Financial Crises, Political Economy and Volatility
Introduction
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This article argues that monetary policy, specifically the monetary policy of the Federal Reserve (the Fed), is iatrogenic in light of its mandated goal to reduce macroeconomic volatility, that is, promote employment and achieve price stability. The most important lesson that can be learned from the Global Financial Crisis (GFC) is that Fed policy is, in fact, harmful, rather than curative, for both financial and macroeconomic stability and functionality. ?
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To justify this assertion, this essay aims at approaching business cycle theory from two unorthodox stances. Firstly, from a system engineering lens principally founded upon the ideas of systems engineer John Gall presented in his book ‘Systemantics’ (1990). Secondly, this essay cites and explores the extensive literature on business cycle theory developed by members of the Austrian School of Economics, namely, Ludwig von Mises and Friedrich von Hayek. Notably, both these unorthodox stances are a cousin to a new field of economics, namely, complexity economics (Beinhocker, 2010), that this essay also briefly includes in its discussion. ?
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John Gall offers systems engineering laws that apply to systems as such, rather than just specific systems. Therefore we frequently apply these systems laws to our study of the financial and economic system. Gall asserts that “large complex systems are beyond human capacity to evaluate” (1990, p. 56), and this is a fundamental idea from which this essay argues. It was Hayek who perhaps best explained that the information or data that a capitalistic economy produces and is thus ran on is unaccountably vast, as famously discussed by Hayek in his article ‘The use of knowledge in society’ (1945). In this article, Hayek argued against centrally planning an economy due to the inability of the central body to attain the necessary knowledge, Gall, in corollary, argues such ideas vehemently also (1990, pp. 40-41). ?
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This complexity of economic phenomena, which I see no reason to need to support, means that central bank action to adjust money supplies and set interest rates - albeit within a freely trading band – are necessarily acting under uncertainty as they lack the necessary data to known what r-star, or the ‘neutral interest rate’ is. That is, a central planner cannot get access to all the data necessary to centrally plan an economy (Hayek, 1945). The Fed, importantly an institution necessarily grounded on coercion[1], then, may be aggravating or even causing the very phenomena it is mandated to alleviate, said differently, and utilising a phrase from medicinal studies, monetary policy may be iatrogenic. It is this idea that the Fed is necessarily a coercive entity that is important to stress. Private companies who act iatrogenically either run out of money (and thus cease to exist) or are shut down by the regulator. It is the perennial question that Milton Friedman asks, well, "who regulates the regulator?"
This essay, by exploring a theory of the business cycle developed by Ludwig von Mises and Friedrich Hayek, argues the regulator should be regulated. I conclude the article by exploring whether another financial crisis is likely, arguing that this is the case. ?
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Part 1 – Monetary Policy and the Business Cycle
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Section 1 – Monetary Policy rethought and simplified
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Central banks conduct monetary policy to reduce macroeconomic volatility in employment, output and in the price level (The Federal Reserve, 2021). The main tool of monetary policy is, speaking simply, the creation of money. Indeed central banks, especially the Fed, often play a qualitive role by regulating, organising and assisting financial institutions in their functioning. One example is in the event of a failed financial company like Long-Term Capital Management, where the Fed organised the large U.S. banks to acquire the assets of that failed hedge fund (Lowenstein, 2011). This mediator role is qualitative, that is, it doesn't show up on the Fed's balance sheet, yet it remains a highly important role in monetary policy. However, with that being said, what differentiates a central bank from a regulatory agency or a Treasury – which could fulfill this qualitative role – is the central bank’s ability to create money. With this newly created money, central banks (herein the Fed) buy assets or issue loans to entities under the premise that undergoing these monetary operations will reduce macroeconomic volatility, that is, they will help. As the Fed has grown and developed its methods, it is true more ‘unconventional’ policies have been engineered. However, I find myself on sure footing to repeat my original notion, albeit with an additional point, that monetary policy is simply the creation of money and the distribution of that money. Thus, monetary policy lacks idiosyncrasy and so is repetitive. ?
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I contend that some small subsections of monetary policy may have net profitable marginal returns to each dollar created but monetary policy is inherently blunt, so this essay argues that, net, monetary policy is iatrogenic.? I intend to support this assertion below.
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I make a philosophical point to say that volatility is truth, an idea argued vehemently by Nicholas Taleb (2012, Ch. 1-4) and logical. As Ayn Rand once said: "We can ignore reality, but we cannot ignore the consequences of ignoring reality".
