THE NEW DEPRESSION

Richard Duncan

Sub-Title: The Breakdown of the Paper Money Economy - John Wiley & Sons, N. Y., 2012, 179 pgs., index, notes, tables, graphs

Reviewer Comment:
This is a very important book. The author is correct in his warning about the results coming from the massive expansion of credit. I probably should not quibble, but I disagree with his idea that credit has taken the place of money, narrowly defined as currency and demand deposits. No, because credit was always a component of money. What has happened is that credit has become a vastly larger component of the money supply relative to currency. Since credit=debt is itself most of the money supply, a reduction in debt creates a reduction in the money supply just as if, or worse then, if someone burned billions of $100 dollar bills. And this massive bulge of credit is composed of both government debt and private debt. The linguisticd mix of terms 'money, currency, credit causes more than semantic confusion. It leads to false conceptions about what to do about the dangerous situation. And we see this result in his recommendation in the final chapters for government to 'perpetuate the boom' by increasing massive expansion of debt.

Preface:
Mr. Duncan begins with: "When the United States removed the gold backing from the dollar in 1968, the nature of money changed. The result was a proliferation of credit that not only transformed the size and structure of the U. S. economy but also brought about a transformation of the economic system itself."
Granted the removal he cites was a very significant event, but credit=debt has always been an important component of the American money supply and for that matter important since ancient times. Credit was already expanding before 1968 and actually the elimination of the gold backing was a forced result rather than a cause. I believe the author is correct about the dire consequences of the huge expansion of credit, but not the cause he cites. Yes, he rightly notes that 'credit expanded 50 times between 1964 and 2007' - but note his date of 1964 is 4 years BEFORE the 1968 event, and it was expanding before that. And it had expanded previously, for instance in the later 1920's. Yes, as he notes, credit began to contract in 2008. This effectively reduced the money supply, triggering deflation. In this preface the author briefly outlines the topics he will discuss in each chapter. He concludes with this: "The price the United States ultimately pays for abandoning sound money may be devastatingly high, both economically and politically". Very true, but let us see what his recommendation is in the final chapters.

Chapter 1: How Credit Slipped Its Leash
He begins with: "Credit induced boom and bust cycles are not new." Exactly - He continues that this one is 'extraordinary' due to its magnitude, and I agree. He cites the two legal constraints on credit creation, true enough, but in my opinion rather flimsy given prior history. Duncan then cites President Johnson's request to end the backing of dollars by gold, to which Congress agreed. But why did the President make the request? My answer, for the same reason the Federal Reserve was created in 1913 - to expand the money supply needed for expanding government to achieve its policies. Duncan provides a graph and explanation that dramatically depicts his point. The credit component of the money supply did expand massively. Among his points: "In 1968 credit exceeded GDP by 1.5 times. In 2007 , the amount of credit in the economy had grown to 3.4 times total economic output." (that is GDP). More, "Total credit in the United States surpassed $1 trillion for the first time in 1964. Over the following 43 years, it increased 50 times to $50 trillion in 2007." Of course I agree fully with his data and conclusion, but only point out that the $1 trillion already in 1964 was far too much.
To expand his theory he writes: "The Federal Reserve Act of 1913 created the Federal Reserve System and gave it the power to issue Federal Reserve Notes (i.e. paper currency). However, that Act required the Fed to hold 'reserves in gold of not less than forty percentum against it Federal Reserve notes in actual circulation' In other words the central bank was required to hold 40 cents worth of gold for each paper dollar it issued." Very true, but already paper currency was a smaller and smaller component of the real money supply. Massive amounts of credit were being created by the commercial market. In my opinion he is focused too much on currency and gold and not enough on credit=debt.
For instance. "Once dollars were no longer backed by gold, the nature of money changed. The worth of the currency in circulation was no longer derived from a real asset with intrinsic value. In other words, it was no longer commodity money. It had become fiat money - that is- it was money only because the government said it was money."
In my opinion this misunderstands money. First, all money is only money because the government says it is - it is all fiat money. Second, there is no such thing as 'intrinsic value' and for sure gold has no 'intrinsic' value but only relative value just like very thing else. Third, again, currency is but a component of money. The governments are not the only creators of money, but they are the source of the value of what is used as money because they pass laws that ensure the validity of contracts and the safety of private property.
He continues with very correct data about the FED increasing the quantity of paper dollars, but links this - 'it still served as the foundation upon which new credit could be created by the banking system." But credit was being created by many other agencies than the banking system. In fact we eventually learned about the economists new entity the 'shadow banking system' composed of non banks, for instance, airlines. Mr. Duncan then describes the 'fractional reserve banking' phenomena, a system that has been the core of banking itself since banks were created. He gives the standard, simplistic, description but asserts that this is the only mechanism for credit creation. He correctly does note that banks shifted from reliance on demand deposits to time deposits, but does not mention that banks borrow (that is go into debt themselves) the funds they then lend. Eventually he gets around to discussing non-bank credit creation, dating it as of 1970. I believe the 'shadow banks' were creating credit before 1970, but agree with his depiction of the dramatic expansion of credit he shows in graphs and text related to the creation of 'asset-backed securities' and entities such as Fannie Mae.
His fundamental point is the critical one. "Because credit growth now drives economic growth, the flow of funds in the key to understanding developments in the U. S. Economy." (I hate this term 'growth' - it should be 'expansion'. His exhibit 1.9 is very important as it shows the breakdown by owner of the debt from 2006 to 2010. He shows in Exhibit 1.7 and text another important category - That 15 percent of all credit in the U. S. by 2007 was held by 'the rest of the world."

