Economy/Policy: Which Comes First?

Below is the substance of my remarks made at the teacher's institute at Mt. Vernon on July 17:  

By Robert Wright, Nef Family Chair of Political Economy, Augustana College SD, for the George Washington Teachers’ Institute, Mt. Vernon, Virginia, 11 am to noon, 17 July 2013

Nancy Hayward, the director of this little shindig, asked me to address two questions this morning. The first is the extent to which the economy drives public policy and vice versa. The second is how the Washington administration, particularly the financial reform program implemented by Alexander Hamilton under Washington’s leadership, is relevant to policy issues today. The two questions are intimately interrelated and so shall be the answers, which I will endeavor to make quite explicit.

First, I’ll argue that the economy and policy are co-determined, but only broadly. With just two pieces of economic information, per capita income and percentage of GDP derived from natural resources, I can broadly describe a nation’s major policies and institutions. Conversely, I can predict the order of magnitude of a nation’s per capita GDP based on a general description of its major policies and institutions without any knowledge of its geography, history, or other variables. This isn’t a parlor trick but rather stems from the empirical fact that, with the exception of a few major oil producers, nations that provide its denizens with more economic freedom -- that do a better job of protecting life, liberty, and property as Washington and Hamilton put it – have higher per capita incomes than nations that have more restrictive policies – that practice tyranny in Washingtonian and Hamiltonian lingo.

In other words, nations with per capita GDP in the tens of thousands of dollars allow their citizens to start or shutter businesses quickly and cheaply, have courts that provide what Adam Smith called a “tolerable administration of justice,” keep inflation -- what Hamilton and Washington called currency depreciation – in check, and so forth. The details can be downloaded from the Fraser Institute’s website. The economy of the United States currently ranks tenth freest in the world, in case you were wondering, but has been falling in absolute and relative terms since the financial crisis of 2008. The six freest economies today are those of Hong Kong, Singapore, Australia, New Zealand, Switzerland, and Canada, in that order.

The world’s poorest nations, those with per capita incomes in the hundreds of dollars per year, are the least free because they wallow in anarchy or under the heel of a despot -- as Washington and Hamilton would have said. In such places nobody has any incentive to do other than to live for the morrow as Adam Smith put it. So they do not invest in the future and quickly convert investments given to them from abroad into current consumption because that is the rational thing to do when one’s life or property seem likely to be stolen by a brigand or a tyrant.

Middle income nations, those with per capita incomes in the thousands of dollars per year, are betwixt the two polar extremes but interestingly there are relatively few such countries in existence at any given time as most, like China currently or Japan near the end of the life of Hamilton’s wife Betsey, are either ascending toward the top or, like Argentina in the 1930s and 40s and Somalia in the 1990s, descending toward the bottom.

What I can’t do is tell you the economic effect of specific policies, mostly because most matter so little in the big scheme of things. Consider, for example, raising the federal minimum wage. Adam Smith, Alexander Hamilton, and most economists today explain that a minimum wage law increases wages for some while reducing wages for others by rendering them unemployed. Parsing out the overall economic effect of that is difficult and in the end usually nets to approximately zero. Thousands of other policies are also more about redistribution or reallocation of existing resources rather than expanding or shrinking the overall size of the economic pie. Think about it: policies that definitely expand economic activity in a major way would be political juggernauts certain to pass provided, of course, that they did not threaten entrenched interests. Conversely, policies that definitely shrink the economy would be dead on arrival politically. So most new policies are, in and of themselves, rather minor affairs of great interest to a few but rightly unnoticed by most.

Most major policy reforms, therefore, tend to be initiated during crises or as a reaction to them: the sundry troubles of the 1780s, the Civil War, the Great Depression, and financial panics like those of 1907 and 2008. Many of the nation’s worst policy mistakes, like Social Security and Medicare, began as relatively modest programs but over time grew into the GDP draining monstrosities we love and hate today. The Social Security system, for example, did not include disability insurance until the 1950s and did not include most Americans until the 1960s.

Other major drains on the economy, as outlined in my 2010 book Fubarnomics, include the custom construction industry, higher education, real estate, healthcare, and the continued subterranean existence of slavery both at home and abroad. Policy improvements in each of those areas would raise GDP by non-trivial amounts, or so I argue, because sundry policies, enacted piecemeal over decades, led to the dysfunction apparent in each of those parts of the economy. Fundamental reform has proven difficult, however, because those piecemeal policies created entrenched interests that fight reform at every turn. Imagine how my tenured colleagues reacted to my suggestion that professors should own their colleges in professional partnerships, especially when they learned that such a form of ownership would entail putting a monetary value on tenure. It went over like … well, do people still use the expression like a fart in church?

