Adam Smith Club dinner, 25 May 2011
Thank you Tim Warner for those kind words of introduction.
1776 was one of those magic years when the world seems to move under mankind’s feet.
- It was the year of the American Revolution.
- It was the year in which Gibbon’s Decline and Fall of the Roman Empire was launched in London and became an overnight sensation.
- James Watt finally launched an efficient steam engine after years of poverty and struggle, and arguably this launched the industrial revolution. AND, of course,
- It was the year when Adam Smith’s Wealth of Nations was published.
I think of Adam Smith as capitalism’s philosopher. His ‘invisible hand’ provided a concept that economists still see as the essence of how capitalism works. He endorsed self-interest as the primary driving force of economic progress, but still saw a role for government doing things that could be done better than by market forces alone.
Smith saw men’s concern for the good opinion of their fellows as modifying the force of naked self interest, a part of his message that has been diluted, if not entirely dismissed, in some centres of extreme capitalism such as Wall Street, New York.
I wrote this book because I have serious concerns about how economic policy is being practiced. ‘Too much experimental ‘discretion’, too little use of stable, well understood rules’.
Unhelpful actions include near zero interest rates in the USA plus ‘quantitative easing’ (= printing money). This misguided policy is laying the basis for serious global inflation, is reinforcing the great Greenspan-Bernanke asset bubble and will be a primary cause of the next great asset bust.
Massive, largely wasteful, programs of government spending were introduced in advanced western nations in 2008 in a panicked response to the crisis. Now, just a bit over two years later the world has angst and hand-wringing about the size of government debt in major nations, including America.
The willingness to bail out all the major financial institutions in trouble but one, Lehman Brothers, was a clear sign of scary inconsistency in the thinking of America’s leaders. This inconsistency created a massive crisis of confidence in global finance which fortunately was overcome before the world was plunged into depression.
But we are not yet out of the woods. This week, market participants, the canaries in the coalmine of capitalism, are wobbling on their perches for two reasons – concerns at debt mountains in Greece and some other Eurozone nations, and because China might stop its runaway boom,
Some lessons of history.
When I spoke at a Quadrant dinner in Sydney, Keith Windshuttle kindly said Great Crises of Capitalism is built on a solid foundation of economic history. Tonight I only have time to make brief comments about each crisis but I shall focus on the key points.
Tulip Boom, Holland, 1636
There is a lot of controversy about whether the Tulip boom really was a mania and this debate has great interest for economists who differ about whether markets are always in equilibrium.
The episode showed something that became accepted as inevitable – asset booms are followed by asset busts. Also that the losers in such events lobby for assistance, and retribution.
The government of Holland wisely fumbled the ball and in the end said the issue should not involve action on its part. The Dutch courts were also appealed to, but it described trading in tulips was gambling and therefore beyond its jurisdiction.
Holland in 1636 certainly understood the virtue of a policy of caveat emptor far better than capitalist nations do now.
Mississippi Bubble, 1720
Here we find one of the many enterprising Scotsmen who made Europe what it is today. John Law murdered a man in a duel and had to leave Scotland. He travelled Europe, living as a professional gambler, whilst seeking a sponsor who would let him implement his invention of paper money. The French economy was struggling, with heavy national debt. Clipping the metallic currency was an established practice.
France had an innovative Regent who allowed Law to try out his ideas via the vehicle of the Mississippi Company. A small amount of paper money improved the French economy, so let’s try a larger amount seemed to become the plan. Like most governments after his, the temptation to print money was irresistible and the net result economic ruin.
First, however, there was the mother of asset booms, with great people clamouring to be allowed to invest in Mississippi stock, poor people becoming rich, rich people becoming even richer as the value of Mississippi company stock increased one thousand-fold. Then came the inevitable crash.
Retribution was arbitrary and savage. The borders were closed to prevent people from escaping with their loot. One enterprising aristocrat took gold out of his bank, filled a cart with this portable wealth and a covering of manure and old bags, dressed himself in rags and took his fortune to Belgium – obviously an enterprising fellow with an ego under sufficient control to pass as an impoverished peasant.
Another aristocrat was broken on the wheel, a horrible death whose savagery greatly exceeds the modern alternative of time in a comfortable low security goal.
South Sea Bubble, 1720.
Some people were smart enough to take profits in Paris and go to London for another roll of the dice. In London it was John Blunt who became the entrepreneur of the year as he got a mandate to turn the national debt into stock in his South Sea company.
Buoyed by tales of wealth for all from trade in the ‘South Seas’, the value of stock rose sharply amid scenes reminiscent of those only months earlier in Paris. England was more restrained however, with the cumulative rise in South Sea stock only eight times, still sufficient to make great fortunes before the inevitable crash wiped out the fortunes of those holding stock at the time. Some of the saddest cases were lords of the realm who had mortgaged their vast properties to buy South Sea stock on margin, which worked out just fine until the price of the stock plummeted.
Retribution was more systematic than in France, but penalties included loss of all, or almost all, the wealth acquired during the boom. The grandfather of the great historian, Gibbon, had his fortune confiscated but his grandson was proud to record much later that his grandfather made another fortune before he died.
