Friday, July 24, 2009

National Credit, National Debt

This is the text of a speech I gave at Mt. Vernon this week. The whole affair was lovely. I woke up in the house of Abraham Lincoln (well, a hotel named after him a few blocks from his home in Springfield, Ill.) and went to bed in the home of George Washington (well, his slave quarters, but they have been upgraded since then and are now quite nice):

National Credit, National Debt

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College S.D.

Once upon a time, in a land not so far away, a subjugated but enlightened people cast off a great tyrant. But their liberty, won with promises as well as with the blood of patriots, came at a high price. Burdened by debt, weak government, a pressing scarcity of money, and an uncertain future, the people wallowed in idleness and rebellion. Men of brilliance met, theorized, compromised, and, over some weighty objections, soon constituted a new type of government, one that was powerful yet benign, led by the ablest but dedicated to protect all. Taxes were collected, new loans procured, and old debts repaid. The details flummoxed some but most people understood, and applauded. Throughout the land, they bought the new government’s promises at high prices and sold them at will, sometimes to people in distant lands eager for good investments. Through such trading, the interests of the governed and the government became one. The debt blessed the nation as bankruptcy turned to honor and despair transformed into hope. The fruits of their labors now secure, the people worked hard and smart. Not all of their innovations succeeded, but all told their farms flourished, as did their factories and ports. The nation’s debt dwindled according to plan, only to rise to new heights in a second war against tyranny. Hard work, intelligent taxation, and disciplined leadership again combined forces to tame the fiscal beast. The debt, rightly considered an imposition on the unborn, soon disappeared completely.

But the people, not as enlightened as they once were, did not live happily ever after. Their leaders, now mere politicians instead of statesmen, began to accumulate massive new debts to ensure their popularity rather than to fend off encroachments upon liberty. As foretold, the blessings of debt became a great curse, one that looms larger every second of every day, threatening the people’s happiness and the productivity of their raucous economy. This is their story and it is an important one because within it dwells a great truth about happiness and sullenness, progress and regress, prosperity and poverty.

With those words, I began my book One Nation Under Debt: Hamilton, Jefferson and the History of What We Owe. I penned them … well, clacked them on my laptop … months before the book appeared in March 2008, which was right about when Bear Stearns bit the dust, and they came to me a full year before Fannie and Freddie, Lehman and Merrill, WaMu and AIG joined Pearl Harbor, 9/11, and a handful of other dirty words in infamy. Since I wrote, the national debt has ballooned to $11.5 trillion dollars, enough in $1 dollar bills laid end to end to stretch for 1 billion miles, give or take. That’s from Washington, D.C. to Saturn, and by that I mean the planet, not the former GM subsidiary, though I’m told Saturn was always about a billion miles away from profitability. I kid; I own two of them. [Pause, with head down slowly shaking it.]
In any event, I’m not here today to discuss the causes of the financial crisis or the many problems caused by the subsequent bailouts. To learn of my views on those subjects, Google me or, better yet, read my book Bailouts: Public Money, Private Profit, just out from Columbia University Press and the Social Science Research Council, and Fubarnomics, which should be out from Prometheus early next year. Today I am here to suggest that the Founders, especially Thomas Jefferson and Alexander Hamilton, and by extension their boss, George Washington, had some very important things to say about the national debt, that mighty sword of two edges.
Jefferson thought the national debt a monstrous fraud on posterity, an intergenerational wealth redistribution scheme of dubious morality. The retort is that there is nothing intrinsically wrong with passing a debt along to the next generation if the youngins’ receive something of value in exchange, like a smoothly functioning central bank, growth-enhancing transportation infrastructure, or, most compellingly of all, a free country. Of course the next generation might not desire specific investments, as in the case of a disastrous, unpopular little war waged mainly due to faulty information. And yes my last statement could refer to the War of 1812 or the Iraq War.

So more important -- in my view – was Jefferson’s warning that politicians would find the temptation to borrow and spend as irresistible as a toddler finds sugar or a frat boy finds Natty Light. Taxing and spending has its own natural limit, at least in a democracy. Borrowing and spending, however, can be a winning political strategy for a long time because it allows politicians to appear to provide public services to their constituents at no cost. In reality, of course, more borrowing today means higher taxes tomorrow. Two centuries ago, the brilliant British political economist David Ricardo formally showed that if capital markets are efficient, and they appear to have been in both the United States and Britain in the late eighteenth and early nineteeth centuries, borrowing and taxation are economically equivalent. Americans of the Early Republic had already intuited that and behaved appropriately at the polls. As a result, most early American politicians talked about increasing absolute government budget surpluses ASAP, not merely maybe reducing deficits as a percentage of GDP some years hence.

