated seven 'causal models' that have been advanced in the historical literature for the inflations - the 'price revolutions' as he terms them. These are monetarist, Malthusian, Marxiast, agrarian, neo-classical, environmental and historicist. Each wave was different in its particulars, but similar in general features. Here is his description of the phases:
The first stage 'silent beginnings' had a slow advance - 'prices rose slowly in a period of prosperity'
The second stage occoured when prices broke through the previous boundaries - sometimes as a result of war or other outside events.
The third stage began when people discovered that they were in a long-term price inflation. They tried to counter it or protect themselves, making changes that drove prices even higher.
The fourth stage - institutional inflation - higher prices - unstable prices - increasing volitility - money supply expanded and contracted violently - social imbalances increased.
Finally the 'great wave' crested and broke with shattering force. The final result was falling prices, rents, interest - short, sharp deflations followed by an era of equilibrium . Fischer was writing during what he recognized as the final chaotic period at the end of a great inflationary wave. He decribed the charateristics of the late 1990's, comparing them with the typical characteristics of the final phases of the previous three great waves.

Philipp Bobbitt - Shield of Achilles,


Ludwig von Mises - Human Action: A Treatise on Economics, 3rd edition, Henry Regnerhy Company, Chicago, 1949, index. Socialism; an Economic and Sociological Analysis


John Mauldin - Bull's Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, 2004
We are in a long term bear market. Mauldin describes the broad trends for the coming decade. The period to 2010 will be much different from the 1980-1990's. Now stock markets have high valuations, interest rates are extremely low, the dollar is declining and there are huge deficits in the foreign trade balance and government debt. This means a secular bear market. In bear markets the 'buy and hold' strategy will not work - one has to focus on absolute returns. The bench mark for judging investments is the money market and success is in beating the return of Treasury bills. One must carefully control risk. Bear markets may last 8 to 17 years. But the general economy will do just fine eventually.

George Soros - On Globalization, Public Affairs, NY., 2002, 191pgs., index.
The author provides an excellent description of the details of the financial crises of the late 1990's. He brings together the traumatic but separate events that tend to be, if not forgotten, at least thought of in issolation. Taken together, these financial crises and the reponses of governments to them describe what Fischer saw as the final crest of the great wave of the 20th century inflation. Soros also describes in terms of globalization at least a part of the causes of these crises. Unfortunately his prescriptons for increased rather than decreased government intervention and regulation would only shift the outcomes in other directions. Soros has some very interesting ideas, such as this. " Japan, for instance, had built up a very efficient industrial system, but its financial system was geared not to obey market signals but to take instructions from the Ministry of Finance. When financial markets opened up, the financial system frittered away the wealth that the industrial system generated, Japan is mired in a financial crisis from which it seems incapable of extricating itself." Yet Soros advocates increased government controls. And this gem, "Sovereignty is an anachronistic concept. It has its origin in the GTreaty of Westphalis (1648) concluded after30 years of religious warfare. It was decided that the sovereign could determine the religious of his subjects: cuis regio eius religio. When the people rose up against their rulers in the French Revolution the power they captured was the power of the sovereign. That is how the modern nation-state was born, in which sovereignty belongs to the people. There has been a tension between the nation-state and the universal principles of liberty, equality and fraternity ever since." Soros has this mostly right. See Bobbitt, Shield of Achilles for a better description. Soros continues, "It may be anachronistic, but the concept of sovereignty remains the foundation of international relations." But he advocates that states cede as much sovereignty as possible. He apparently has views on the future of the nation-state similar to Bobbitt. But his for sure disagrees with the whole body of thought of Ludwig von Mises and the Austrian School.


Kenichi Ohmae - The End of the Nation State - 1995
The author's thesis is that the political structure of 'nation states' cannon meet the needs of future society under future economic conditions. The political-economic forces at work have already raised troubling questions about the relevance


Fredrich A. Hayek - The Constitution of Liberty, Gateway Ed. 1959, 570 pgs, index, footnotes.
This is one of the basic books on liberty (or freedom) versus socialism. The author writes that the basic principles of western civilization's concept of freedom have been under assault for so many years that the public has even lost understanding due to confusion, despite valiant efforts to clarify the issues. The first part seeks to show why we want liberty and what it does. The second part examines the institutions of Western civilization that were developed to secure individual liberty. The third part tests these principles by applying them to current critical public social and economic issues. Among the many valuable sections the author discusses socialism in contrast to the concept of the 'welfare state'. He notes that this modern concept originated in the Prussia of Bismark. He shows that, although propagandists for the 'welfare state' focus on benign issues such as state provision of aid to the poor and provision of public amenities, ultimately the coerceive power of the state enters the picture and liberty of individuals is curtailed. For instance, he notes that labor unions have become 'uniquely privileged institutions to which the general rules of law do not apply. They have become the only important instancde in which governments signally fail in their prime function - - the prevention fo coercion and violence." Further, he notes, "It canot be stressed enough that the coercion which unions have been permitted to exercise contrary to al lprinciples of freedom under the alw is primarily the coercion of fellow workers." He devotes a chapter to the issue of redistribution of wealth through the use of 'progressive' taxation policy. His view may be summarized in this comment. "As is true of manyu similar measures, progressive taxation has assumede its present importance as a result of having been smuggled in under false pretenses." He quotes J. R. McCulloch - "The moment you abandon the cardinal principle of exacting from all individuals the same proportion of their income or of their property, you are at sea without rudder or compass, and there is no amount of injustice and folly you may not conmit." He continues with discussion of the fact Karl Marx and Freiderich Engles advocated 'a heavy progressive or graduated income tax..." One of the most important chapters in the book relative to the discussion here is the one titled 'The Monetary Framework." He notes that the great disturbances in monetary affairs of the 20th century are due to government interference - and related to the extensive use of credit as money. But he writes that it is now too late to get government out of the monetary business. He remarks about the role of money, "The reason for this (volitility) is that money, unlike ordinary commoditeis, serves not by being used up but by being handed on." This chapter on monetary reality is extremely important. Hayek writes, 'With government in control of monetary policy, the chief threat in this field has become inflation. Governmentrs everywhere andat all times have been the chief cause of the depreciation of the currency." And, "we have seen how every one of the chief features of the welfare state which we have considered tends to encourage inflation". ... "It it is gtrue, however, that the institutions of the welfare state tend to favor inflation, it is even more true that it was the effects of inflation which strengthened the demand for welfare measures." What a brilliant insight. The welfare state creates inflation, inflation increases the demand for the welfare provided by the state. I cannot include here even a fraction of the valuable lessons Hayek presents in this book.

