The Truth and Financial Meltdown

  • Print

Today’s anti-Wall Street protests show that many citizens are blaming Wall Street for the country’s economic difficulties. Even the President of the United States has expressed sympathy for the protestors. In recent days police and protestors have battled in Manhattan – with protestors shouting “Hell no! We won’t go!” These children of America apparently feel that the traditional wellspring of American prosperity is den of iniquity. This view was summarized in a 2010 documentary film titled Inside Job. The film outlines “the systemic corruption of the United States by the financial services industry….” Most critics gave the film high ratings. But Barrons economics editor Gene Epstein warned readers in an Oct. 2010 review that the documentary’s outrage was “misdirected.” Those who watch the film, wrote Epstein, “will still be left with a dim understanding of the root causes of what happened, and thus a dim grasp of what should be done to prevent it from happening again.” The people who made the film were not financial experts.

In 2009 Carmen M. Reinhart and Kenneth S. Rogoff came out with a book titled This Time is Different: Eight Centuries of Financial Folly. According to Reinhart and Rogoff, “…financial crises follow a rhythm of boom and bust through the ages.” Our time is not different from other times. We are subject to error, like our forebears. We saw the warning signs and ignored them. Asset price inflation and rising leverage mean something. Too much credit makes a bubble, and signifies a mountain of debt. A government that cannot live within its means during prosperous times is going to fall off a cliff in bad times. “On average,” noted Reinhart and Rogoff, “government debt rises by 86 percent during the three years following a bank crisis.”

When bubbles burst wealth is lost and society suffers a large-scale setback. As Reinhart and Rogoff noted, “The aftermath of systemic banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources.” In the process of balancing the system, huge public debts are accumulated. In the end, these debts cannot be paid off. Default becomes inevitable.

Default is a universal phenomenon. It is not merely a phenomenon of developing countries. One merely has to look at the present situation of Europe and America.  Under a democratic system, however, debt becomes politicized. At the same time, governments tend to maintain a low level of transparency regarding their books. Government also prefers to mask the instrument of its default (i.e., inflation).

History shows that financial systems are fragile, confidence is fickle, and governments are spendthrift. A prolonged period of prosperity sends the wrong message to investors and to government. People are spoiled by past success. They expect the future to resemble the immediate past. They forget what happened to their grandparents.  According to Reinhart and Rogoff, “What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fused asset price explosions seem too good to be true, they probably are.”

It is human nature to repeat certain mistakes. It is human nature to say, “This time is different.” Those who say that we cannot have another Great Depression were wrong. Those who say the United States government cannot default were also wrong. As the authors noted, “The traditional public finance literature warns about the shortsightedness of governments in running fiscal deficits and their chronic failure to weigh the long-run burden that servicing debt will force on their citizens.” There is a fundamental connection between collapse and debt.

The capitalist system is far from perfect. It engenders a cycle of bust and boom. Through the eight centuries of financial crisis outlined by Reinhart and Rogoff, the global economy has enjoyed tremendous growth. Crisis was part of the price for that growth. You cannot have a vibrant and creative economic system without an adjunct of “creative destruction.” Those dictators or demagogues who have curbed the capitalist system for its “excesses” have only succeeded in establishing grinding poverty for the majority of their own citizens. For such economies, there is only bust.

It is not street protests that will guarantee economic recovery. Only the freedom to buy and sell grants the possibility of a better future. This is the teaching of history. This is what the protestors on Wall Street need to know. 

CLICK HERE to subscribe to the free weekly Best of Financial Sense Newsletter .

About JR Nyquist

Quantcast