If the former is the case, then you can’t reduce volatility by avoiding it. If you attempt to do so you only delay and widen it, a phenomenon that Taleb observes everywhere. Corollary, in psychology, consciously avoiding small anxieties only grows that anxiety into severe anxiety. Corollary, when outside the earth’s atmosphere, astronauts must synthetically exercise their muscles to avoid musculoskeletal degradation that the lack of gravity, that is, the lack of daily volatility given by process of walking, standing or even sitting, causes. Here I find myself justified to propose a universal systems law: Systems require stress, volatility and change in order to remain robust and functional. ?
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Section 2 - Monetary Policy decisions interconnectedness
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There is significant unrecognition of the degree to which monetary policy decisions are constrained by endogenous factors, that is, monetary policy operations of today has significant impact on the monetary policy operations of tomorrow. ?
The Fed, by acting into the economy, changes the structure of the economy, and thus the Fed is both conducting monetary policy based on its observation of real economic phenomena but also based on the observation of the effects of its previous policy response, a phenomenon partly explained by Goodhart’s Law and Keynes’ Beauty Contest (Keynes, 1936, Ch. 12). By this, I do not mean that the Fed is seeing whether its previous method of monetary policy was successful or not, instead I mean that the Fed changes the fundamental nature of the economy by, say, increasing the net worth of bond holders when it acquires government securities in QE, and so forth. Further, the market then begins acting based on what it perceives the Fed will do tomorrow, a phenomenon known as ‘Fed watch’. This is an unsatisfactory and problematic occurance for the Fed, as Gall explains: “Now, when a Primatologist observes Primate behavior, there is one piece of behavior that the Primatologist does not want to observe and that is the Primate observing the Observer as the Observer tries to observe the Primate. That sort of thing Gets In The Way” (1990, p. 77). We cede exploring this theme further, and I merely need to cite Mises’ two works, Socialism (Mises, 2016) and interventionism (Mises, 2011), to support that centrally planning an economy is not just inefficient, but impossible. Impossible. Indeed the economies of the West are not centrally planned, but the Fed oversees the central control of money and credit. Money, needless to say, plays a highly important role in the economy as it takes one side of every transaction. Thus I find myself justified in saying it is an attempt by the Fed to centrally plan an aspect, and a very important aspect at that, of the economy. Former Fed chair Bernanke agrees when he wrote, speaking of the Fed: “the economy . . . is best thought of as being run by a central planner” (Bernanke, 1983, p. 20). ?
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Expansionary monetary policy conducted today increases the case for expansionary monetary policy tomorrow as the economic and sovereign balance sheet system acclimatises to a low rate environment, thus it grows increasingly averse to higher ones. Policy decisions, then, when looked at on an individual basis, may seem correct but when looked at in totality, they may be shown that policy decisions are misled. The Fed, if caught in this position, increasingly becomes a growing elephant in the room. Materially, this is shown by rising debt/GDP and a more general (non-debt based) increasingly fragile financial system and macroeconomy which places policy makers between a-rock-and-a-hard-place, facing mandate trade-offs and weakened monetary policy tools. Policy decisions, then, are not just reacting to exogenous factors, but they are also being made on account of policy decisions of yesterday, and these decisions also enforce endogenous factors to policy decisions of tomorrow.[2] ?
It is this arrow of time, this feedback loop and this avoidance of volatility (which we make the case that is impossible to avoid) that one must understand. This cannot go on forever.
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The GFC was a crisis of greater size and complication than the more ‘orthodox’ stock market bubbles of South Sea, 1929 or .com. This is no coincidence. As I will explore, the Greenspan Fed attempted to reduce macroeconomic volatility before and after the .com bubble burst, and by doing so only caused unexpected consequences elsewhere by creating a housing bubble, that is, macroeconomic volatility was moved into the future. ?
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It is true that an increased understanding of economics allows us to patch and repair fissures, and then residual regulation is a barrier to repeat those same events. The fast and decisive response to the Silicon Valley Bank and First National Bank crises in 2022 certainly exists in support of this notion. However, one of Gall’s system laws, namely, “the army is now fully prepared to fight the previous war” (1990, p. 31), alludes to a worrying reality. This reality is, as Galbraith wrote, that “fissures might open at other new and perhaps unexpected places” (Galbraith, 2021, p. 156) and thus a central bank can never regulate and manage an economy free of crisis. This is because the central bank is the very cause of economic crises, as I explore below. ?
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Section 3 - The Austrian Theory of the Business Cyclenbsp;
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Mises’ and Hayek’s work on business cycles, on which Hayek won the Nobel Prize in economics, exist in fundamental disagreement with the foundations of monetarist and Keynesian macroeconomics. Their work argued that after undergoing expansionary monetary policy, that is, after the money supply was arbitrarily increased, a cluster of business errors that would cause a recession was inevitable. It is not the purpose of this article to explain the Austrian Theory of the Business Cycle (ATBC) in depth, the following only acts as a concise summary for a reader unfamiliar with the theory. I do not cite Mises and Hayek in text in the following explanation to avoid repetition, instead their works are cited here (Mises, 1949/2012) (Hayek, 1967). ?
