World's First Economist

An imaginary conversation with Fan Li

“Okay, what is your best idea?” I inquired of the ancient sage.
“Suspenders.”
“What?”

“Things that work. Suspenders hold up pants. Most economic concepts don’t hold up anything. They need the support of facts, authorities and long-winded explanations. If support exists at all it is usually a contentious balancing act or a weak link.

“That is why I like Chinese and Market Economics. Chinese Economics is taught like Geography. In a Geography class you learn the names of countries. The name is never in dispute or requires a proof. Names are facts. The location of cities, the length of rivers, the height of mountains, and the depth of lakes are all facts. The price of Barbie dolls, the amount of milk fat in a dairy product, the make of new cars sold at the local dealership, the weight of a sack of flour are all facts. The western economic approach is composed of equations and concepts: supply and demand, velocity of money, natural rate of unemployment, monopoly, Income Elasticity of Demand, equity, assets, returns, etc. All these concepts are subject to interpretation,” Fan Li explained.

Fan Li is considered the first economic thinker. He lived south of modern day Shanghai in the 6^th century B.C. near an area of fresh water lakes and lowland agriculture. Unlike the western economic tradition that looks at people as equal and similar acting, Fan Li emphasizes knowing and evaluating customers and suppliers. This gets to the issue of which customers will be granted credit and which will be denied credit. Fan Li states each participant in an economic activity should have their character evaluated. A business person should have the “ability to know people's character. You must perceive evidence of characteristics from experience.” This gets to the idea of whether a person can fulfill the commitment they are making. The western tradition is based on social rights and the legal system’s interpretation of those rights. Does the person have the legal right to enter into a contract? Whether the person can fulfill the contract is left to the party making the contract.

I think you can see where the western tradition leads to trouble like occurred in the Housing Bubble of 2007. Loan originators looked only at the market to see whether they could sell the loans they were originating. The originators felt their responsibility extended only as far as ensuring the loans met the legal requirements of HUD and the GSEs. In the Chinese tradition begun by Fan Li the originator would evaluate the character and ability of the borrower to repay the loan. If such an approach was applied in the United States between 2004 and 2007 there would have been no Housing Bubble.

Fan Li’s system involved evaluating each borrower. This is the way the western tradition began, but it was subverted when the state stepped in to expand the qualifying pool of people. The government’s actions to set qualification hurdle tests destroyed the individual evaluations that Fan Li and early bankers established. Removing this step from the loan qualification system removed the support of reasoned evaluation from the loan portfolio. Everyone was evaluated according to an inflexible set of standards established by HUD. HUD relaxed the qualification hurdle to include groups of people who lacked financial maturity. The result was a built-in failure rate like a circus clown wearing trousers six sizes too big without suspenders. Exposure was guaranteed.

Poverty

Help me out with something. I think poverty can be solved with jobs. Am I a naive selfish right-wing bourgeoisie? Well, not entirely. Maybe I should let you decide. I spent part of my childhood in a public housing project called Rainier Vista in Seattle. We had our own school in the project. I assume so we would not contaminate the strain of people who could pay market rents.

My First Grade school yard was a 50' x 50' fenced enclosure about the same size as the chimp enclosure at the zoo, but without the elaborate play equipment or high fence. Escape was tolerated after check-in. Our teachers explained to us numerous times throughout the year that if we were not in class when attendance was taken the state would not pay the school. It worked on me. I had a job to do. I was there every morning at 8:10 to be counted. Perfect attendance. I was learning. I was surely on the path to college.