Unfortunately, Jefferson’s worse fears have come true; We the People were vigilant for a long time, but not eternally. Until the Third Millennium, the history of the U.S. national debt was the history of wars. The debt as a percentage of GDP increased during wars, higher during bigger wars, but it trended downward in peacetime, usually to quite low levels. It rose in the Reagan years but arguably to win the Cold War against the evil communist specter that had so long haunted the planet. During the 1990s, you may recall, the federal government made concerted efforts to reduce the rate of budget growth below the rate of economic growth. The result fit the usual pattern, rapid reductions in the ratio of debt-to-GDP and even a few years of primary surplus.

I can scarcely believe that just a decade ago, when I was lecturing in Money and Banking at the University of Virginia, one of the key policy questions was how the Federal Reserve would conduct open market operations when there were no more Treasury bonds to buy and sell. That was one problem the Bush administration solved handily! Instead of asking Americans to sacrifice for the war effort, which would have ensured his defeat at the polls in 2004, technically his second straight loss, Bush borrowed and spent, then borrowed and spent some more. As a result, the government’s ongoing bailout of the financial system appears much larger and more ominous than it would have if the national debt had not grown so obese after 9/11.

Imagine the economy is a boat and the national debt is a guy in the boat. The ratio of the guy’s weight to the boat’s size is the key determinate of the boat’s continued buoyancy, which is to say of the economy’s ability to withstand unexpected waves or shocks. Cognizant of that, American politicians put the guy on a strict diet even when the boat grew bigger each year. The Bush administration, by contrast, force-fed the guy Krispy Kreme donuts drenched in lard. The guy grew faster than the boat, making it sit ever lower in the water. Due to the financial crisis and bailouts, the boat is currently shrinking while the guy has surpassed Homer Simpson in size and is rapidly approaching the combined girth of Comic Book Guy and Barney. And yes Barney could mean the Springfield town drunk or the purple dinosaur.

Even more damning, the flabberlanche is going to be difficult to reverse anytime soon. About a month ago Christina Romer, the chairwoman of Obama’s Council of Economic Advisers, told readers of The Economist that her biggest goal is to avoid repeating the mistake of the 1937-38, the Roosevelt Recession, by turning off the stimulus spigot too soon. By the end of Obama’s first term the national debt could equal 100 percent of GDP. There is nothing magical about that number – it was higher after World War II. But the figure began heading downward immediately after the war as it had in all periods of peace and prosperity until the current millennium.
Although we have been headed in the wrong direction for almost a decade now, very few voter-taxpayers appear concerned and the government has been getting a substantial amount of cover from economists of a certain ilk who claim that the debt is nothing to worry about. To be frank, they sound an awful lot like the economists who told us not to worry about rapidly rising home values, subprime mortgages, and credit default swaps! Here’s a hint: just because somebody has a Ph.D. in something doesn’t mean that he or she knows anything about it. Some doctors turn out to be quacks, some Major League pitchers can’t throw a strike – they seem strangely attracted to this region for some reason – and some economists don’t understand the economy as a system.

Don’t get me wrong, I’m sure they are great at solving arcane mathematical problems but that isn’t what we need now. What we need is economic statesmanship and one Founding Father in particular can provide some, if only posthumously. I think Alexander Hamilton had it exactly right, X-ACT-LY right, when he said that QUOTE a national debt, if it is not excessive, will be to us a national blessing UNQUOTE. The qualifying clause “if it is not excessive” is of course crucial to understanding Hamilton’s view of the debt; it is strange how often the clause is elided, especially by his detractors. It was not a throwaway line or a bone to those in his own time who dogged him. Hamilton actually specified how big he thought was too big. A debt is too big if:

ONE: The government cannot honor its contracts and pay the principal or interest when promised. Hamilton wrote when the government did not have the power to create money out of thin air. Today he might say a debt is too big if the government cannot honor its contracts without causing inflation, which is known in the biz as a “soft default” as opposed to the “hard default” Hamilton so feared and deprecated. Today, many fear a serious bout of inflation a year or two out.

A debt is also too big if it:

TWO: raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. Again, this is a major fear at present as yields on longer dated Treasuries and mortgages have risen even as the Fed continues to flood the markets with money.

A debt is too big if it:

THREE: necessitates a high level of taxation. Like Adam Smith before him and David Ricardo after him, Hamilton understood that taxes are necessary evils best minimized. Today, Obama appears poised to increase the taxes of the richest Americans and many fear the middle class cannot be far behind. Higher payroll taxes for Social Security and health insurance also appear well neigh inevitable.