The Kirznerian market process (Kirzner, 2007) explains the centrality of the pricing system as a tool for distributed individuals to coordinate production harmoniously. The ATBC focuses on the effects of an expansion of the money supply. It argues that such an expansion discoordinates the market process by distorting the pricing system of the economy. This distortion is a consequence of government coercion because an arbitrary increase in the supply of money can only occur on a hampered market with a fiatcurrency. In an unhampered economy the ability to arbitrarily inflate the money supply is impossible without an illegal cartelization of the banking system (Sechrest, 1993) (De Soto, 2020). The business cycle is, then, an “illustration of Hayek’s profound insight: (that) whenever a universal legal principle is violated, either through systematic state coercion or governmental privileges or advantages conferred on certain groups or individuals, the spontaneous process of social interaction is inevitably and seriously obstructed” (De Soto, 2020, p. 169). ?
Money is the most saleable good in the economy, thus it can be used to acquire anything the owner of those money-units demands. Money can be, then, thought of as a representation of present goods. A cash balance (as opposed to a bond or other such investment) carries optionality in the marketplace to acquire any good. Changes, then, in the value (exchange value) and price (interest rate) of money represent changes in the scarcity of consumer and capital goods. Cetiris paribus, an increase in the volume of money causes two phenomenon’s, firstly, a lower interest rate and secondly a lower exchange value of money. ?
A rise in the volume of money causes an artificial lowering of the exchange value of money, resulting in the real prices of factors of production falling. This is the case for these prices do not instantaneously react to the higher money supply, this was a point Hayek stressed often. To the businesses who receive newly created money first, they face lower prices of scarce consumer and capital goods, a phenomenon known as the Cantillon Effect. ?
On an unhampered economy interest rates are set by the aggregated consumption/savings ratios of individuals in the economy. As money represents present goods, a higher savings ratio means that there exists a high level of saved present goods in the economy. A fall in interest rates, then, means the savings ratio of the aggregated economy is rising, which must mean less consumption is occurring thus there exists surplus (lower priced) consumer goods that, very simply speaking, can be diverted to provide sustenance to workers that are lengthening the production cycle. Thus, after a fall in the interest rate, businesses borrow present goods (money) to lengthen the production cycle. ?
However, a rise in the volume of money leads to an artificial fall in the market interest rate. A lower interest rate sends a false message to entrepreneurs, namely, that there exists more real savings in the economy than actually exists. Entrepreneurs, undergoing economic calculation with this new lower interest rate, as they would do when real savings increase, observe that previously unprofitable business ventures have become profitable as the rate of discount has fallen. It appears as if the market is signaling to entrepreneurs that it demands a lengthening of the production cycle, rather than more consumer’s goods, but this is false. ?
Nevertheless, entrepreneurs begin investing to lengthen the production cycle, moving scarce capital and labour away from producing lower order goods (consumer goods and early stage capital goods) toward producing higher order capital goods. The real resources needed to finish these investment projects, however, do not exist. There are not enough consumer or lower stage capital goods to support the lengthening of the production cycle. Present goods become scarcer (the exchange value of money falls, that is, the prices of consumer goods rise), and, as people re-gain their real consumption/savings ratio (as the value of money returns to equilibrium), interest rates rise (exposing that there did not, in fact, exist a higher amount of savings in the economy). This raises the cost of all business’s inputs, but especially those who only launched their business enterprise due to the provision of newly created money and the fall in interest rate. It turns out these business ventures were malinvestment. This malinvestment fails. The economy-wide nature of the manipulation of money means there exists a cluster of business errors, in other words, a recession. ?
The cause of the recession was the arbitrary increase in the money supply, because it led to too many businesses competing for a scarce amount of savings. This is the cause of the business cycle, but the trigger factor is the process that exposes the fact that there doesn’t exist enough savings in the economy to lengthen the production cycle. This process is the increase of the interest rate back its natural level and rise in the real price of consumer goods. Policy makers, then, can avoid or truncate a recession by creating more money as this further reduces interest rates and again reduces the real value of consumer goods. A recession, then, can, may be and in history has been avoided. The economic system, however, then finds itself back at stage 1 of the ATBC, and a recession remains inevitable but, as the dose of inflation is higher, the volume of malinvestment created is also larger, and thus the inevitable recession will be deeper. ?
Section 4 - The Political Economy of the Austrian Business Cycle
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I have already explained the central role of the policy maker in causing the business cycle, but another important analysis was the ability of the policy maker to then delay or truncate the recession. Mises and Hayek argued that a deflationary recession was inevitable after an increase in the money supply, but the difference was how an economy approached what can be called a ‘Minsky Moment’. They argued that there was two distinct ways, and, in my interpretation, this is a political economy issue. ?