Chapter 2: The Global Money Glut
In this chapter Mr. Duncan describes the world money system starting with Bretton Woods. This system also broke down in 1971 when many central banks began 'printing' money. The short chapter is devastating in its depiction of massive world-wide credit creation. I am pleased to read Mr. Duncan's debunking of the so-called 'global savings glut' one of former FED chairman Bernanke's excuses for FED incompetence.

Chapter 3: Creditopia
In this chapter the author explains what the '$50 trillion' credit expansion did to the U. S. economy. It ain't pretty, Magee. He focuses first on who borrowed money. The many graphs show what happened. He writes: "Credit did more to the U. S. economy than make it grow (sic). It also radically changed its composition. His graphs depict the change. One shows that the manufacturing section, which had contributed more than a quarter of all economic output during the first two decades after the war (WII), went into steep decline just as the Bretton Woods System broke down in 1971." "Meanwhile the share of economic output of the finance and real estate sector grew, particularly after the credit boom of the early 1980s got underway."
Of course I dispute the basic data on 'economic output' (nominal versus real) but deny that the financial sector contributes anything to either - it is a parasite on the economy that extracts wealth from those who create it.
He continues, "The nature of money changed in 1968, and that change transformed the economy. It has become increasingly difficult to distinguish between money and credit. Moreover, the amount of credit has grown so large relative to the amount of what was previously understood to be money, that it has made money irrelevant."
This is only true because Mr. Duncan persists in failing to realize that credit has always been a component of money, only varying in extent over the centuries. Of course it is difficult to distinguish between money and credit. Credit IS money. Now it certainly is true that the credit component of money has expanded to unprecedented extent and relegated currency to inconsequence and with dire results..

Chapter 4: The Quantity Theory of Money
Again, the author begins with a misconception. "So long as gold was money, credit creation was limited by the supply of gold." But gold has never been the significant component of money even though the U.S. dollar was defined on the basis of a fixed quantity of gold. For centuries currencies were mostly silver, not gold. And, as I have noted, credit has always played a significant role as well. The role of the 'gold standard' he is thinking of was a very brief interlude in the history of money. But his topic here is the 'quantity theory of money'. Another dubious theory.
Nevertheless, due to his insistence that credit is something different from money he invents a new theory 'the quantity theory of credit'. He asserts: "Focusing on credit instead of money, the quantity theory of credit creates a powerful analytical framework that explains the causes of the new Depression, as well as the government's policy response to it thus far." But all we have to do is recognize that local bank creation of credit as an important component of the money supply repeatedly in the 19th century and the subsequent collapse of that credit generated the repeated bank crises and short depressions that are discussed in any course on American history. He then brings in Irving Fisher's theory of money and economy with the famous equation - MV=PT. Naturally, he has to comment of this imaginary V - velocity and create an equally imaginary concept of velocity of credit. Well, I will skip discussion of this V - velocity here. But point out that David Hackett Fischer in his real history of prices "The Great Wave' showed that waves in rising prices since the 12th century were due to many other factors than the 'quantity theory of money'. Mr. Duncan discusses all this at length including the confusion amongst 'monetarists'.
My point is that Mr. Duncan is correct in his focus on the unsustainable volume of credit but that he introduces an unnecessary confusion by calling it something other than money.