So our national debt proper is clearly headed into territory Hamilton would call excessive and the government’s contingent liabilities for entitlements, valued at $50 to $100 trillion dollars depending on the various assumptions made in the calculation, are already there. Of course the situation was much, much worse when Washington asked Hamilton to serve as the new nation’s first Treasury Secretary on September Eleventh … 1789. Washington had met Hamilton in 1776 and came to know him intimately as they experienced the trials and travails of the Revolution together. The two became so close that some speculated they were father and son. That was utter balderdash but Washington and Hamilton clearly knew how to work together in the face of adversity. They prevailed against long odds during the war against the Redcoats and again during the heated political struggles of the 1790s.
To win its independence, America had instituted a so-called currency tax that took the form of depreciation of Continental paper currency and state-issued paper money called bills of credit. It also borrowed prodigiously abroad and at home. In the latter instance, it sold bonds to willing purchasers but also forced bonds upon some of its creditors. Moreover, the army got in the habit of taking the provisions it needed in exchange for hastily composed, hand written IOUs. Before we judge it too harshly, it is important to note that most armies throughout history have taken without giving anything in return and that by the war’s end the soldiers too were paid primarily in IOUs.

By the war’s end, the national government, such as it was under the Articles of Confederation, and the state governments were essentially broke. Most simply defaulted on their obligations or paid interest on their IOUs with yet more IOUs. One, today nicknamed Taxachusetts, enacted and forced the collection of high levels of taxation. It enjoyed a relatively good credit rating but at the cost of strangling its economy and fomenting a rebellion in its western hinterlands. The silver lining was that Shay’s Rebellion and other uprisings enabled Hamilton, Washington, James Madison, Ben Franklin, and other leading lights to forge a new frame of government in Philadelphia in the summer of 1787.

In and of itself, the Constitution did nothing to ameliorate a debt growing ever larger through the power of compound interest. Its ratification, however, did provide Hamilton the tools he needed to reverse the trend. First, he got the government’s tariff revenue flowing by quickly organizing an efficient collection system. Coffee in hand, Hamilton had a knack for running large, complex organizations with the utmost efficiency. Properly caffeinated, he was a great administrator and also a first-rate policymaker and statesman, a combination as rare as an albino moose. Most people who can pay meticulous attention to detail can do little else of import, like see the forest for the trees. If thrown into a policy role they drown in a quicksand of minutia. Not so Hamilton, whose mind and actions constantly flowed between policy and implementation, mundane detail and stroke of genius.

Improvements that Hamilton made to tariff rates, basically the heavier taxation of demand inelastic luxury goods like fine spirits and fancy horse carriages, also improved the national government’s revenues, which increased from almost zero in 1788 to over $10 million dollars – a weighty sum for the day -- in 1800.
The customs system and tariff reforms made it possible to restructure the nation’s foreign debt. Between 1790 and 1794, the U.S. government borrowed millions of dollars, mostly in Holland’s capital market, and used it to pay off its wartime obligations to France, Spain, and earlier Dutch investors. It serviced the new bonds religiously, paying them off when due in the first decade of the nineteenth century. A memorandum penned by Hamilton in 1794 made Washington’s role in the restructuring quite explicit:
From the special connection of the President with the Subject, owing to the authority to borrow being immediately vested in him from the circumstance of the existence of a particular discretion to be exercised by the President as to the anticipated payments of the foreign debt, and from the official relation of each head of a department to the President, the Secretary of the Treasury considered it as his duty from time to time to submit the disposition of each Loan to the consideration of the President, with his reasons for such disposition, and to obtain the sanction of the President previous to carrying it into effect, which was always had. The communication to the President and his sanctions were, for the most part, verbal. UNQUOTE
And hence lost to history I should add. Clearly, the buck stopped with Washington, who delegated the details to Little Hammie.

Under Washington’s aegis, Hamilton also restructured the domestic debt, a tangled mess of literally scores of different types of obligations many of which even the nation’s nascent stock brokers knew little about. Like Alexander the Great cutting the Gordian Knot with his sword, the great Alexander Hamilton cut through the knotty problem of the debt by offering to take old IOUs, those of the states as well as those of the national government, as payments for just three ingenious new ones. Sixes were the most valuable because they paid one and a half percent interest at the end of each quarter, or six percent annually. Threes, by contrast, paid only three-quarters of a percent interest quarterly, or three percent per year. Deferreds paid no interest until 1801, when they became Sixes. By exchanging a blend of the new bonds for older obligations that generally promised six percent, Hamilton reduced the nation’s debt burden with the voluntary consent of its domestic creditors. Much more of a libertarian than most observers today give him credit for, Hamilton did not force people to make the exchange and some indeed hesitated, hoping to receive their full six percent interest. The vast majority ended up making the exchange, however, because the new bonds were safer and much more liquid than the Revolution-era bonds. In other words, Sixes, Threes, and Deferreds were quickly, easily, and cheaply sold to other investors at widely reported prices, a valuable characteristic, and were backed or funded by dedicated tax revenues.
Despite much rhetoric, then and now, to the contrary, Hamilton did NOT, repeat did NOT, want to make the national debt perpetual. He simply wanted to pay it off more slowly than Jefferson and his followers did, partly because he did not want to stymie economic growth with high taxes and partly because he saw some beneficial aspects of the debt. Historians have missed the best evidence of his desire to pay off the debt slowly because it is somewhat technical and buried deep in the bonds themselves. Basically, Hamilton built a contract feature into Sixes that gave the government the option, but not the obligation, to return 2 percent of the principal of each bond annually. That turned them into something akin to a 30-year amortizing mortgage. As soon as it was financially able to make the payments, the government began doing so and by that mechanism completely extinguished the original Sixes circa 1820.