The first way that an economy can approach the Minsky moment is when the central bank adopts a strict laissez-faire policy, that is, it does not continue to expand the money supply and then does not expand the money supply when the money supply falls as lending intuitions fail. Policy wise, this would be a tightening of monetary policy to zero balance sheet growth and a cessation of lending to financial institutions. This, in the current macroeconomic climate, is a radical position, but in the long history of banking such a policy is not so radical. In this situation, the process explained at length above occurs, and the market clears the malinvestment and re-allocates scarce factors of production to productive (profitable) owners that are producing lower stage goods that the market demands in a deflationary recession. ?
The second way is an even more extreme one but remains necessary to explore. This alternative way is when the central bank acts at every economic crisis to expand the money supply in perpetuity. A government can pursue this inflationary path for a time, but Hayek argued this could only end in hyperinflation, and, therefore, a deflationary recession when that money is replaced by another monetary good and prices are then accounted in the new non-inflationary currency. This is an extreme scenario that we cease exploring here, but it is important to stress that Mises and Hayek believed that monetary inflation must, at some point, be stopped or it would lead to hyperinflation. This extreme scenario is perhaps best showed in revolutionary France in the period 1789-1796 (White, 2019). ?
Both paths, Mises and Hayek argued, lead to a deflationary recession, which what the original rise in the supply of money made inevitable, but it remains a political economy question of what course economic policy and therefore the economic system takes. A government can certainly delay the macroeconomic volatility, but by doing so they only widen it, and therefore Mises and Hayek recommend a government should adopt a strict laissez-faire monetary policy. ?
Returning to the Galbraithian notion that “fissures might open at other new … places”, we have explored how the Fed cannot contain macroeconomic volatility. Any delayed volatility will merely burst through “unexpected places” as it did during the GFC. Complex crisis calls for ‘unconventional’ policy, be it quantitative easing, the creation and application of the Maiden Lane entities () or numerous special facilities (TARP, PDCF, MMLF etc (St Louis Fed, 2015)). These, continuing from our core definition of Fed policy, are synonyms for ‘creating money but giving it out differently’. As different policy responses lack idiosyncrasy, post-crisis economic/market conditions too lack idiosyncrasy; they are a repetition of conditions after the previous crisis, namely, reduced macroeconomic volatility in the short term but, to get there, higher doses of monetary inflation and therefore higher levels of malinvestment. ?
This International Monetary Fund study (Valencia & Laeven, 2008) tracked the 124 international banking crises that have occurred from 1970-2008. Four occurred in the 1970s, 39 in the 1980s, 74 in the 1990s, and 7 since the year 2000 (not including the Great Financial Crisis, which, qualitatively, was disproportionately large). After observing increased frequency of financial crises since the 1970s, I cite another of John Gall’s systems engineering laws, to say “if things seem to be getting worse even faster than usual, consider the remedy may be at fault” (1990, p. 206).? ?
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Part 2: A theory concerning volatility
?Section 1 - The Fed: Selling short macroeconomic volatility
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The Fed, in creating money (loaning money to financial institutions, buying troubled assets, offering repurchase facilities etc) attempts and often successfully reduces macroeconomic volatility. This reduction in volatility calms markets, allowing the economy to return to stability and thus to growth. However, as explained by the Austrian Business Cycle, Fed monetary policy is the cause of the macroeconomic volatility. As such I find myself justified in asserting that the Fed is entering a short position when they conduct monetary policy. A short position is a financial transaction where a financial security is borrowed from a counterparty, sold into the market and then repurchased later to return the security to the counterparty. Applying this conceptually to the Fed, the Fed borrows macroeconomic volatility from the future, ‘sells it’ into the market today to decrease present macroeconomic volatility, but they must buy this volatility back or else the short position could risk unlimited loss. Needless to say, the Fed does not sell actual macroeconomic volatility, for such a thing does not exist, but instead it acts to support that which creates macroeconomic volatility, be it deflation, high debt servicing costs or financial bankruptcies. ?
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If expansionary monetary policy is selling macroeconomic volatility, then contractionary monetary policy buys macroeconomic volatility. This makes sense, for a Fed selling its securities destroys money and thus increases interest rates, reduces the money supply, reducing aggregate demand, that is, it increases macroeconomic volatility. 2013 saw a socalled ‘taper tantrum’ (McGeever, 2023), where financial volatility spiked causing the market to spook as the Fed began to tighten policy, that is, buy macroeconomic volatility. The market was too fragile to the Fed’s policy of buying volatility. ?