It is also difficult to get people to listen rationally to reforms based on a private-insurance healthcare system when they don’t understand the differences between mutual corporations and joint-stock companies, differences of course familiar to both Washington and Hamilton. If people coming out of high school knew the differences between the two types of business, we’d have many more credit unions and a lot fewer deposits in the big banks that almost brought down the financial system five years ago.

So, again, I think that policy and economy are broadly co-determined in the sense that scholars can predict one if they know the other. Most specific policies, however, have little net effect on per capita output. In the aggregate, however, they affect the economy by increasing or decreasing the overall level of economic freedom. In nations with representative governments, truly bad economic policies, like the New Deal’s National Industrial Recovery Act, will be short-lived if they see the light of day at all. Growth positive policies, however – like the ones that I come up with -- can be stymied by entrenched interests and/or public apathy or ignorance.

And that leads me to suggest that policies and the state of the economy are co-determined in another way as well. Nations that are very poor do not suddenly adopt enlightened – as Hamilton and Washington would say – pro-growth policies. Rather, upwardly mobile countries, from Holland in the seventeenth century to China in the twenty-first, tend to have some economic spark first that is subsequently built upon as their policies improve. So if this looks like a chicken-egg problem to you, it essentially is. Economic freedom causes economic growth but is also caused by that growth. The American Founding can be used to make this point. The U.S. Constitution and Hamilton’s financial reforms did not so much outright “cause” the two plus centuries of economic growth that followed as they “sparked” or “unleashed” it by initiating a positive feedback loop between increased incomes and increasingly freer policies, or by extending existing policies to new groups such as women, immigrants, African Americans, and I hope to be able to one day say Native Americans as well. Americans entered the late 1780s with an economy that was moribund but they still possessed significant capital: physical capital in the form of land and improvements, tools, and livestock; human capital in the form of some formal education and extensive amounts of work experience; financial capital in the form of some money and lots of IOUs, though both were of tenuous value. By protecting existing capital to an extent that Americans had not known since the Imperial crisis began in the early 1760s, the Constitution provided people with incentives to create more. Soon after, Hamilton and his reforms, especially funding, assumption, the Bank of the United States, and state corporation law, allowed for the creation of more and better financial capital.

So that is one way to make Washington and Hamilton relevant: to cast them not just as creators of our political system but also of our economy, which is why I named my first born son Alexander Hamilton Was Wright. Yep, that’s right, Alexander Hamilton Was Wright. Look it up in the Wall Street Journal. Anyway, the story I have related about Hamilton and economic development in One Nation Under Debt and sundry essays is rather different from the standard one, which makes some silly assertions about tariffs, factories, and government planning. Hamilton’s contribution to economic growth was through institution-building, particularly the Constitution and the Treasury Department, and policies that led to capital market development – funding, assumption, and the Bank of the United States again -- and also the easy entry of corporations, which proliferated widely in the 1790s and 1800s thanks in part to precedents set by Hamilton, who helped to establish the Bank of New York and the Merchants Bank of New York as joint-stock companies without the government’s charter or other official stamp of approval. Had he lived, I am sure that Hamilton would have championed general incorporation laws, in which case American entrepreneurs may have enjoyed the benefits of those salubrious policies decades earlier. Corporation formation and economic growth were deeply intertwined, or so I argue in Corporation Nation forthcoming from Penn Press this December.

But we can’t stop here in our quest for relevance. The views of Hamilton, Washington, and their contemporaries are relevant to almost every major policy topic, economic or otherwise, today. History doesn’t repeat, of course, but as Mark Twain said, it does rhyme, sometimes quite closely. So today we debate abortion instead of infanticide. Influenza epidemics today loom as large as yellow fever did in the 1790s. Inroads against smallpox mirror those being made against cancer today. Muslims quote unquote terrorized American ships in the 1790s. Interestingly, in the 1790s it was Americans who spilled over the border into Spanish lands. International trade policies spurred riots in the 1790s as well as the 2000s. I’m thinking Jay Treaty and Seattle of course. In the 1790s, small farmers and retailers found it impossible to compete with larger, more efficient rivals. And on, and on, and on. So from my point of view, the issue isn’t so much whether or not the 1790s are relevant today – they certainly are, as is every other era of the nation’s past – it is whether individual teachers have the skills and knowledge to draw out the connections effectively in the classroom because doing so requires knowing students and pedagogy inside and out but also current topics and, most daunting of all, details of history not found in high school or even college textbooks.

I certainly can’t tell you about your students and the last time I studied pedagogy in earnest was in the late 1980s, when I was contemplating becoming a high school teacher. I can, however, try to guide you regarding the public policies I know best and that are most likely to arise in your classrooms in the next several years.