Charles MacKay quote – p 251 of Great Crises – no-one blamed the people for their ‘credibility and avarice’.
Time speeded up as the eighteenth century saw the beginning of the industrial revolution.
The Age of innovation
The late eighteenth century and the nineteenth century was the time when the industrial revolution really took off. Invention after invention occurred, all building on the enormous efficiency involved in capturing energy from fossil fuels and using it to generate new wealth. Invention produced new industries, colonisation exploited new markets and new lands and financial booms and busts became almost a regular part of what came to be called the trade cycle.
In 1849 and again in 1851 there were vast gold discoveries in California and Eastern Australia, and the new gold fired up the economies of newly industrialising nations of the west, leading US shares to rise by five times in fits and starts in the second half of the century.
Booms and busts were relatively contained, however, both compared to those we have already discussed and those later booms of the twentieth century. I attribute this to the relatively smooth working of the gold standard. Certainly it is the absence of the gold standard, which was by-passed during America’s roaring 1920s (as explained in the book) and absent from the early 1970s (after America’s President Nixon cut the US dollar’s link to gold) that is the major difference in the regulation of capitalism between the relatively tranquil nineteenth century and the turbulent twentieth century.
The book devotes a chapter to Marvellous Melbourne’s astounding property boom of the 1880s and awful property bust in the 1890s, which produced one of history’s truly horrible depressions. Currently Melbourne’s house prices seem to be stable, or even falling. But there are many similarities between this time of great commodity boom and the great development of Marvellous Melbourne from 1851, so I urge caution. History suggests that every great boom is followed by a great bust.
Keynes quote – p 45 of Great Crises – ‘extraordinary progress’ ended in August 1914, due to Germany’s ‘insane delusion and reckless self-regard …’ and ‘roll of the iron dice’.
The Age of Inflation and the remedies for this.
The twentieth century was another age of great technical and commercial progress. Sadly, however, progress was both checked and advanced by two horrific wars and a Great Depression.
These were great crises, notably in financial terms that following the major boom of American share prices in the Roaring Twenties. The gold standard was effectively avoided as the US Federal Reserve system lent to private bankers, against its stated policies, at a low rate of interest, allowing private bankers to lend to investors to purchase shares on margin, with far higher interest rates nevertheless irrelevant while-ever share prices kept rising.
Why the major asset bust which followed the Roaring Twenties turned into a Great Depression, has not been satisfactorily explained by economists, at least not in my opinion. Thus the modern tendency to allow asset booms to run until they run out of steam more or less on their own – stated as doctrine by Alan Greenspan, endorsed so far by Ben Bernanke – is more than a bit worrying. Also worrying is the apparent tendency for asset booms and busts to become both more frequent and larger in the late twentieth century, which I attribute to American monetary policy – based on paper money and marks in great computers - providing an insufficient ‘anchor’ for the global economic system.
My proposed remedy is introduction of a modern version of the gold standard. Such an approach was in fact suggested by John Maynard Keynes at the Bretton Woods conference in 1946. As victors-in-chief, the Americans rejected that idea and insisted that the US dollar be the global currency. I have also learned that the Chinese central bank has recently promoted a similar idea. In effect I am proposing a global central bank with a mandate to control goods and services inflation and to lean into the wind of asset inflation.
The world also needs simpler, more transparent and more consistent rules for the conduct of fiscal policy and approaches to the bail out of financial institutions.
Deep-dyed conservatives, some present tonight, will object to the thought of a global central bank with a mandate to provide steady growth of some sort of commodity standard. I suggest that this is the least-bad way to secure a prosperous future for capitalism. Without a stable, non-inflationary anchor at the heart of the capitalist system, the alternative will be a return to widespread protectionism, with controls on capital flows, less free trade in goods, services, people and assets generally.
This is the choice we face – we reform free-market capitalism in the way I suggest or we adopt constrained capitalism and a far poorer future.
Editor’s note: as in earlier presentations, the proposal for a global, inflation fighting central bank caused great controversy. As Michael Warby said, it would be far easier and more practical to get major countries to have sensible and consistent monetary policies. PDJ agreed, but said that a global central bank with a commodity standard would provide a better anchor for the world economy and would allow national currencies (and other competing monies) to become legal tender everywhere, following an old libertarian dream.
Others objected, arguing that allowing a free market in monies would fix problems without the tyranny of a global central bank. PDJ said he would not wish to risk the chaos of a free market in monies without a stable anchor at the core.
In summing up what was a vigorous debate, President Tim Warner said that PDJ’s proposal was an interesting half-way house between the gold bugs and free monies proponents. Getting the two positions to contemplate the other is ‘a very good thing’ as ideas in isolation do not tend to improve.
Michael Warby’s review of Great Crises of Capitalism.
Part 1 http://lorenzo-thinkingoutaloud.blogspot.com/2011/05/great-crises-of-capitalism-i.html
Part 2 http://lorenzo-thinkingoutaloud.blogspot.com/2011/05/great-crises-of-capitalism-2.html
Part 3 http://lorenzo-thinkingoutaloud.blogspot.com/2011/05/great-crises-of-capitalism-3.html
Carson Scott’s interview, SkyNews, 29 April 2011