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The Fed, once it sells short macroeconomic volatility, finds it hard to unwind the short position by tightening monetary policy, as such, the cause of the business cycle, namely, monetary inflation, is perpetuated. This is the idea of endogenous dynamics explained. ?
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Section 2 – Monetary Policy surrounding the GFC
I have spent significant time explaining the cause of recessions and financial crises as such. I now intend to apply the above commentary to the GFC. To explore why monetary policy is iatrogenic, we must explore the development of the GFC. The idea that policy is inextricably linked to previous policy point me to first look at the decades prior to the GFC. According to some macroeconomists, the causes of the GFC have zero to do with the years prior. I think this is a non-sensical statement. Alas they are Nobel prize winners.? ?
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A complete systemic look at the global economy is necessary to explain why the GFC occurred, this would involve historically tracking U.S. economic policy all the way back to World War Two, or even before. I lack the space to do that study here, but will do this in my forthcoming book. It will suffice to say, then, that the causes of the GFC did not just start in the 1990s for the issues surrounding the 1990s were so due to conditions begot from the 1980s, and so on, as the idea of this article explains. Nevertheless, I begin my analysis in the 1990s. ?
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Greenspan made critical errors during his Fed chair tenure which go far to explain the causes of the GFC. Needless to say, Greenspan eased monetary policy repeatedly, but, further, also for no reason. Even those supportive of the Fed accuse Greenspan for this crime. It seems he is not the Maestro after all.
I have gone to great lengths in explaining the power of monetary policy, it is thus unfortunate that Greenspan, as opposed to a more monetarily conservative figure like Paul Volcker, oversaw the Fed for nearly twenty years. Even for one who disagrees that the Austrian Theory of the Business Cycle is the correct explanation of the causes of financial and economic crises, I argue that Greenspan eased unnecessarily and thus metaphorically threw fuel on the fire – often a reason which neoclassical economists will give as a cause for an economic crisis. ?
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Firstly, Greenspan’s words, he “moved short-term rates lower … we held them at unusually low levels through the end of 1993—both absolutely, and, importantly, relative to inflation” because of “balance-sheet strains resulting from increased debt” (Fleckenstein & Sheehan, 2008, p. 13). It strikes me as a monetary policy mistake to ease because of “balance-sheet strains resulting from increased debt” by reducing the cost of taking out and paying debt. If we respond to the problem by encouraging the problem, what behaviour and future are we thus incentivising?
Further, in July 1995 Greenspan said in an FOMC meeting that “risks are beginning to ease slightly, there is no urgency here; but I do think we should move because I find it increasingly difficult to argue in favor of staying … unless one can argue that inflationary pressures are still building” (The Fed, 1995, p. 59).?Again, exists insufficient reasoning that justifies an easing of monetary policy. Meanwhile, the U.S. money supply grew aggressively, and equities marched higher. Greenspan’s 1995 rate blunder fuelled speculation and accelerated the rise of equities. The years 1994-1995 being a clear beginning of the accelerated stage of the .com bubble.? ?
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The fact the market was in a bubble was clear. Theglobe.com, with revenues of $2.7m, went public on the 13/11/1998. It opened on its initial public offering (IPO) at a $710mn valuation, already an excessive valuation for a company with revenues, not even profits, of $2.7 million. At the close of the market the very same day, it had risen nearly 1000% to an over $5bn valuation (Weisenthal & Alloway, 2022). Four days later, November 1998, Greenspan cut rates again because, in his words, "although conditions in financial markets had settled down materially since mid October, unusual strains remain" (The Fed, 1998). It must be admitted that the failure of the hedge fund Long-Term Capital Management[3], and the Asian financial crisis, did produce market headwinds, specifically widening credit spreads, but on cannot forget what the macroeconomic environment was, namely, highly inflationary and bubbly with strong macroeconomic performance. Greenspan responded with strength, announcing 3 surprise rate cuts to ease conditions and tighten spreads. The stock market erupted higher in the year 1998. The Greenspan ‘put’, the idea that the Fed would act to reduce macroeconomic volatility in times of crisis, was developing. ?
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In 1999, facing “inflationary forces that could undermine economic growth” (The Fed, 1999), the Fed began the tightening cycle which helped pop the .com bubble. The Fed raised rates, but they didn’t reduce the money supply or their balance sheet, which, to me, means the Fed simply eased the rate at which they were creating money (that is, did not stop selling macroeconomic volatility, just sold less of it than the market could take). This alludes to an idea developed by Hayek, who said that inflation will have to accelerate in order to avoid recession (a.k.a macroeconomic volatility). Said another way, the Fed must continue to sell short more and more macroeconomic volatility and even if they just reduce the dose of that stimulus the market suffers a "taper tantrum".