I learned other skills. I learned to tell time, so I would know how long I had to wait for recess. What I didn't learn in class I more than made up for with the learning experiences at recess. On the playground the girls played hop-scotch on the paved half, and the boys played marbles on the dirt half. All the boys played marbles in circles scratched into the dirt. My family was too poor to buy a sack of marbles, and I was to shy to ask anyway. One day my friend, Jerome, and I were digging around the drain cover at the edge of the playground when we got the cover loose. Inside half buried in the mud we found six marbles. We split the loot. Over the next couple of months I watched the other boys play on the dirt patch and practiced on the carpet at home. Carefully I started to play at school and did surprisingly well. I eventually had a lunch sack of marbles, maybe two pounds of glistening round gems. I even named a couple. My books stayed at school, but my marbles traveled everywhere with me. Then one spring day an older boy walked on to our schoolyard and challenged me. He was good. He could balance a marble on his thumb, use his fingers to rise above the dirt circle and send the marble through the air striking a pack of sleeping marbles in the center of the circle. I used the typical grade school technique with a shy marble poking out from a curled fist cave like a hot dog sticking its head out of a bun. I lost two things that day; all my marbles and my confidence. I learned a lot on the playground and nothing in the classroom where I specialized in coloring, tracing and keeping my head down, so I wasn't called on.

But did I learn about poverty? Not really, I was too young to understand what was happening around me. What I did learn about is want and disappointment. These are the scars of poverty. My stupid question to you is this: Do the poor want free medical care, food subsidies, transit subsidies, good condition used clothes, or do they want the ability to support themselves? Do they want some of your money, or do they want their own money?

Humor me. Assuming poor people want their own money, how would you go about that? Would you have the government create more jobs. Recognize if the government does that, it would be a huge expense to you. It might put you and your children in debt for the rest of you life and their lives. And then how would you pay off the debt? Government's only source of revenue is taxes. Each paycheck government will take a little of your earnings to repay the debt. There is a way to avoid dying a pauper. To keep the government out of your pockets, the business sector has to create the jobs and pay the salaries. Think about it. Do you have enough extra money to pay another person's salary? The business sector is the only sector that can afford it. They have a trick to create new money. They use new ideas to create new jobs, and profit to pay for those jobs. The two horrible P's, profit and productivity allow the business sector to provide jobs without taking our money. They do it by providing services and products we want to spend our money on. Instead of kicking and screaming when the government takes our money, the business sector can get us to give up our money willingly. Somehow by making me happy with new products and services, business is able to provide jobs to the unemployed.

Okay you say, but that is not always the case. Sometimes the economy is too weak to support new businesses. What can we do in that case? Appeal to the government for help?

That is a blind alley. The government is not a source of solutions. Government is simply a source of funding. New ideas must originate outside of government. They must have a private sector structure.

Government should be an reservoir of needs. The government can poll their constituents for a list of services or products that they want. For example they might state they want childcare for two hours after school. The next step for government would be to seek solutions from the business community, simply asking the business community how to solve this problem with a private sector solution. The government can require that a certain percentage of employees come from the ranks of the unemployed. The government can require the business firm use only private sources of funding. Maybe, the firm can get some funding from Kellogg's to test taste new cereals? Maybe, Mattell will pay to test some new games? Maybe, Randomn House will pay to have the children rate different books? Maybe, Amazon will pay to wear test some clothing? Maybe, Safeway will pay to test some vegetable dishes and teach a class on nutrition? I can imagine an entire curriculum developing from private sector involvement.

Here is another example. Citizens might ask for more drug abuse councilors. A private company could step forward to train unemployed people to work as councilors for their company in exchange for the education. The government could sweeten the burden on the training company through tax credits that the company could sell.

So what am I proposing? A system that uses a private company to provide a service or product and reduce the government's burden to provide these services and products to their community. The initial operating costs (tax rebates) might reduce tax revenues over the short term, but overall if structured properly the tax revenue and income from new workers is going to expand the economy and increase the overall wealth in the private sector. Public sector financial burdens should be reduced. It is a true win-win.

If this technique is employed properly by government, the bidding for service and product supply rights could become a source of revenue. Imagine bidding out security services at airports, or ambulance services, or taxi services, or even fire protection services. Huge national companies will develop providing thousands of jobs with world class performance levels. All this paid for by the users of the services, reducing the administrative costs and tax collection bureaucracy of government. Win-win.

What is Conventional Economics?

