This paper is a sneak preview of my Tract: "Pleas for a New World Economic Order." which explains the nature and causes of the economic crisis and proposes a plausible alternative. This chapter denounces Keynes' theory which says that the level of Investment before 1929 was not the cause of the Depression that ensued. It examines the validity of Liquidationism and the notions that relate to it.

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Plea for a New World Economic Order.

Chapter II, Paragraph 3:
Liquidation and Creative Destruction.
"I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment.

I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity... [p. 349]"

John Maynard Keynes
The General Theory and After.
Part I, Preparation.

Abstract:

This paper denounce Keynes' theory which says that the level of Investment before 1929 was not the cause of the Depression that ensued.

It examines the validity of Liquidationism and the notions that relate to it.

As we get into the Liquidity Trap there will, of course, be a feud between the advocates of laissez-faire, the Liquidationists, and the advocate of government intervention, the Keynesians.

Although no one seems to have been Liquidationist (The Austrian school seems to say that they never were, contrary to the views of Brad deLong and Paul Krugman (The Hangover Theory.)) However, Friedrich August von Hayek have been a Liquidationist.

Another point of view is that of Joseph Alois Schumpeter (February 8, 1883 – January 8, 1950), who invented the notion of Creative Destruction. This last notion is more about an economic Darwinism - which is relevant, according to him, whatever the state of the economy. It relates to the omnipotence of Markets. Refer to Chapter II, Paragraph5: The State of Long-Term Expectation. The Austrians were quick to point out that although Schumpeter was an Austrian economist he didn't belong to the Austrian school.

What we are concerned with is Liquidation in a Depression.

The Austrian School has always denied the existence of the Liquidity Trap, but Friedrich August von Hayek had his opinion on the Economic Depression:

"The second point is that up to 1927 I should, indeed, have expected that because, during the preceding boom period, prices did not rise-but rather tended to fall-the subsequent depression would be very mild. But, as is well known, in that year an entirely unprecedented action was taken by the American monetary authorities, which makes it impossible to compare the effects of the boom on the subsequent depression with any previous experience.

The authorities succeeded, by means of an easy-money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would otherwise have been its natural end.
And when the crisis finally occurred, for almost two more years, deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation. It seems to me that these facts have had a far greater influence on the character of the depression than the developments up to 1927, which from all we know, might instead have led to a comparatively mild depression in and after 1927."
Friedrich August von Hayek (8 May 1899 – 23 March 1992) Price and Production. Capital and Industrial Fluctuations
A Reply to a Criticism Paragraph X September 1931

I am going to be the Devil's advocate and show that there is some truth in that belief!

I should have called this tract: "Torah, Qu'ran, Adam Smith, Karl Marx, John Maynard Keynes, Friedrich August von Hayek and Alan Greenspan, a reconciled and unified view!"

The John Maynard Keynes' Fallacy:

No one is perfect and my idol [No one should have one!] did make a mistake, he said:

"It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much over-expansion, as they call it; a nemesis on man's speculative spirit. It would, they feel, be a victory for the Mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidation' to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment.

I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity... [p. 349].
While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history... [p. 347].
Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities [over 1924-1929] could not always be in just the appropriate relation to that of others. But, on the whole, I see little sign of any serious want of balance such as is alleged by some authorities. The rates of growth [of different sectors]seem to me, looking back, to have been in as good a balance as one could have expected them to be. A few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied... [pp. 347-48]."

John Maynard Keynes
The General Theory and After.
Part I, Preparation.

The fact of the matter is that it is the enormous amount of savings and investments that did cause the vast increase of Income Disparity [ID] and, hence, the vast decrease of long-term interest rates that caused the Keynes' Liquidity Trap and the Great Depression.

I want to stress something here: although Keynes discovered the Liquidity Trap he never claimed it was the cause of the Great Depression. In fact, Keynes, contrary to my theory, believed it had no cause, he thought it was due to a random phenomenon. Having no cause, he didn't have to care for them, only cure the symptoms and the sickness would be gone!