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The potency of the behavioural thesis of how bubbles develop maps onto the ATBC well, unfortunately I lack the space to interweave it through. However, the behavioural economic thesis of ‘stories’ and over-confidence is portrayed by Greenspan, exemplifying Taleb’s ‘Stiglitz’s syndrome’(Taleb, 2013, Ch. 23). Greenspan believed productivity advances of technology justified excessively high P/E ratios. He was the poster child of the bubble; “the recent period has been marked by a transformation to an economy that is more productive as … new technologies raise the efficiency of our businesses ... innovations of the past halfcentury began to yield dramatic economic returns” (Greenspan , 2000). Greenspan continually cited this thesis. Technology, though, had marginal impact on the economy’s productivity (Gordon, 2010, p. 35), certainly not enough to justify the level of equity prices. Yet Greenspan stood by this thesis ardently, even after the bubble burst. As Gall points out, “just calling it “feedback”. Doesn’t mean that it has actually fed back”(Gall 1990, p. 139), that is, the data that Greenspan induced his productivity thesis from was not actually feedback of what was truly going on in the economy, but instead led him astray into believing an erroneous theory. ?
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Shiller asserts that “speculative bubbles are not so easily ended; indeed, they may deflate somewhat, as the story changes, and then reflate” (Shiller, 2013). Greenspan, consciously or not, transferred the bubble in equities into housing which undoubtedly goes far to explain the causes of the GFC. ?
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During the .com bubble US outstanding mortgage debt rose from $3.906t in 1990 to $7.401t in 2000, an 89.77% rise.? Interestingly, contrary to what one may expect in a recession, as equities crashed in 2001-2, 77.9% (St Louis Fed, 2020) and 49.1% (FRED, 2020) for the NASDAQ and S&P 500 respectively, there wasn’t even a plateau in the growth of mortgage debt.
Instead, mortgage debt rose strongly throughout 2000-2007, increasing a further 31.47% to $9.749t. Greenspan rate cuts from 6.5% in mid-2000 to 1.75% by years-end 2001, only truncating people’s motivations to de-lever their personal balance sheets. ?
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Greenspan’s thoughts on bubbles allude that he suffered significant lack of theoretical and macro thematic clarity during his time at the Fed. He said that he correctly identified the 1994/5 bubble, and that he “pricked that bubble” and “diffused” it (The Fed, 1994, p. 3). Yet he then said that the 1994/5 bubble was identified but monetary policy cannot defuse a bubble, even going so far to say that monetary policy tightening fuelled the bubble (WSJ, 2006). A year later, he then said that a proposed Fed policy would “guarantee” getting “rid of the bubble” (The Fed, 1996, p. 31). He then said to Congress that one cannot even deduce whether a bubble is underway until after the fact (Fleckenstein & Sheehan, 2008, p. 68). All these contradictory theoretical statements occurred within a close period. Greenspan then, in 2002, highlighted, “the ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices” (Greenspan , 2002). Yet the Greenspan Fed, acutely aware of bubbly conditions in the real estate market, further reduced rates to 1% in
June 2003 and kept them there for an entire year. From 2002 to 2007, house prices rose 40%. ?
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?In 2004, the Fed faced an economy with “solid gains in output and employment along with indications of some increase in inflation” (The Fed, 2004), alike to the tightening cycle preceding the .com burst. The FOMC voted unanimously in June 2004 to begin raising rates. The following 2 years saw repeated rate hikes. Notably, though, there occurred no plateau in money supply or Fed balance sheet growth, that is, the Fed was still selling macroeconomic volatility – they only did so at a slower rate. Unsound positions, both personal (mortgages) and business (production cycle lengthening and debt), known as malinvestment, failed as rates rose toward their natural level. Thus, people began selling housing and other assets turning the bubble around. The Minsky moment was here, many lower tranches of toxic CDOs failed, sparking the chain of events that led to the Global Financial Crisis. ?
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Contractionary monetary policy wasn’t the problem. The phenomenon of deflation is an inevitable necessity as explained earlier in this essay. The issue lies in the initial programme of expansionary monetary policy. This shorting of macroeconomic volatility, which artificially reduces natural levels of volatility in the market, is what creates the economic fragility that results in a financial and economic crisis when the Fed eventually tightens (buys macroeconomic volatility) or when exogenous shocks beget volatility into a fragile economy. This is the consequence of the idea of endogenous dynamics, that is, an increasingly fragile financial system and macroeconomy.?? ?
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What I have explored is the Austrian Business Cycle Theory (ABCT) in practice. Monetary policy manipulated the market by arbitrarily changing the interest rate and money supply (which increased 41% from 2000-2007) which arbitrarily distorts prices. This arbitrary manipulation of prices by a central planner necessarily leads to a misallocation of resources, as explained by Hayek (1945 and Mises (2011). Thus the sensory organs of the market economy, money and prices, were distorted, and, as Gall notes, “a system is no better than its sensory organs” (1990, p. 46). In the case of the .com bubble, relative price distortion created malinvestment in internet businesses, and in the case of the GFC, malinvestment was created in the financial and real estate sector. ?