Conventional Economics is a term I use in N Theory to describe all currently promoted theories of economics. As Jonathan Schlefer in his book, The Assumption Economists Make, states there are three main schools of thought: Rational Expectations; Real Business-cycle Theory; and DSGE (Dynamic Stochastic General Equilibrium). Rational Expectations theory explains people use their judgment about the future based on what they expect to happen. The prominent factors that influence this judgment are product quantities, quality and prices. Real Business-cycle Theory assumes the market chugs along until conditions change. The main conditions are the cost to borrow money, the cost of labor and the size of the market. DSGE puts all these conditions and factors into a predictive model.

In a world with these three theories, what are we left with to evaluate? We could question whether people make rational judgment about the economic future. We could question whether change in the market will affect market performance. We could put all the factors affecting the market into a model and make predictions about how change may affect the market.  Nothing is wrong with any of these approaches, but they do not get us very far and they can be dangerous when used to tell us what to do next. In any case, this is the three groups of ideas I term Conventional Economics.

DSGE theory was a total failure in the Financial Crisis of 2007. One reason for the dismal performance is that is not a theory. It is a technique and a technique without a purpose spits out meaningless hogwash. So let's put it aside and concentrate on the other two theories. History partially supports both. Ingredient labeling on food packaging caused many consumers to rationally reevaluate what they were buying for their families. The Dot Com bubble did not put an end to electronic technological change, or alter the high premiums for companies in that market segment. Both partial theories are valid. We need both the intelligence of the consumer and the durability of the market incorporated into a robust economic theory. Something similar to the DSGE approach can provide insight, but mathematics alone does not explain what is happening in the economy. It is far too simplistic and artificial. Economics is not physics. Economics is about people. People act less uniformly than do subatomic particles.

Here is another insight about Conventional Economics. Economics is the academic study of the marketplace. Why are we studying Economics? The goal is to design a marketplace that provides products and services with employment opportunities sufficient for a satisfying life for the maximum number of people.

Often we get diverted from the goal of creating an improved marketplace. Our leaders take us in a different direction. They focus on the defects in the marketplace. They argue for having power over the shopping environment regulating the slope of sidewalks and the architecture of facades. Power in the economic equation is never good. European socialist countries, Asian communist states and African dictatorships often try to capture the cash proceeds from commerce, and use those funds to support their lifestyle. This tendency results in two approaches to market management. State regulation of the market, or market participant regulation. Participant regulation is the much better approach. It has at least a twenty thousand year history, sufficient time to work out the kinks. Participant management leaves market regulation to the experts. The other part of that equation is that state regulation is always an economic burden. It takes money out of the market to spend on offices, vehicles and salaries for the State regulators. This is the core of Conventional Economics. It is just not theory, but the artifice and bureaucracy created by a government following a specific Economic theory.

Is Money a Commodity?

One of the most critical issues in Economics is whether money is a commodity. All the major schools of Economics: classical, Keynesian, Austrian and Behavioral agree money is a commodity. Why? Economists observed governments issuing new or additional currency that caused a devaluation of the currency already in circulation.  Another example they looked at was common commodities and observed price movements. It didn't matter if the commodity under the spotlight was gold, silver, oil, corn, sugar, wheat or cotton they all seemed to act the same way when the quantity in the market moved up and down. Looking at the history of money economists found a parallel. When governments increased the supply of money the value of other money seemed to decrease. Money seemed to perform just like cotton. The larger the cotton harvest the less valuable. So economists concluded, if it walks like a duck it must be a duck. Money was declared a commodity.

To simplify the economic logic of money as a commodity you must believe the value of money fluctuates just like the value of apples, the classic example of a commodity. Both act like they may be influenced by the forces of supply and demand. The more apples (Supply) on a store's shelves it is necessary to drop the price (increasing Demand) to encourage a higher rate of purchase. One of the great fears of private economists during the Financial Crisis of 2008 was a fear of inflation from the Fed's strategy of injecting two trillion dollars into the economy. Fortunately, that fear was not realized.

