There are two ways of studying economic theory. One approach is mathematical, and has been much enhanced by the computing power available to the individual economist. The other is historical and relies on the accumulated understanding of economic theory and practice.
The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number-crunchers – it took them completely by surprise. It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.
Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads. By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes. One can say that there is a build up of stress in the system which will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century. Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations.
What we do know from economic history is that there is a cycle of debt which has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.
Keynesian economics, as expounded in his General Theory, 1936, were criticised at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account – partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.
As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.
An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.
for The Daily Reckoning Australia