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Bernanke, who became Fed chair in 2006, faced a severe crisis in the years 2007-2008. Mises and Hayek would warn Bernanke to stop inflating, allow the malinvestment to clear and allow the macroeconomy to return to dynamic equilibrium. This is what Mises did in Austria in the 1920s, which saved Austria from the route the oh-so-progressive Weimar Germany went down which was hyperinflation, saving his country countless lives.
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Instead, alas, Bernanke began the largest expansionary monetary policy programme in history. To avoid repetition, and to summarise Bernanke’s policy choices, he truncated the losses of the malinvestment that should have failed by creating money and shorting macroeconomic volatility. A larger policy response initiates the next growth period of a more fragile, dislocated and thus exposed financial system and macroeconomy. The boom-and-bust cycle, then, is perpetuated. ?
Gall offers another highly relevant systems engineering law, writing that “positive feedback tend(s) to expand to fill the known universe” (1990, p. 29). Inquisitively, the Fed is in a feedback situation where its response causes the crisis which leads to another crisis. This, Mises and Hayek say, is true. The known universe, then, is the U.S sovereign bond market (and beyond?) and the positive feedback which the Fed is caught in means the Fed’s balance sheet (along with the U.S. government) cannot stop growing for the alternative to such balance sheet growth is deflationary recession. This is, needless to say, politically unacceptable. Greenspan’s decisions forced Bernanke’s hand to make such expansionary decisions, id est endogenous dynamics. In a democratic society with a central bank, it is in the best interest of the politician to delay macroeconomic volatility. We have explained, then, why Hayek, near his death, wrote “we now have a tiger by the tail … if the tiger (the inflation) is freed he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished! I am glad I will not be here to see the final outcome…” (Hayek & Shenoy, 1979, back-cover). ?
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Part 3 – Is another crisis inevitable, and are these issues being addressed?
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Section 1 – Is another crisis inevitable?
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According to the ATBC, another crisis is inevitable because central banks have not fully allowed the system to rid itself of malinvestment. Every time the system tries, when it enters a recession, central banks meet this healthy process with monetary inflation which only prevents the disease from being cleared, and only adds to its severity. ?
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Debt
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Global debt levels signify are highly elevated. The average maturity of US national debt is 5 years and the current average interest on this debt is 2%. Bond rollovers, with current rates across the whole yield curve no lower than 3.7% (World Government Bonds, 2023), will result in a substantial rise in interest expense, which further elevates inflation as US fiscal spending goes deeper into deficit. Similar scenarios are present across all advanced economies. ?
The UK gilt market’s reaction to the ‘Mini Budget’, where ‘bond vigilantes’ sold off government bonds which raised market interest rates put the UK financial system hours from crisis. The market reaction to an inflationary government spending programme made necessary the Bank of England’s emergency intervention in the UK gilt market, that is, the BoE had create money and acquire bonds to reduce the macroeconomic volatility which in the first place was a rejection to inflationary deficit spending. I see this iatrogenic irony prevailing in many economies. The economic problems are globally systemic, not jurisdictionally unique. ?
A rebuttal to an Austrian economist can be as simple as “there has been no inflation, CPI has been very low for decades”. This, however, with proper economic analysis, which we do not have the space to do here, is shown to be a futile rebuttal. The Misesian position, here, said simply, is the fact that a 10% increase in productivity that would ordinarily lead to a roughly 10% rise in the exchange value of money (-10% CPI), that is counteracted with a 10% rise in the money supply, is still wildly inflationary even though CPI remains unchanged (). The productivity growth the world has experienced, especially since China and the Asian tigers have become increasingly globalised, has allowed the CPI to remain stable even when significant monetary inflation, which undermines the economy, is occurring, something argued vehemently by Booth (Booth, 2020). This is highly relevant to debt, as the deflationary nature of technology and globalisaiton means a highly indebted economy requires monetary inflation to avoid a deflationary debt cycle.
Section 2 – Conclusive commentary
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100 years of economic iatrogenics, arguably began with Keynes’ deeply flawed (Hazlitt, 1960) (Hazlitt, 1973) (Ludwig von Mises, 2013) work between the two world wars, is partly to blame for the global economies fragility, stagnation, inequality and inflation. These iatrogenic policies have thrust policy makers between a-rock-and-a-hard-place, forcing them to decide between the lesser of two evils, recession or monetary inflation. What I have tried to show is both why and the fact that monetary inflation is always chosen. ?
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Are these lessons being addressed?? ?