This experience from the Financial Crisis was counter to the money as commodity theory, but few people took notice. Maybe, money is not a commodity. Let's look at money in the marketplace to see the parallels with apples. Clearly, money is not a fruit. Money does not grow on trees. Money is not harvested by farmers. Money is not sold on grocery store shelves. Money is not seasonal. Money is not perishable. Money doesn't taste good or provide a nutritious snack. Does this deductive track lead anywhere? It is interesting, but leads only to a baffling syllogism. Money is called a commodity, but money does not share features with other commodities, therefore money is not a commodity. The question about what money is remains unanswered.

Let's delve into that question. Money seems as mysterious as an alien from outer space. If we encountered a space alien how would describe what we saw? First, we would describe what it is similar to "about the size of a dog, but walking upright and carrying a rifle like object in its four hands." We can make a description of money, "Two and a half inches by eight, made of paper, printed on both sides with a picture of a politician on one side and a building on the other." The description tells us nothing about what it is used for or how it works in the economy. It seems like part one might be a description, but part two needs to be an explanation of the role it plays in the economy. I can see some of you wiggling in your chairs to tell me money is a 'a medium of exchange.' I bet you can even explain how the barter system needed a reservoir of value if a seller did not want to make a product for product exchange, and that prompted the creation of money. True, but money is more. Money can be thought of as an equality of value. What? Money represents value. The value of the chicken you traded or the work you did in the field.

Money is a value equivalency. If I do 'x' you will give me six of those green bills. Done. It is not a commodity that will change value, or age and spoil. It is money, a marker of value usually earned through the accomplishment of work. Why is that important? It creates a connection between work and money. So money can not be circulated unless there is a work product to anchor its value.

Think about this for a moment since it radically alters conventional Economics. This concept is the basis of my textbook, Rule of Money.

Do low interest rates stimulate economic growth?

Starting in the mid 1990's Japan pursued a low interest rate policy. Unfortunately, the reason the Central Bank lowered rates did not have the intended result. Japan's finance ministers wanted to induce economic growth. Instead the economy faltered. Why? Don't lower interest rates reduce the cost of borrowing for companies? Of course, but unless the companies need to borrow, low interest rates have no effect. Often low interest rates are imposed in times of economic stress. Many companies are unwilling to borrow in such perilous times. Consider the effect of a stagnant economy on Japanese business. In Japan the size of corporate debt went from 147% of GDP in 1990 to 99% in 2011 (Mariko Oi for BBC News, Tokyo, 17-09-2012). One should conclude low interest rates actually reduced corporate borrowing by 50%.

Although Keynesian Economics argues low interest rates are the cure for economic malaise, the facts indicate the opposite. Why? Keynesian Economics is built on the assumption of interest rates driving the economy. The fact is other economic conditions weigh heavier on markets than interest rates. What are these economic conditions? First, it is the confidence in the future of economic management, i.e., the government's ability to manage the economy. Keynesians take this as a given, but business people see it quite differently. Low interest rates are a perfect example. Keynesians see low interest rates as an inducement to business to expand. Business people see low interest rates as an indication of a stagnant economy. Governments see a stagnant economy as an opportunity to utilize Keynesian debt strategy to spark a recovery.  A government supported by an economic theory that lauds their economic prowess is a strong inducement for government to increase their borrowing and the national debt. Unfortunately such a strategy did not work during the Great Depression or the Great Recession. It did solidify the business sector's opinion that the economy was in a downward spiral. In the same article noted above Mariko points out public sector borrowing went from 59% of GDP in 1990 to 226% in 2011.

Even if governments behave themselves and do not increase debt, low interest rates are not good for the economy except in the short term. The short term being a couple of years to induce capital purchases put off because of the weak economic situation.  I would argue it is never good for the government to try and manipulate the market. But there are other reasons besides my opinion. Low interest rates encourage marginal loans. The group of business ideas that work with a 1% interest rate is not the same quality as those that work at 5%. In addition, the origination revenue banks obtain from low quality loans and 1% interest is marginal at best. A healthy banking sector is fundamental for a vibrant economy. Banks play an essential role in taking the new money creation allowed by a central bank and finding places to invest it. If banks buy notes from the Treasury of a country to earn interest no new business is created that can grow. The interest banks earn in the feedback loop and new business creation expands the economy. It is tax paying job creating business that expands the economy; not money creation by the government. A strong economy can not exist supported on a thin feedback loop. The thinnest possible loop is a low interest government bond.