Threes did not have an amortization feature because they did not need one. Three percent was cheap money under the specie standard then controlling the domestic money supply. If it saw fit, the government could extinguish Threes by purchasing them in the open market. Hamilton created an institution, called the Sinking Fund, to facilitate those purchases and to provide a resource the government could use to help stabilize the economy after a financial panic, a use to which Hamilton actually put it to help stem the Panic of 1792. A pernicious myth to the contrary notwithstanding, Hamilton did not believe that the Sinking Fund sped up retirement of the debt, an illusion that some of his contemporaries did hold. Rather, he saw it as a symbol of European-style fiscal orthodoxy and a commitment device that signaled the government’s desire to pay down the national debt. As with the foreign debt, the President was ultimately responsible for the Sinking Fund and again Washington appears to have deferred to the decisions of the Sinking Fund Committee, which during much of his first term was composed of John Adams as V.P., John Jay as chief justice, Jefferson as Secretary of State, and Hamilton as Treasury Secretary.

That is not to say, however, that Washington’s role was always a passive one. A clear instance of Washington’s guiding hand came during the brouhaha over the Bank of the United States, a largely privately-owned and privately-operated central bank. Hamilton argued the bank was necessary, and hence constitutional, because it would provide temporary loans to cover any government revenue shortfalls as well as provide the government with other important financial services. When Jefferson and Attorney General Edmund Randolph, both Virginians, urged a veto of the bank’s charter on constitutional grounds, Washington could not with propriety ignore their entreaties. So he asked them to write out their arguments, which he then turned over to Hamilton. The Little Lion, as Hamilton was known, roared ferociously and famously in response and Washington signed the bill. In a similar incident, Washington referred to Hamilton for his comment 21 of Jefferson’s biggest complaints about the funding system.

Overall, Hamilton’s program appeared to please Washington immensely. The Father of Our Country, after all, was a fiscal conservative: “As a very important source of strength and security,” he once wrote, “cherish Public Credit.” In a private letter to David Humphries penned in March 1791, Washington lambasted those who questioned the new government’s credit. The derogatory remarks of a certain European Count, he wrote, QUOTE are such as do no credit to his judgment and as little to his heart UNQUOTE. He then enumerated the steps taken by Congress, at Hamilton’s behest, to bolster public credit: the tariff reforms, the Bank of the United States, and the establishment of a mint. He noted that the southern and eastern states divided on those issues but added that the government conducted business QUOTE with great harmony and cordiality UNQUOTE. Five years later, Washington wrote that it was acceptable to accumulate debt for good causes, like fighting an unavoidable war, provided the government paid the debt down QUOTE by vigorous exertions, in time of peace UNQUOTE.

It is not surprising to learn, therefore, that Hamilton and Washington also worked together to keep expenditures in check. It is wrong to think of the Federalists as the party of big government and the Republicans as the party of small government. By today’s standards, the Federalists were the party of tiny government and the Republicans the party of teensy-weensy government. Both parties thought the national government should do little more than regulate international and interstate trade, define the dollar in terms of gold and silver, and protect the country from domestic rebels and foreign powers. The Federalists believed the best way to keep the country at peace was to make some preparations for war. Better to spend moderate sums and appear formidable to potential foes than to scrimp by and appear an easy target. The stakes were high because the biggest threat to Hamilton’s financial program, even bigger than the political challenge posed by the Jeffersonian wing of the emerging Democratic-Republican party, was war with a major power. That’s why the administration sought commercial ties to Britain and why Washington’s Farewell address, which Hamilton drafted, advocated neutrality. Both men knew that military victory was glorious but expensive and would also pinch government tariff revenues, as it had during the Revolution and would again during the War of 1812.
To diversify the national government’s income stream in time of peace and war and also to minimize protection of domestic distillers, Hamilton induced Congress to pass an excise tax on whiskey. Yes, I said to minimize protection. That Hamilton was a protectionist – by which I mean an advocate of high tariffs – is one of the most perfidious myths about his policies. He sought to maximize government revenues not to protect infant industries, particularly the distillers of cheap swill. As you probably know, the distillers were not happy about it and although Hamilton and Washington successfully snuffed out a minor rebellion in western Pennsylvania the whiskey excise never brought in much net income. The same could be said of other direct taxes, like those implemented during the Adams administration, which also touched off some agrarian rebellions. Federal land sales were also minimal.
In short, the tariff was the key to public credit. While it strains credulity to call any tax popular, taxation of imports for revenue purposes was then sufficiently politically palatable, especially compared to the distrust of the national debt instilled in Americans by Adam Smith and their colonial experience with Mother England’s massive obligations, that it caused no rebellions. That only large merchants directly paid it helped immensely. They passed the cost onto their customers in the form of higher prices, of course, but unlike sales taxes today, reminders of the toll were not embedded in receipts, bills of sale, and so forth, rendering the incidence of the tariff opaque if not invisible.