In order to get out of the Keynes' Liquidity Trap, you need to increase ID above its Liquidity Trap value. How can this be done? We see that ID is independent of the price level. It only depends on income repartition. Is there any way that a Depression or a Economic Policy changes ID in a meaningful way and hence gets us out of the Liquidity Trap?

At first sight, some might think that a crash would lower the ID. But in fact the poor lose even more income (proportionately) than the rich. Hence in a Depression ID increases and doesn't decrease.

In fact, the Wealth Disparity being independent of price level is dependent on the distribution of the physical assets. Only their physical destruction alters in a meaningful way their distributions.

An arbitrary increase of lower incomes can instantaneously increase demand. However, because it doesn't change the Wealth Disparity [WD] it can't have a lasting effect on ID, hence on Demand.

In order to get out of the Liquidity Trap you need a drastic New Deal, a a new repartition of wealth and incomes. In a capitalist economy the only way that can be done is by the physical destruction of productive assets through rust or war. That can take an excessively long time or be extremely deadly.

The only way Capitalism knows how to get out of a Liquidity Trap is through Liquidation (May be this is why Liquidity Trap and Liquidation have the same origin). It is not that I like it or enjoy it: it is a mathematical fact: I am not a Liquidationist, Capitalism is Liquidationist!

A striking example of Liquidation or Creative Destruction is WWII. I will show that is is the almost necessary consequence of the Great Depression. No one, I hope, is saying it is something we want to repeat, even if it brought some of the fantastic historic economic growth we have witnessed since.

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence."
John Adams US diplomat & politician (1735 - 1826) Argument in Defence of the Soldiers in the Boston Massacre Trials. December 1770

Don't get me wrong; I am not saying that you shouldn't use a Keynesian fiscal stimulus in order to keep some sort of aggregate demand, I am just saying that it wouldn't be enough to get an economy out of a Liquidity Trap. No fiscal or monetary policy can get an economy out of a Liquidity Trap (confer Chapter IV: Economic Policy in a Depression.). Although it is a necessary evil, we must be aware that a long period of Keynesian intervention will necessarily stifle the free market forces and would give raise to arbitrary economic policy by those who would decide which venture will be funded (Private bank and financing don't work in a Liquidity Trap.) and which sector would be the customers of the government.

"But this long run is a misleading guide to current affairs. In the long run we are all dead.

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."
John Maynard Keynes A Tract on Monetary Reform. Ch. 3 1923

The only way out that does right to both sides, both on the short and long run, and is my Adjusted Credit Free, Free Market Economy (confer Chapter V.: The Adjusted Credit Free, Free Market Economy.) There is no other Plausible Alternative.

Friedrich August von Hayek seems to fault the low interest-rates policy that preceded the depression for its length. As I said the short-term rates are mostly irrelevant to a Keynes' Liquidity Trap. I showed that the only good monetary policy is to manage a normal yield curve. I believe, without having proved it yet, that any other monetary policy increases the speed of the fall in the Liquidity Trap. It is hence normal that the FED would decrease the short-term yield when the long-term yield were going down.

As far as to say that excess liquidity increases the length of the Depression, it defies my intelligence. I don't see why it would. I will prove that Quantitative Easing and trying to inject excess liquidity don't help in the Liquidity Trap (This is precisely why it is called a Liquidity Trap - Chapter IV: Economic Policy in a Depression) It is like a placebo: if it doesn't help, it doesn't do any harm either.

In fact, Alan Greenspan did increase short term rates in order to avoid the Keynes' Liquidity Trap. Would that it had worked, it would have caused a recession and a hike in long-term rates. But it didn't. It did however caused the inversion of the yield curve and the infamous sub-prime meltdown. The supreme irony here is that many have blamed the low interest rate policy of the Maestro for what was caused by his high interest rate policy!

Economic Darwinism:

If competition is necessary in any free market economy, too much competition might defeat its own purpose: an excessive competition does destroy any cooperation, which can be necessary to achieve economic development and other goals of the society. The behavior of economic agents might become predatory and cause the destruction of the economy or the society: it is precisely what causes the Liquidity Trap. Moreover, what is a good venture? How do we know which one should fail?