Who creates Money

Does the origin of the money in your wallet make a difference? Often. If the money is counterfeit you may have your money confiscated before you can spend it. If your money was manufactured by certain countries you may find it impossible to get the face value in other countries. For instance, the 5 trillion note issued by Zimbabwe will never be equivalent to any other currency. Why is that? The value of a currency is not the value stated on the bill, but is the value when used to make a purchase. If the note from Zimbabwe can be exchanged for a new Xbox, then is equivalent to $319 US dollars since that is the amount of currency necessary to purchase the product in the United States. The comparative value of a currency defines a currency into a known item. Think about "one." Your first question is "one" what? In the case of currency the "one" is the number of another currency.

There is one unique difference about paper money. Other products get a value when they go to market. Walmart will put a product on their shelves at a price they hope the product will sell for, but if it doesn't sell, they will reduce the price until a value is found that customers accept. Money has a value printed on the front of each bill, but banks will not reduce the notational value on the face to get their depositors to take the bills out of the bank. In fact the government dictates the currency must be accepted at the face value. Consequently, if the currency value is greater than the public will accept the product value must go up. This situation occurs everyday throughout the world to various currencies. What do banks do? If they are exchanging one currency for another they adjust the exchange rate. If a customer is withdrawing funds to make a now higher priced purchase, they will complain to the bank, but are powerless to restore the value of their currency. The result is what we call inflation. These movements in the value of currency are very destructive to a stable economy. Stability is extremely important. Why? Pricing is based on convention and forces that upset or change economic conventions often result in economic stress and uncertainty.

How do the institutions in the United States attempt to maintain stability? The Federal Reserve does not give money away to individuals, they use the private banking system to distribute it. The Fed distributes money through banks or federal agencies to maintain control. Ignore distribution through federal agencies for the moment. Most money is distributed through banks so let’s look at that process. Physically the money does not exist until it is utilized. The Fed sets certain rules to ensure more money is not created by the banks than products. The Fed creates potential, but money only comes into existence when a bank takes it figuratively out of the Fed. And, this is the most important point, banks only take it out when they have a borrower able to repay the funds. The amount of dollars requested by the borrower sets the value of money created. Let's look at that from a slightly different angle. The federal government does not create money, the Fed does not create money, the banks do not create money; borrowers create money by agreeing to expand the quantity of circulating currency by starting a profit earning business or investment, and repaying their loan. Note the importance of profit. It is one of the most important economic concepts. Note the insignificance of government printing presses and regulatory restraints or incentives. The final judgment is in the hands of a country's entrepreneurs. The cleverness of entrepreneurs determines the growth rate of a society not a government agency.

Now you can see why rising interest rates is an effective deterrent to economic expansion. Higher interest rates place a roadblock in the way of the money creators, the borrowers.  But let me return to the point of this brief article. Money creation by the government is meaningless unless the money is utilized by borrowers. Most governments outside the top twenty focus on the wrong strategies to grow their economies. They buy things: roads, bridges, schools, military equipment, etc. to increase the appearance of government. Nothing is wrong with these acquisitions, but building wealth in the private sector is the only way to put in motion a mechanism to pay for such purchases. Public services and facilities are great, but if a private sector does not exist to pay taxes then the facilities will not be maintained. Governments should put the focus on creating entrepreneurs. This is the strategy China is utilizing to grow their economy.