In Washington’s world tariffs were ubiquitous and hence justifiable, especially in a nation that did not take kindly to other forms of taxation. Unfortunately, tariffs can’t come to our aid now, as today they are a dirty word and rightly so. However, I think it would behoove us to think about new taxes, perhaps one on producers of greenhouse gases, that might prove politically palatable due to the nature of the levy and the obscurity of the incidence. I’m not saying, I’m just saying.
In any event, Hamilton’s financial program was a smashing success. Before the Constitutional Convention in 1787, the national government was bankrupt, the state governments were bankrupt or scarred by rebellion, and the economy languished. The financial system consisted of three small banks, a handful of securities brokers, and a coterie of inefficient individual insurance underwriters. By the end of 1795, the year Hamilton left office, there were in operation 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges. Entrepreneurs teemed in both the cities and the growing agricultural hinterland. The nominal level of the debt was unchanged but the rapidly growing economy and burgeoning population had shrunk its burden from about $20 per person to about $15. Perhaps most importantly of all, yields on government bonds dropped from high double and low triple digits in 1787 to around six percent in 1795. Just two years later, in March 1797, yields on U.S. Threes actually dipped below yields on British Consols in London. Yes, in London, due to the threat of a French invasion combined with the high esteem British investors now held of their erstwhile colony’s creditworthiness.

Over the years, foreign ownership of U.S. government bonds waxed and waned but was always a significant percentage of the national debt. Critics complained that foreign owners siphoned off substantial sums each year but Hamilton retorted that entrepreneurs put the foreigners’ principal to good use clearing forests, building roads, ships, and other transportation infrastructure, and running banks and insurance companies. So long as we borrowed at 6 percent to fund projects that returned 8, 10, 12 or even higher, it was all good. That’s a paraphrase, by the way.
The national debt was a national blessing in other ways as well. The debt made direct contributions to the creation of America’s transcontinental empire. The government’s strong credit abroad made possible the purchase of Louisiana in 1803 and its strong credit at home allowed it to tangle effectively with Amerindians, French frigates, and Barbary pirates and to fight Britain to a draw in the War of 1812.

Perhaps more importantly, the price of the debt signaled confidence in the government and its policies. If you want, you can go to EH.Net and download the early U.S. bond price data that some of my colleagues and I collected about a decade ago. We have at least weekly data on Threes, Sixes, and Deferreds after 1791 in Boston, New York, and Philadelphia, and later for B-more, Alexandria, Richmond, Charleston, N’Awlins, and London. We took them from public newspapers so it is clear that any early American who wanted to know the capital market’s view of the nation’s long-term prospects needed only to look up from his or her morning coffee … or afternoon tea or rum punch.

Wannabe entrepreneurs who saw Sixes trading consistently right around par could forge ahead with their business ideas safe in the knowledge that the young government was on the right path and political and expropriation risks were very low. And forge they did. By the Civil War, over 20,000 corporations formed in the United States, including some sixty-five hundred in the South. Many thousands more formed manufacturing and mercantile sole proprietorships and partnerships. And the nation’s farmers, still the bulk of the population, became the most efficient and adventurous in the world. Many businesses failed and the agricultural sector was prone to asset bubbles, including one in sugar beets that I detail in One Nation Under Debt, but the vigorous spirit of enterprise evinced by early American entrepreneurs created one of the world’s most vibrant and fastest growing economies.
The national debt was also a great boon to entrepreneurs and investors because it provided them with a safe, liquid investment option. Financial institutions and large mercantile firms held U.S. government bonds as remunerative secondary reserves. Widows, orphans, trustees, and non-profit organizations bought them as long-term investments certain to make interest payments on time. Planters bought them as hedges against bad harvests and urban artisans to mute the pain of periodic periods of unemployment. Speculators purchased them in the hopes of a rapid price change in the correct direction, up for longs and down for shorts. Lawyers, doctors, and professors owned them too, for a multitude of reasons.

