One hundred years ago yesterday, one of the intellectual titans of the 20th century was born. Had the warnings issued by JK Galbraith up until his death two years ago been better heeded by the policymakers of today, it seems unlikely we would find ourselves so deep in the economic mire.
A lifelong liberal who advised successive Democratic presidents and presidential candidates, Galbraith ceaselessly warned of the dangers of financial excess. In his extensive writings — most famously The Great Crash 1929 — Galbraith described the common events that precede and accompany particular financial crises, events that are conveniently forgotten by politicians, regulators and their advisers in the good times, when financial deregulation takes grip.
Galbraith, like Keynes before him, identified the instability of modern capitalism in terms of the drive to accumulate excessive wealth and the fragile nature of the financial system. As Galbraith remarked, all stock market bubbles exhibit “seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures”. Galbraith argued that an unfettered, competitive capitalist system, operating on pure free-market principles, was inherently cyclical and unstable, requiring robust regulation and active government.
Starting with the tulip bulb mania in the 1630s, bubble after speculative bubble has been erased from the popular memory: The South Sea bubble in the early 1700s; the Mississippi bubble, which caused a stock market crash in 18th-century France; the Florida real-estate bubble in the 1920s; the stock market crash of 1929; the stock market crash of 1987; the Nikkei bubble, which began in 1991; and the Nasdaq bubble of 2000.
These episodes share a theme: A perceived fundamental change in the economy arouses euphoria and heightened expectations of return, leading to excess, fraud and collapse. This pattern underpinned the folly of subprime lending. The expansion in business activity feeds entrepreneurial and speculative behavior in the financial sectors. It drives monetary innovation and the new forms of financing structures that are contrived to allow firms to participate in the boom.
Heightened expectations stimulate a credit boom, with the banking system keen to cash in on the new situation.
As Galbraith remarked in his book, “Money”: “The banks, needless to say, provided the money that financed the speculation that in each case preceded the crash.”
As Galbraith and Keynes before him warned, such speculation inevitably leads to euphoria or overtrading in which rising asset prices encourage speculative excess. As debt accumulates, soon it can only be serviced by the issue of new liabilities. As long as the financial markets are booming, it is possible to sustain low levels of cash inflow by issuing new stocks and securities to finance current liabilities. But when the hangover comes it hits hard.
When the financial markets slow their expansion, organizations that have covered their future liabilities through issuing more debt are forced to sell assets to meet their liabilities. These “distress” sales cause asset prices to fall, at which point the financial markets, and businesses with exposure to those markets, collapse. The next phase, in which investors try to get their money back out of the markets, naturally gives way to one of “panic”. This is the essence of The Great Crash.
At this stage, prices freefall and asset markets break down. As Galbraith highlighted, both bank failures and the fear of bank failures have the same effect. Both are “forces of compelling power to induce deflation — to contract consumer spending, investment spending and therewith sales, output, employment and prices”.
The flurry of action by governments and central banks around the world in recent days suggests that Galbraith’s works have finally been pored over by politicians. The experience of the 1930s must be avoided. This financial crisis must be met with programs designed to maintain demand and avoid another Great Depression. On the 100th anniversary of Galbraith’s birth, his words matter more than ever.
— Stephen Dunn’s The Economics of John Kenneth Galbraith will be published by Cambridge University Press next year.