Lessons from the Great Depression

Here we are in the sixth year the economic plague we call the Great Recession. Although the Great Depression lasted twice as long it did not infect as much of the world. Are there lessons to be learned from this earlier crisis? The classic work on the Great Depression is The Great Crash 1929 by esteemed economist John Kenneth Galbraith. Professor Galbraith’s book is a magnificent work of research and his account of the events surrounding and contributing to the cause of the Great Depression is greatly admired and studied. His description of the events from 1928 to 1940 is enthralling and enhanced by his elegant language. A very high standard for economic literature, but does his analysis rise just as high and does it help us understand our current financial crisis?

It is acknowledged by Professor Galbraith and most other economists that the trigger event of the Great Depression was the loss of money in the stock market. Investors were stopped out of their margin accounts when the market suddenly declined. These margin accounts were constructed by using broker’s loans (loans collateralized by the securities purchased on margin).  The popularity of this type of loan increased substantially during the 1920s from one billion early in the decade to more than 6 billion in 1928. A billion in 1929 is equivalent to a 100 billion today. Banks were not deterred from making these loans since they could “borrow money from the Federal Reserve Bank for 5 per cent and re-lend it in the call market for 12.” Not unlike the sweet arbitrage the banks could make in the prelude to our Great Recession by packaging mortgage loans into large bonds and turning a substantial profit by holding the bonds for a couple of years. During both periods people realized there was a speculative bubble, and that eventually the bubble would burst. This fact did not deter speculation even though voices were warning of impending disaster. Paul M. Warburg of the International Acceptance Bank in March 1929 predicted unless the “unrestrained speculation” was halted an eventual collapse would “bring about a general depression involving the entire country.”

The irony is everyone benefited initially from the bubble’s rise. Caution was not a serious concern. There was a general feeling among speculators that the market was supported by three strong legs. The action of speculators was one leg of support for the market. The second leg was the upward momentum of exuberant expectation of a continual rise. The third leg of support was a general sense that there was nothing to fear since who would move to deflate the bubble. In other words ineffective regulation was seen as support for the market since the government was unlikely to act and everyone in the market was benefitting from the rise.  Unfortunately, no one stopped to consider how other investors would react if the market turned downward and whether there would be time to exit.

After the Great Depression, Professor Galbraith pointed out, “it has become obligatory for the regulators at every opportunity to confess their inadequacy, which in any case is all too evident.” In March of 1929 the Federal Reserve Bank began daily meetings. They did not inform anyone outside the Fed what the subject of the meetings concerned. Suspicion and rumor focused on the stock market, but that was unconfirmed. During 1929 there were some breaks in the market caused by rumor, but overall the speculative stampede continued. Corporations and even wealthy individuals lined up to provide more liquidity as the banks struggled to provide more and more funding for brokerage loans. By that summer these loans were growing by “$400 million a month.”  There was concern about the degree of speculation that these brokerage loans implied. These concerns were dismissed as coming from people who “simply did not know what was going on.” The 1920s were the period when Wall Street arose as an investment opportunity for the public. It was a very immature industry without a history and a culture of caution and restraint. This exuberance was supported by the highly-regarded academic community. In the autumn of 1929 the foremost American economist of the time, Professor Irving Fisher of Yale made his often quoted estimate of the market, “Stock prices have reached what looks like a permanently high plateau.”

Irving Fisher’s comments reflected the fact that stock speculation had become part of the culture. This trend during the 1920s legitimized an activity that had not earned a place in the economic system through trial and error. Likewise, in the Great Recession housing speculation and expansion of the mortgage market to include lower and lower income participants would also prove disastrous. When A&E launched the TV show Flip this House in 2005 starring Armando and Veronica Montelongo house speculation or flipping was an accepted get rich scheme. Two years later the Housing Bubble burst.

One of the most interesting sections in Professor Galbraith’s book is his debunking of the suicide myth surrounding the Crash of 1929. He shows that statistical analysis supported a slight rise, but nothing to justify the media's characterization of crowds standing on sidewalks waiting for the next businessman to jump to his death. The media similarly misled the public in explaining the cause of the crisis. Instead of looking at the government they focused on finding someone in the private sector to blame. There were Bernie Madoffs in the Great Depression, but like Madoff they were crooks not promoters of speculation.