Chapter 5:- The Policy Response, Perpetuating the Boom
The author begins on a high note. "What a pity that Bernanke did not read Ludwig von Mises instead of Milton Friedman in graduate school. If he had, he would have known that credit creates the boom and that all booms bust." Simply outstanding. Again, I believe this is the central issue and that the author correctly focuses on it. He points out that Bernanke and the FED have been basing their faulty response in 2008 to their misunderstanding of the causes and failed responses to the Depression in the 1930's.
"Those who want to understand what lies ahead must understand that the FED's one and only policy has been and will continue to be to perpetuate the boom by ensuring that credit continues to expand." The chapter describes what will result from this mistaken FED policy. Again a key comment: "The Austrian economists provided the best explanation for the business cycle, the alternating boom and bust pattern that has characterized the economic process in capitalist economies since the beginning of the Industrial Revolution. They identified credit expansion as the catalyst" Just what I was trying to point out in comment on the previous chapters, because credit WAS money. The chapter contains an excellent critique of FED policies such as QE1 and QE2 and monetizing the debt. Then the author turns to "Diminishing Returns". He writes that the impact of these policies such as QE are subject to the law of diminishing returns. So right. The more credit expands the less favorable impact can be achieved by a further unit of expansion. In other words the FED puts the country on a tread mill that requires more and more credit expansion to sustain economic activity.

Chapter 6: - Where are We Now?
Answer, "We are at the top of a forty year, credit induced economic boom without any obvious means of expanding credit further." "One of the themes of this book is that credit growth has become the driver of economic growth during recent decades."
But my question is "Is this real increase of wealth? The author is concerned that credit cannot continue to expand. He discusses each major economic sector such as 'household debt' to see. He provides graphs and data that indicate that household debt cannot expand - nor the private sector as a whole. Now we are becoming scared at what is coming.
He notes, 'It was only a $4.6 trillion increase in government debt since the end of 2007 that prevented a contraction in TCMD (the economy) so sharp that it would have produced a replay of the Great Depression." And of course there has been more debt increase since 2007. He then discusses the 'safety' of the banking industry - especially the big banks. His conclusion is that the situation has not improved.

Chapter 7: How it Plays Out
Mr. Duncan focuses on the business cycle (that is this boom and bust cycle). He quotes von Mises again that booms always result in busts. But then we become alarmed when we read. "It is important to understand that the increase in government debt did more than just offset the contraction in private sector debt. Had government debt not increased by so much, the economic crisis, would have been far worse and consequently private sector debt would have shrunk by far more." He gives year by year data on decrease in private debt with increase in government debt. He is concerned that private debt will contract more. He writes: "Credit growth, inflation, and fiat money creation will determine the fate of the U. S. economy over the years immediately ahead." Certainly true, but what to do? Now, this book was written in 2011 so the author's predictions are for 2012.

Chapter 8: - Disaster Scenarios The author begins with: "The New Depression and the Great Depression were both caused by credit-fueled economic booms. In both instances, the boom began when the link between money and gold was broken."
The first sentence is right but the second is not. The were indeed caused by credit expansion, but so were the many boom=busts in the U. S. during the 19th century and many others around the world including famous ones in England and France. What made them worse was the creation of a more unified bank system thanks to the creation of the FED. Again his concept of money betrays him.
He writes: Consider first what happened last time. In 1930, the United States' money supply comprised currency held by the public (9 percent) and deposits held at commercial banks (91 percent). Banks fund their loans with their customer's deposits."
But currency was and is only a component of the money supply. Already in the 1920's credit=debt was created not only by banks. Among other sources of credit=debt were margin accounts with stock brokers. And there were debts in agriculture.
But his description of the cascading result of the collapse of credit is excellent. In fact he notes that the contraction of credit was a shrinkage of the money supply. Well, which is it? No one was burning paper money, currency was not contracting, it was unsupported credit that contracted. And the reason it created a 'systematic' collapse was because the FED created a 'system' that had not been so unified before. He provides more graphs and text to describe the wide spread results of this contraction. Among them he notes: "The most rapid descent into disaster would occur through a collapse of the banking system." Exactly, because individual banks were now linked into a system since 1913. Just as it is today, when one institution's assets are another's liabilities and reverse. When liabilities cannot be paid by A then B's assets shrink and the results are contagious. He then correctly describes how a contraction today of (for instance the $52 trillion in the U.S. to $35 trillion would cause a massive contraction throughout the economy. I just wish he would not persist in calling this credit 'new money' or conger up an abstract concept that there is a 'velocity' of credit. Volume - Volume, not velocity is the culprit. Otherwise, his descriptions of other results are also valid.