I can make these generalizations because I spent a month at the Virginia Historical Society in Richmond tracing the lives of a hundred Virginia bondholders. Many interesting stories emerged, including that of Charles Dabney. The son of a prominent planter, Dabney served his parish as a vestryman, his county as a justice of the peace, and his colony on important commissions. By the late colonial period he was already a prominent Hanover County planter and co-partner in a blacksmith shop. Dabney conceived of Virginia, not Britain, as his homeland and so was an ardent Patriot, first as the captain of a company of minutemen, then as the lieutenant colonel of his own eponymous legion. In September 1782, the large and athletic Dabney put down a small mutiny, probably by brandishing his trademark weapon, a large bore rifle that bore his name. Dabney nevertheless wrote QUOTE unless the troops get money soon, I fear it will be out of my power to keep them in service. UNQUOTE He somehow succeeded until mustering out at the end of April 1783.
In 1791, Dabney converted some £1,900 pounds of Virginia IOUs into federal bonds under Hamilton’s funding program. By that mechanism and further purchases, Dabney accumulated federal bonds between January 1791 and September 1802 –over 14 thousand dollars of Sixes, Threes, and Deferreds in 21 transactions, some of which he stashed under the books on the left hand side of his bookcase. The money for his 1795 bond purchases came directly from the proceeds of the sale of some of the western lands his military service entitled him to. In 1812, Dabney began to divest. In 1818 he sold almost $9,000 of his Sixes and in 1824, 5 years before his death, the government redeemed the balance of his portfolio.

A Federalist, the immorality Dabney saw in Virginia’s cities, particularly Williamsburg and Richmond, disgusted him to such an extent that he refused to leave the area around his home in Hanover. He had one of his young relatives, Billy Dabney, draw the interest for him in Richmond. Although not highly formally educated, Dabney had in the words of a contemporary an excellent “natural understanding” and a “large stock of valuable knowledge,” a claim that Dabney’s commonplace books certainly bear out. For instance, he knew of a simple cure for piles, more commonly known as hemorrhoids today, that entailed applying a ¾ inch long piece of cold, wet, strong British alum to the affected area morning and evening for seven days. Those attributes – the knowledge and understanding, not the piles -- made him a natural leader in war as well as in peace. Dabney was also said to possess QUOTE a thorough knowledge of human nature UNQUOTE and nowhere did that show more than in his unusual relationships with his slaves. He understood that slaves did not respond well to physical punishment so instead of whipping them, he credited them wages for the year, making deductions whenever they slacked or misbehaved and settling balances due in cash each Christmas season. Also, he paid his overseer on a salary plus commission basis rather than a salary only, an astute tactic designed to mitigate overseer slacking. Dabney’s descendants claimed that his unorthodox methods did not work but then again they had ideological reasons to question them. The productivity of his plantation certainly did not seem to suffer.

As Hamilton predicted, men like Dabney helped to keep the young nation together. The debt served as a so-called cement of union because public creditors like Dabney did not want to suffer a loss on their investments. They therefore would not countenance systemic tax evasion, talk of secession, or rebellion. Although only about 1 in 200 Americans directly held federal government bonds at one time, they tended to be more substantial citizens, like Dabney. And as I show in One Nation Under Debt they were spread throughout the country, even in seemingly unlikely places like Central Virginia. Moreover, many other Americans owned indirect stakes in the government through their ownership of corporate stock, bank deposits, or insurance policies or through their interests in churches, municipalities, or other non-profit holders of government bonds.

Today, many Americans fear the fact that the Chinese government owns over $700 billion dollars worth of U.S. government bonds. I don’t. In fact, I think it a shame that North Korea, Cuba, and Iran don’t own more of our debt. Nobody looks out for you more than your creditors do, and that includes Mom. It’s not like bondholders of an insolvent corporation; they can’t dictate terms to us. The worst they can do is sell. If that is what it takes to give rise to a new economic statesman, then so be it.

Thank you.

