[Editor’s Note: The "V&V Q&A" is an e-publication from The Center for Vision & Values at Grove City College. Each issue will present an interview with an intriguing thinker or opinion-maker that we hope will prove illuminating to readers everywhere. In this latest edition, Dr. Paul Kengor, the executive director of The Center, interviews Dr. Jeffrey M. Herbener, the chair of the department of economics at Grove City College and fellow for economic theory & policy with The Center, on the topic of economic booms and busts. This is one of an ongoing series of interviews on the current economic crisis with Jeff Herbener.]
Dr. Paul Kengor: Dr. Herbener, about 10 years ago, you were writing about boom and bust. What part of the world were you talking about, and how does that have relevance for America today? Are we repeating that very recent history right now?
Dr. Jeffrey M. Herbener: We are reliving not just the recent history of the booms and busts of the dotcoms, Japan, and the Asian Tigers, but the history of booms and bust around the world for the last several hundred years. In the 1980s, the Japanese embarked on a policy to make the yen a reserve currency in Southeast Asia. Under this system, the Bank of Japan would inflate the yen and then, through international trade, some of the additional yen would wind up in Thailand, Malaysia, and other Southeast Asian countries. The central banks and commercial banks in those countries would hold more yen as reserves against the issue of their own domestic money stock. As long as the monetary inflation was coordinated among the countries, their currencies would not suffer significant devaluations or appreciations against each other, even though monetary inflation continued apace. Unfortunately for the Japanese, as they began to inflate the yen more heavily in the second half of the 1980s, the United States adopted a “strong dollar policy,” which caused the yen to devalue against the dollar. For this reason and others, countries in Southeast Asia gave up their yen reserves for dollars and the yen-reserve system crashed to the ground. The repatriation of yen to Japan threatened price inflation, and when the Bank of Japan shifted from expansionary to contractionary monetary policy in response, it precipitated the financial collapse beginning early in 1990.
Kengor: And you say that what followed for Japan has been disastrous?
Herbener: What followed was a series of policy blunders that have mired the Japanese economy in a nearly 20-year slump. The problem in an economic bust is that a significant number of capital projects built up during the boom prove to be unprofitable. New mines, factories, equipment, etc., constructed to satisfy rising demands during the boom, now sit idle for lack of demand. To make the best use of this malinvested capital capacity, some of it, at least, must be sold to other entrepreneurs, and used by them in other lines of production which are profitable. Unless the liquidation and reallocation process is permitted to run its course, the economy will never recover and return to normalcy. Since 1990, the Japanese government has done everything in its power to prevent liquidation and reallocation. Bailouts of businesses and banks, more monetary inflation—even to the point of driving interest rates nearly to zero—massive public works projects to rebuild infrastructure, all have done little to lift the Japanese economy out of its slump. After peaking at 38,915 in December of 1989, the Nikkei 225 fell 79 percent to a low of 7,992 in March of 2003, and now stands at 8,438—still 78 percent below its peak.
Kengor: What has been the primary long-term consequence for Japan?
Herbener: The main accomplishment of the Japanese government in nearly 20 years of attempting to revive the Japanese economy is government indebtedness. Currently, Japan’s 170-percent debt-to-GDP ratio ranks third highest in the world behind Zimbabwe and Lebanon. The next highest developed country is Italy at 104 percent.
Given the eerie similarity between the current and promised policies of the U.S. government and those of the Japanese over the last 20 years, Japan’s experience bodes ill for our own future.
Kengor: What about elsewhere in Asia?
Herbener: The dollar-reserve system fared no better in Southeast Asia as a replacement for the yen-reserve system. When the Federal Reserve inflated the dollar in the first half of the 1990s, banks in Southeast Asia dutifully held them as reserve against the issue of their domestic money stock. By mid-decade, however, the central banks in Southeast Asia could not resist the temptation to over-inflate their domestic currencies relative to their increasing dollar reserves. The over-inflation of the Thai baht, the Malaysian Ringgit, and others led to severe devaluations internationally and price inflations domestically starting in 1997. As the system disintegrated, dollars moved out of these countries and were invested and held in other areas of the world. A repatriation of dollars started, which, coupled with continued Fed inflation of the dollar, fueled the dotcom boom-bust in the United States. After peaking at 5,048 in March of 2000, the NASDAQ Composite Index fell 78 percent to a low of 1,114 in October of 2002 and now stands at 1,506—still 70 percent below its peak.