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Gall offers us a frightening systems law, by saying “taking it down is often more tedious than setting it up” (1990, p. 128). As I have showed, the monetary inflation of the prior 100 years alludes to an economy plagued with significant malinvestment. That is to say, many global economies are already too far down the path of monetary inflation and misallocation, thus purposely onsetting a large recession to clear malinvestments is politically unacceptable. The feedback loops and dynamics I explore ultimately end in, and I do not use this word lightly,? hyperinflation and currency re-structuring. It is no coincidence that Ayn Rand’s stories always end in the complete destruction of the system, be it the American economy (Rand, 2005) or the architects building (Ayn Rand, 1943). Taking a Randian position, that instigating coercion on a peaceful individual is immoral, then we can reject the existence of fiat currencies and recommend that western economies allow the market to choose which commodity that is to be used as money. Thus, in this context, any effort to improve the Fed’s ability to conduct monetary policy is immoral and is to be avoided. Only creating a new monetary system can rid the global economy of this iatrogenic paradigm. Historically, such monetary re-structuring has happened numerous times. This was what French economist Jacques Rueff vehemently argued for in the 1960s (Rueff, 1964) (Rueff, 1972). ?
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To answer the question, is this being addressed, I would say it is not. However, the recent growth of the Austrian School of Economics, which is the fastest growing school of economics worldwide, may allude to the fact that the themes discussed in this essay are being addressed. Further, the invention of a digital private money, called Bitcoin, is certainly a notable event in monetary history and the history of economic libertarianism. It is yet to be observed the impact that this technology has had on global economies. ?
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There is little addressing of these problems at the Central Bank level, who continue to utilise and conduct policy based off unsound inductive economic theories. Taleb (2017, p. 14) importantly notes that “you will never fully convince someone that he is wrong; only reality can.” Under this idea, if Mises and Hayek are right, then reality may be economically painful and only then will policy makers may understand that “if you are not part of the solution, you are part of the problem” (1990, p. 172). ?
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This is a reality that Argentinian voters realised. 100 years of creeping economic collectivism, that inevitably caused socio-economic issues, that were further attempted to be cured with economic collectivism, caused Argentina become impoverished, turning from being one of the wealthiest economies to one of the poorest in the world (Llamas, 2020). Thus, they voted in Javier Milei, and Austrian economist, who is acting upon Gall’s systems engineering law and Misesian economics to reduce the size and role of the state in the economy and abolish the central bank. ?
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Conclusion
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After a period of monetary inflation, deflation and recession are what the economic system would organically undergo but monetary policy denies it this action. As I have explained, if central banks deny economic freedom perpetually then the currency will hyperinflate. Austrian economics and Gallian systemantics is a call to humbleness in the face of a complex system.
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Yet, as Adam smith teaches us the free market can march on “in spite of all the extravagances of government” (Smith, 1999, Book V, Chapter II, Part III). Thus the state in which the primarily western economies find themselves in, namely, increasingly unequal, inflationary and stagnating economies, may continue in spite of monetary policy iatrogenics. ?
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In economics, physics-envy is ever salient. Philosophically, inductive economics exist now in an epistemological crisis. That is, validity has replaced soundness as the core of economic rhetoric. Inductive economic theories by their very nature are unfalsifiable until experimented in reality, yet this experimentation, as I have made the case, is the cause of the business cycle. Only when inductive economics is firmly rejected, replaced instead by deductive economics (Mises, 2013) can economic policy find its foundations in scientific analysis and therefore no longer be iatrogenic. Our current economic and philosophical paradigm finds us entering a crisis and trying plan A, then B, then C. What I have tried to show is monetary policy is not idiosyncratic, but repetitive and inherently causative, so plan C is generally the same as plan B, and so A, so D.? ?
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This conclusion is certainly radical in context of prevailing thought. But such a conclusion, recommending laissez-faire monetary policy, would have been the standard response only 100 years ago.? This conclusion is justified in its radicalness because I identify the scale of the problem. The GFC, corollary to that, the climate crisis, socio-economic inequality and geopolitical issues, are an increasingly threatening problem. Big problems require us to ask ourselves big questions. Maybe the problems root is in the medicine that we believe is curative? If that is the case, that monetary policy is iatrogenic, then the question that remains is what Plan is economic laissez-faire chosen. I fear closer to Z.? ?
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[1] Central Banks are not a product of a free market, instead, they are necessarily the product of government action into the banking system? ?
[2] I label this idea ‘endogenous dynamics’ for ease of referencing in this essay. ?
[3] Interestingly, this hedge fund sold market volatility short and quickly became bankrupt – the same trade which I propose the Fed is doing. In the Fed’s case, however, as it is the issuer of money, it cannot go bankrupt. ?