Chapter 9: - The Policy Options
Now we get to the meat of the whole exercise. We discover that the author's extensive descriptions have been prepared as the intellectual basis for the policy prescription he proposes to save us from Armageddon. He begins thusly: "Capitalism was an economic system in which the private sector drove the economic process through saving, capital accumulation, and investment. The government's role was very limited. The United States has not had that kind of economic system for decades."
Note the past tense. Well, he is right, although the leftist progressives continue to blame every problem on the free market and capitalism. He continues: "This is not capitalism. Market forces no longer drive the economy. The current system is government -directed, but not planned. " Well, now he has hit the proverbial nail. But wait. He has more: "The new credit-based economic system is now in crisis because the household sector cannot bear any additional debt. The gap between its income and its debt has become too great." All too true. Next, he describes the credit based economy and claims that the situation is beyond repair by reduction in government created credit-debt. With more graphs and text he determines that the only solution is for MORE government debt-credit. Never mind that history shows the huge number of economic collapses due to a crisis in government debt. Finally, after claiming there is no private sector solution but only a massive government expansion of its debt-credit, he gets to specifics of what this great government 'investment' should be. We have been waiting for it. Answer - SOLAR ENERY. By going more trillions into debt the government can save the world. He actually writes: 'The benefits would be both immeidate and never-ending." (Really) "From the beginning, government borrowing and spending, if on a large enough scale, would create jobs and prevent the economy from collapsing into a New Great Depression. Moreover, as mentioned before, the program itself would cause the price of oil to plummet, which would not only boost domestic consumption in other products, since the public would spend less on oil, but sharply reduce the country's trade deficit." BINGO - here we have both fallacies at once. First, expanded government subsidy for solar energy goes mostly to China. Note requires that this industry be totally government controlled. (Imagine the result of that.) Second, the wages lost by the very high paid oil workers won't generate added consumption and would never be equalled by solar panel installers. Third, the increase in oil production now promises to Reduce the trade deficit once the government stops prohibiting export of oil and natural gas into the world market. But he continues to extol this 'new' credit based economy,
There is more. "A large government directed investment program to develop genetic and biotechnology would create medical miracles. Heavy government investment into nanotechnology would generate a new Industrial Revolution." Unfortunately, history shows the opposite results.
The chapter ends with these assertions. "The point to grasp, however, is that our global civilization has been built on and around those distortions (caused by abandonment gold and creation of the 'new' credit money) and that it could very possibly collapse into ruin if those distortions are not perpetuated through further credit expansion." "That REQUIRES government to borrow and invest." Would that be capitalism? No. We do not have capitalism now, however," The question is not whether we are going to abandon capitalism and replace it with a different kind of economic system. We did that long ago. The question is: are we going to allow the economic system now in place to collapse."
This is really a brilliant effort to insist that SOLAR ENERGY created by government debt is inevitable.

Chapter 10: - Fire and Ice - Inflation and Deflation
Well, this chapter is based on erroneous ideas about both the causes and results of inflations and deflations throughout history. But, given the policy prescriptions advanced in the previous chapters, the author has to find a way out. Remarkably, he does mention the deflations of the 1830's and 1870's even though they disprove his previous discussion, and while mentioning them he fails to note that their overall result was very positive and greatly renewed economic expansion. He also discussed previous inflation but only of the 20th century (ignoring those of previous centuries). For this he cites at length Irving Fisher's explanation.
He does make one valuable comment. "In the very harsh economic environment that is likely to prevail over the next ten years, it is likely that a great deal of wealth is going to be destroyed." He concludes by offering some basic, typical, ideas about diversifying one's private investment portfolio.

Conclusion:
In two pages the author cites his previous books as evidence that the public and policy makers should take heed.