Kengor: What’s the common causal factor between what happened abroad in the 1990s and what’s happening in America right now?
Herbener: Countries around the world have the same government-controlled monetary system. It consists of a government-run central bank, which produces legal-tender, fiat paper money, and government-regulated commercial banks that issue money substitutes (mainly checking accounts) only partially backed by reserves of money.
Central bank monetary inflation drives the boom in the following way: It increases reserves of money held by banks against their checkable deposits. Since the banks are required by the central bank to hold a certain fraction of their checkable deposits as reserves, any additional reserves of money allow the banks to expand their checkable deposits by a multiple of their additional reserves. For example, if the central bank requires a five-percent reserve against checkable deposits, and it increases bank reserves of money by $1 billion, then banks can issue an additional $20 billion in checkable deposits and still meet their five-percent reserve requirement. The banks issue the additional checkable deposits by writing new loans. Because the central bank can issue new fiat-paper money indefinitely, it can continuously increase bank reserves and drive forward the banks’ issue of checkable deposits and expansion of credit. Monetary inflation and credit expansion fuel the economic boom.
Kengor: Why are the banks in trouble? How do commercial banks and the central bank fit into this current crisis? Who did what and when?
Herbener: At any point in time, banks have made loans to the most eager and most credit worthy borrowers. When the Fed induces monetary inflation and credit expansion, banks extend credit to less eager and less credit worthy borrowers. Although the greater risk is not problematic for the banks during the boom when asset prices are rising, a wave of defaults washes over them when asset prices collapse in the financial crisis. During the eight years of the Bush administration, the Fed generated an increase in the money stock of 85 percent through additional bank lending.
The problem of bad loans is made worse by various government regulations. Since the creation of Fannie Mae in 1938, the Federal government has sheltered banks from the greater risk of the loans they make during a credit expansion. In 1968, the federal government converted Fannie Mae into a quasi-private institution and, two years later, it created Freddie Mac as a brother Government Sponsored Enterprise. Fannie Mae and Freddie Mac purchase mortgages written by banks and then hold them or broker them to other investors. Because the banks that write mortgages have a ready buyer for them, they do not have to worry about the riskiness of the loans they make. Someone else will be holding them when the wave of defaults comes. Around 21 percent of newly written mortgages from 2004 through 2006 were subprime, compared to only nine percent from 1996 to 2004. As of 2008, Fannie Mae and Freddie Mac owned roughly half of the $12 trillion in mortgages in the United States. When the government took them over in September last year, Fannie and Freddie had $1.7 trillion in unsecured debt and $3.5 trillion in mortgage guarantees. By the time the subprime mortgages written by U.S. banks collapsed in value, they were being held by financial institutions around the world.
Kengor: How does the FDIC fit into this?
Herbener: Another government regulation that worsens the bad loan problem is deposit guarantees by the FDIC. These guarantees lessen the check on bank expansion of riskier loans by reducing the incentive people have to redeem their deposits for cash. If banks always had to make good on their redemption promises out of their own reserves of money, they would be less likely to issue more un-backed checkable deposits by writing riskier loans.
In addition to the problem of bad loans, banks that hold only a fraction of their checkable deposits as reserves of money are subject to bank runs. When even a small portion of customers try to withdraw cash from their checking accounts, the bank runs out of reserves of money and cannot meet its obligation to redeem such accounts for cash. Despite the FDIC and the efforts of the Fed, bank runs are not a thing of the past, as the failure of IndyMac Bank and Washington Mutual illustrate.
Kengor: Dr. Herbener, thanks for your time.
Herbener: Thank you.