The real tragedy was the Press’ failure to understand what happened and outline what to watch out for in the future. Professor Galbraith made it clear in his 1954 summary, “It would be unwise to expose the economy to the shock of another major speculative collapse.”  Do you recall anyone in 2006 drawing a parallel between the Housing Bubble and the Stock Market Bubble of 1928? I do not. Why? It is because the gurus over complicated it. We would be better off to simply look into get rich quick schemes and asset bubbles for the next financial crisis rather than a trend line of monetary expansion.

There is no quick way to riches. There is only hard work and slow steady returns. Blaming the cause of financial disasters on lack of self-control or greed is counter-productive. These are characteristics of the human species. Criticism is better directed at the people who create our economic institutions and fail to structure them to constrain speculative impulses and greed. Speculation is only a problem when the economic system lacks proper controls. The problem is an economic system without proper curbs, not people who lack adequate self-control.

When Professor Galbraith asks himself what the cause of the Great Depression is he looks first at why business activity slowed. He finds his answer in the unequal distribution of income. His argument is that if the middle class had more money they could sustain the economy. Isn’t it much more likely that with the financial shock of their monetary loss in the Crash many wealthy investors lost their appetitte for new investment? Looking back we know private investment collapsed reducing job creation and economic growth. These two factors are the cornerstones of business activity. Professor’s Galbraith’s explanation lacks credibility since middle class income levels did not change until after business activity slowed. The Great Depression was led down and kept down by business people unwilling to take risk.

What we can say definitively is that people lost money. Losing money has quite an impact on people. Imagine a gambler from New Jersey arriving in Las Vegas with hope and cash-filled pockets. He leaves his bags with the front desk and goes straight to the tables. Six hours later he has lost 75% of the money he brought along on his vacation. How enthusiastic is he going to be to go back to the tables after dinner? This is precisely what happens after a financial bubble bursts. The shell-shocked business people and investors are not going to charge out of their trenches into the battle again. They are going to hunker down, reassess and wait for a “real” opportunity. Professor Galbraith misses the real causes of the Great Depression and misunderstands the pivotal role of banking and business in making the system work. The problem is the system, not the people in the system.

Rereading this book made me realize Professor Galbraith focused on stock speculators and not on the characteristics of the financial system which nurtured speculation. We now know that the crisis would not have occurred if margin loans were disallowed. We also know that the stock exchanges could have employed curbs to retard large daily movements. Risk curbs also could have been created to protect novices in the market by tying their investment actions to the facilitating brokerage firm. In other words, if the clients of a brokerage firm lost a certain percentage of their client’s money, funds could be removed from a reserve account required to be held by the brokerage firm to reimburse their clients for bad advice. This technique would tie an investor’s risk to a firm’s risk, making both parties act with more caution. Another problem in almost all financial crises is excessive leverage.  Leverage is easily regulated by market rules.

When economic conditions are not persuasive for business expansion investment is going to dry up. Without new investment an economy is going to slowly decline as loans are repaid and money is removed from the economy. It is not the potential for investment that matters, but actual new money coming from banks to create new business lines. More investment means many more jobs and more money looking for products to purchase. Whether this money is equally shared is not significant. One rich man spending an extra $100,000 or 100 people spending an extra $1,000 makes no difference to an economic system. 

Seventy-seven years later a speculative bubble again devastated the economy, an event we now call the Great Recession. The two events are almost twins. The approach of the Great Recession could be seen by a blind economist, but not by a sighted economist looking for help from a government regulator. Sighted and blind economists before and after both crises suggested fine tuning government action was the key to avoiding a repetition. The whole idea of government action doing anything to improve an economy is an inheritance from Galbraith and Keynes. Their focus on government as our financial savior implies the coach is more important than the players. It is the team on the field that plays the game and determines the outcome, not the coach. When the players refuse to play a loss is inevitable. Even if the coach implores the players to play harder and the general manager increases their compensation, if the players decide not to expend all their effort in a game, the team will lose. Speculators did not cause either crisis. The economic field was not prepared properly for the intensity of the game.