Sunday, July 12, 2009

In Answer to My Coz DP

Dr Wright
In the high school where I work I noticed pictures on the wall in a class room of moments in history. One picture says the American Revolution ended at Yorktown (somewhat untrue) and there was another that stated the Great Depression ended with FDR's social programs but I have read that World War II had an impact on the recovery, since you have wrote of the causes of it and other problems later in history could you comment on the recovery from the depression?.... signed (your cousin) DP


World War II rapidly brought the economy to full employment and beyond. It did not, repeat did not, bring the U.S. economy out of the Depression. FDR's social programs didn't either. What did the trick was loosening the gold standard (1 oz. gold to $35 from $20), which allowed the Fed to reflate the money supply, which lowered REAL (inflation adjusted) wages and interest rates, both of which had become far too high due to the deflation associated with the infamous bank panics and the stock market crash and subsequent decline in aggregate demand. 2H 1933 through 1936 were periods of strong growth (increases in per capita GDP). Unemployment decreased as well but more slowly. (As our beloved president recently noted, employment is a lagging indicator.) The unemployment rate would have been back near its normal low level by 1939, and certainly by 1941, even without the war had it not been for the so-called Roosevelt Recession of 1937-38, when FDR tried to balance the budget, in retrospect prematurely, and the Fed capriciously raised banks' reserve requirements for reasons only a central banker could "understand."

For more info., see a cute little volume I edited called Bailouts: Public Money, Private Profits due out from Columbia UP/SSRC shortly. It's only like 12 bucks on Amazon and my part of it is sort of a prequel to my Fubarnomics due out from Prometheus early next year.

Monday, July 06, 2009

1929: The Sequel

This is the text of a webcast I did last week. To view the slides, etc:

1929: The Sequel

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD

The Great Crash of 1929 did not literally repeat in 2008. As we will see, there is one crucial difference between the two episodes and it likely will be our savior. Nevertheless, striking similarities between the two crashes are evident. Foremost, as shown on slide 2, in both instances the economy was in recession BEFORE financial crisis struck and in that sense the financial system could not be said to CAUSE either economic downturn, only to exacerbate problems in the real economy like inventory gluts, softness in construction and real estate markets, and energy price spikes.

In both periods, the financial system proved to be EXTREMELY fragile due to the use of leverage, the purchase of speculative assets with borrowed money. In both periods the bursting of asset bubbles, real estate bubbles followed by corporate equities bubbles, led to the destructive processes illustrated on slide 3. When commercial and housing real estate markets softened in the 1920s and recently, corporate balance sheets weakened and mortgage default rates increased, which in turn increased asymmetric information, the great bane of financial institutions then and now.

In both crashes the “bank problems” listed second from the bottom were particularly potent. In the face of elevated default rates, damaged balance sheets, and high levels of uncertainty about future business conditions, banks raised the interest rates they charged some borrowers and stopped lending entirely to many others. That slowed business investment which led to further decreases in economic activity, even higher levels of default, and, ultimately, bank failures, and a massive degree of additional uncertainty.

Of course the crashes of 29 and “aught eight” are not identical. As Mark Twain once said, history rhymes rather than repeats. During the Depression, small banks bit the dust first, with the big ones staggering only in the later stages of the economy’s three-year death spiral. Today, it is the big boys who first fell but the pollution their crashing and burning creates is now suffocating smaller institutions. As summarized in slide 4, the changing but always inept nature of banking regulation explains why small banks gave way first during the Depression while big ones could not withstand last year’s crash. Prior to World War II, most Americans and their politicians possessed a morbid fear of large financial institutions. Andrew Jackson vetoed the re-charter of the Bank of the United States, pictured on slide 5, partly because he thought the institution had grown too large and powerful. Some 80 years later, a government fearful of the power accumulated by investment banker J.P. Morgan created a new central bank, the Federal Reserve System, but simultaneously tried to limit its influence by dividing it into 12 districts, also shown on slide 5. For similar reasons, throughout much of the nation regulators forbade banks to operate a branch across the street much less across state lines. As a result, most banks outside of the major money centers were tiny affairs that, even if conservatively run, were highly susceptible to local economic shocks. Places that allowed branch banking, including California and Canada, weathered the Depression much better than adjacent territories dominated by unit banks because they suffered many fewer failures.

That led regulators to conclude, erroneously, the bigger the better. In the years leading up to the current crisis, regulators not only allowed banks to grow large they actually strongly encouraged them to do so with the “Too Big to Fail” policy. Concocted in the aftermath of the Continental Illinois failure in 1984, TBTF policy promised that the government would prevent systemic financial crises by aiding the largest financial institutions should they face insolvency or bankruptcy. Because the government charged nothing for the guarantee and never made clear which companies were covered under it, many financiers used TBTF as an excuse for constant, rapid growth, mainly through the acquisition of smaller institutions. TBTF encouraged other types of excessive risk-taking as well by promising government aid in all events. Because risk and return are positively correlated, it essentially generated private profits with public money.