Fredrich A. Hayek - Studies in Philosophy, Politics and Economics, Simon and Schuster, NY, 1969, 356 pgs, index.
This book contains a number of the author's speechs, essays and studies. The three main parts deal with the three subjects of the title. All are necessary for a full understanding of contemporary political-economic life. Again, the author demonstrates the falicies of socialism. He discusses the differences between 'commutative justice' and 'distributive justice'. He shows that as much as the proponents of 'distributive justice' claim an altrustic purpose and that policies seeking to further this, in reality such efforts must involve coercion and the curtailment of freedom. He shows that real-world systems are much to complex for theoriticians to describe them adequately, and this is true in economics as in all other academic disciplines.The result is that governments cannot properly control economic markets in the way governments think they can. The chapter titled, "Inflation Resulting from the Downward Inflexibility of Wages" is particulary relevant today. As I noted above, the force of labor unions expressed through the power of the state seeks to prevent the decline in wage rates so essential for the economy to adjust properly from an inflationary to deflationary era. He considers the Keynesian economic theories to be a major intellectual support for this condition. The Keynesian theory presumes that wage rates 'cannot' be lowered. "The decisiveassump;tion on which Keynes' original argument rested and which has since ruled policy is that it is impossible ever to reduce the money wages of a substantian group of workers without causingexgtensiveunemployment. The conclusion which Lord Keynes drew from this, and which the whole of his theoretical system was intended to justify, was that since money wages can in practice not be lowered, the adjustment necessary, whenever wages have become too high to allow 'full employment', must be effected by the devious process of reducing the value of money. A society which accepts this is bound for a continuous process of inflation." Further, he notes, "We cannot expect inflation-born prosperity to last indefinitely. We are bound to reach a point at which the source of prosperity which inflation now constitutes, will no longer be available. The conception that we can maintain prosperity by keeping final demand always increasing a jump ahead of costs must sooner or later prove an illustion. because costs are not an independent magnitude but are in the long run determined by the expectaton of what final demand will be."


Amity Shales - The forgotten man,


Martin Mayer - The FED: Inside story of how the world's most powerful financial institution drives the markets


Garet Garrett - The People's Pottage


Martin Weiss - Crash Profits


Glyn Davies - History of Money


Jack Weatherford - The History of Money, Three Rivers Press, NY, 1997, 288 pgs, index, bibliography, footnotes.
A very readable history of the role of money from ancient times to the present. The author's purpose is to make readers aware of the serious problems with money today. However, the releatively short chapters on money in ancient and medieval times do provide interesting background. The author describes the Roman Empire as the first 'welfare state". He explains the results of the increasing economic problems as the emperors struggled to prevent economic ddcay. he then moves to the development fo the banking system in the 14th century - the destruction of the Templars - money lending - Italian merchants - bills of exchange and more. He notes the collapse of the Peruzzi and Bardi and others when King Edward III of England defaulted on his debts. he describes the interesting origins of the Ameerican use of 'dollar' for our currency, and the use of paper money in the colonies. He devotes much space to the role of gold versus paper money.


Frederic Mishkin - The Economics of Money, Banking and Financial Markets


G. Edward Griffin - The Creature from Jekyll Island


Victor Sperando and Alvaro Almeida - Crashmaker


Massim Taleb - Fooled by Randomness - and - The Black Swan


William Bonner and Addison Wiggin - Financial Reckoning Day, John Wiley and Sons, 2003, index, footnotes.


Addison Wiggin - The Demise of the Dollar, Agora Press, John Wiley and Sons, 2008, 197 pgs, notes, index.


Bill Bonner and Addison Wiggin - Empire of Debt


Bill Bonner and Lila Rajiva - Mobs, Messiahs, and Markets, John Wiley and Sons, 2007, 424 pgs, index, footnotes.

Addison Wiggin and Kate Incontrera, I.O.U.S. A. John Wiley and Sons, 2008, 266 pgs, index


Robert Shiller - Irrational Exuberance, Broadway Books, 2001, 319 pages, index, bibliography, footnotes.


David Colbert - Eyewitness to Wall Street


Martin Mayer - The Bankers

These videos present a good picture of the situation.