In a Liquidity Trap it is true that, at the beginning, the most likely to fail are the weakest. Those would have failed anyway. But later on no one is immune: those who fail are those which are financially leveraged, operationally leveraged, those whose customers rely on credit to finance their purchase, those which are in a market for discretionary goods, and those whose products have a cheap alternative.

For example, I can perfectly conceive that one of the first companies that will fall will be Apple. Does that mean that this company has become suddenly bad and that it doesn't deserve to survive? What I want to stress is that what is good in one environment might be bad in another one. Do we want to emerge without an Apple after the Depression? The result of a Liquidity Trap is a great leap backward in civilization.

Obviously Economic Darwinism is not an argument for Liquidationism.

Moral Notion:

Economy is a science, a difficult science, but when you have found the hidden variable it leaves few room for random phenomenon.

Because for certain there is so much randomness in Economists' models, they believe that they can apply to the economy their vision of good and bad as if they were like some mini Gods that could create the universe from Tohu Bohu. These madmen in authority have no place in science, they belong to cults where only Gurus prevail.

Economy is not about Good and Bad, it is about Equity, Supply and Demand. It is only after we have done the analysis, after we have defined what are the necessary conditions in order to obtain a viable system that we observe the result and ask ourselves if we have been instruments of good or for evil.

I have, like others, strayed outside the rigor of Mathematics, probably even more than many others. Like any Mathematical intuitions, mine comes from associations. But after all things are said and done, I finish my scientific work and test it from a logical and mathematical standpoint.  Then I will allow myself to examine it from a religious, philosophic or moral point of view. For if it doesn't work who really cares about its consequences?

"The writer of a book such as this, treading along unfamiliar paths,
is extremely dependent on criticism and conversation if he is to avoid an undue proportion of mistakes.

It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics (along with the other moral sciences), where it is often impossible to bring one's ideas to a conclusive test either formal or experimental."
John Maynard Keynes, 1st Baron Keynes of Tilton
(5 June 1883 – 21 April 1946)
The General Theory of Employment, Interest, and Money.Preface 13 December 1935

On both sides of the aisle, people have tried to judge Liquidation and Creative Destruction from a moral standpoint. It is something that does not belong to a scientific analysis. I shall not address the issue here. All this belong to the last Paragraph of this tract: Chapter V, Paragraph 3: Moral, Philosophic and Religious Implications of the Credit Free Economy.

All of This Stays True Until the Poor Becomes Richer Relatively to the Rich.
Extreme Economic Conditions Call for Radical Solutions.
The Controversial Innovation Since John Maynard Keynes and Milton Friedman.
You Can Comment on This Chapter Here. I Will Incorporate Any Meaningful Contribution Into my Tract and Credit the Author. If you can Make a Significant Contribution to my Work Please Apply Here.

Authors Website: blog.yield-curve.net

Authors Bio:
Shalom P. Hamou
Tel Aviv, Ramat Aviv, Israel


I am the youngest economist at My Yield Curve.

Since spring of 1994 I have been working on economic depressions.

I am writing The Tract The Religious Interpretation of Employment, Interest, and Money..

It explains the nature and causes of economic depressions.

After a period of Irrational Exhuberance, which has inflated the Mother of All Asset Price Bubbles, we will have a Keynes' Liquidity Trap, The Crash and The Deep Depression.

The Crash will take place on Wednesday, 2nd September, 2009 5:10 PM EDT.

There is plausible alternative to The Deep Depression, The Adjusted Credit Free, Free Market Economy.

I designed a system, F**k the F*d, by which our economy can gather momentum for a successful and quick implementation after The Crash.

I have an MBA from Boston University ,USA, an Engineering Diploma from Ecole Centrale de Lyon France, a degree in Computer Engineer from Sivan Marchevim, Israel.

I have worked as a bond trader in Paris, France and as a NIP (Local) on the Paris MATIF.