I am not, however, one of those folks who puts all the blame on the government. Properly understood, both the Depression and the current crisis are examples of a broader phenomenon I call “hybrid failures.” As slide 7 jokes, by this I do NOT mean a Prius that won’t start. Rather, as in slide 8, a hybrid failure is a combination of classic market failures like asymmetric information, asset bubbles, positive and negative externalities, and public goods INTRICATELY INTERTWINED with government failures like the creation of perverse incentives, misguided regulation, the inability to foresee and fix problems before they cause major economic disruptions, and implementing counterproductive bailouts.

Slide 9 summarizes the hybrid failures at the heart of both the 1929 and 2008 crashes. You’ll quickly perceive that they are identical. If we zoom in more closely, however, differences appear. The 1920s real estate bubble was not as big as the recent one shown in Slide 10. The stock market bubble of the 1920s, however, was much bigger than the fluff that survived the dotcom bust. We’ve already seen that very different yet equally misguided banking regulations played a role in both crises, as did the inability of the government to foresee the perverse incentives those regulations gave rise to. The most maddening thing about the “aught eight” debacle was that it was the 7th time in American history that regulators allowed mortgage originators to take full commissions upon closing and the 7th time that a mortgage securitization scheme exploded in our faces.

Finally, and most importantly, while fiscal stimulus, TARP, and other recent bailout attempts have hardly been unqualified successes to date they do not appear to be as disastrous as some of the policies implemented during the early stages of the Depression. The Smoot-Hawley tariff was extremely destructive and is unlikely to be repeated. We are also unlikely to repeat the creation of a bad bank, which works better when it has to liquidate numerous small institutions, as the Reconstruction Finance Corporation and the Resolution Trust Corporation did during the Depression and the Savings and Loan crisis, respectively.

We will also likely avoid creating anything like the National Industrial Recovery Act, the infamous blue eagle of which is pictured on slide 11. The NRA sought, luckily in vain, to INCREASE real wages when the economy desperately needed lower real wages. Wages stuck at high levels due to deflation and the unwillingness of workers to accept nominal wage cuts were of course the proximate cause of the very high levels of unemployment that disrupted America’s social, political, and financial systems during the Depression. Even at 10 percent, the unemployment rate today is much less than half of that experienced during the hard winter of 1932-33.
Moving on to slide 12, the only government policy during the New Deal with a demonstrably positive effect on the economy was the devaluation of the dollar and the de facto abandonment of the classical gold standard. Because it had to defend the nation’s gold stocks, the Depression-era Federal Reserve could not appreciably lower interest rates or increase money growth in the aftermath of the stock market crash. It did not even replace the money destroyed when thousands of banks failed, paying just pennies on the dollar to depositors. As a result, the money supply actually shrank and the price level declined dramatically, effectively increasing real wages and real interest rates. By greatly loosening the link to gold, Roosevelt allowed re-flation and decreased real interest rates, thereby fueling the expansion of 1933 to 1937.

Loss of the gold standard cost us our long term price anchor but gave us in exchange tremendous domestic monetary policy flexibility. Today’s Federal Reserve does not need to maintain gold stocks or the value of the dollar in international markets. It can, if it wishes, decrease interest rates to zero, print prodigious quantities of money, and lend it to whomever it sees fit. In fact, after the failure of Bear Stearns the Fed kept a pretty tight reign on the money supply in order to support the value of the dollar in international markets. After the failure of Lehman, by contrast, it let out all the stops and, as illustrated on slide 13, essentially implemented one-half of Alexander Hamilton and Walter Bagehot’s famous rule of central banking and lent freely to all who could post solid collateral. In addition to its traditional discount window, the Fed now lends via seven new so-called term facilities. The only disappointment is that it provides the funds very cheaply, rather than at the penalty rate espoused by Hamilton and Bagehot, thus subsidizing private concerns with public money and increasing moral hazard and hence the probability of future crises.

Clearly, the Fed wishes to avoid the melancholy scenes depicted on slide 14 -- the dust bowl, the breadlines, and the public health crises that characterized the Depression. Thanks largely to its efforts, the sequel to the Crash of 1929 will turn out to have a much happier ending, at least in the immediate term.
Nevertheless, longer term, as indicated on slide 15, troubles loom. I was warning about the alarming growth of the national debt in 2007 and now of course am very concerned that the debt may cause interest rates to increase to levels that will hamper a robust recovery. Fears of a soft default or inflation are foremost as are concerns that foreigners will stop buying U.S. government bonds, at which point domestic crowding out may occur. I’m also concerned by the fact that the government has yet to price Too Big To Fail and other federal guarantees and backstops at anything close to market rates. That means, in effect, that the government is still subsidizing private risk taking with public money so it is only a matter of time before another financial crisis strikes. When and where it will occur I of course do not know but if the government doesn’t act decisively to force people to wager only their own money, I fear “The Great Crash III, They Did It Again” will be coming to an economy near you in the not-so-distant future.
I’m done. Thanks for your time and attention!