The most obvious of these is the federal budget. Hamilton is often quoted as having written that a national debt … then ellipses … will be to us a national blessing. The ellipses leave out a crucial caveat: quote if it is not excessive. unquote That phrase of course begs the question of what differentiates an excessive national debt from a healthy national debt, a topic that was hot in the news a few months back when a graduate student found a major computational error in an empirical paper by a couple of economist hot shots who argued that a debt to GDP ratio of 90 percent is the cutoff between health and excess, between a national debt being pleasantly plump and morbidly obese. Hamilton took a more nuanced approach and argued that a national debt is excessive if it leads to a hard default or in other words a missed interest or principal payment, or if it causes a soft default or in other words inflation, or if it significantly raises the real interest rate and thereby reduces private investment, or if it necessitates tax increases large enough to stymie economic growth. Under the Articles of Confederation the national debt was clearly excessive, breaking all four criteria. Under Hamilton’s tax and financial reforms – again the great trinity of funding, assumption, and the national bank – the national debt went on a diet and became a blessing.

In the same famous quotation just mentioned, Hamilton also says that the national debt will serve as a quote powerfull cement of our union unquote. What he meant was that people who owned federal bonds, the Sixes, Threes, and Deferreds create by his funding and assumption reforms, would have strong incentives to support the new national government so as to keep up the value of their bonds. That could lead to a classroom discussion about how the national debt today keeps foreign creditor nations like China and Japan interested in the prosperity of the United States and how Social Security and other entitlements keep individuals from contemplating the demise of the U.S. government, despite the modest box office success of not one but two recent presidential snuff films. Deficit financing -- enlarging the national debt every year by borrowing -- ensures that every state in the Union receives more federal money than it pays into Washington’s coffers and thus keeps secessionist movements on the fringe.

The size of the government as a percentage of the economy is another obvious topic to grow out of discussions of the federal budget but it is a tricky one because many people, perhaps even you, learned that Jefferson wanted a small national government while Hamilton wanted a large one. In fact, Hamilton wanted a large government only relative to Jefferson’s vision. From today’s perspective, both wanted a miniscule government. Under Washington and Adams, federal revenues averaged just 1.72 percent of GDP. Under Jefferson, they averaged 1.67 percent, or less than 1 in every 50 dollars of value created by the economy. From 2001 through 2010, federal revenues averaged 20.56 percent of GDP, or just over 1 in every 5 dollars of value created by the economy. That naturally begs the question of what the government does now that it didn’t do then and that could lead to a fruitful discussion of U.S. foreign policy – Washington’s Farewell Address anyone? – or to the constitution of American military forces and the debates over militia versus regular forces and Navy frigates versus privateers or Jefferson’s littoral defense forces. It could also lead to a discussion of America’s changing role in the world and so forth.

The issue of enlarged government could also lead to discussions of transportation infrastructure and their provision mostly by private corporations or state and municipal, not federal, governments during the Early Republic and antebellum eras. Some students might wonder about old age annuities and healthcare, leading to discussions of changes in the age structure, the development of the medical profession, and the long tradition of what we might term private or family income security.

Another budget-related topic almost certain to appear in the news over the next year is the debt ceiling, a kooky institution that emerged during World War I and that is diametrically opposed to Hamilton’s view of public finance. Hamilton, and presumably Washington, believed that the government should not borrow money without first securing a stream of revenue to repay it. Today, Congress raises the debt ceiling, then worries about how to pay for the newly authorized obligations. Another important tidbit here is that Hamilton and his contemporaries generally thought of taxes in terms of dollars actually raised, not in terms of tax rates. So they didn’t get into theoretical disputes about the revenue effects of raising tax rates, they adjusted tax rates until they supplied the sum of money the government needed, whether that meant moving tariff and tonnage duties and excise taxes up or down. It is absolutely essential to understand that Hamilton did NOT, repeat did NOT, advocate protective tariffs, tariffs designed to allow domestic manufacturers to compete against foreign ones. Rather, his tariffs were for revenue purposes and in his famous Report on Manufacturers, which more people cite than actually read or understand, he ultimately decides that production bonuses are more efficient at promoting manufacturing than protective tariffs are, and does so on proper theoretical grounds I might add.

Sequestration is another budget topic likely to remain in the news. This one is best handled, I think, with reference to Jefferson’s claim that in democracies politicians do not have incentives to “tax and spend” because the tax part will cost them in the next election as much as the spending part will benefit them. Rather, politicians have incentives to “borrow and spend.” That way, their constituents get a new freeway, a low cost college education, or what not, but don’t suffer higher taxes. Not today anyway. Economist David Ricardo showed two centuries ago that government borrowing is simply a form of deferred taxation but not many people know that, or don’t care if they do. As a result of the electoral incentive to borrow and spend, politicians are unlikely to enact a policy of taxing and cutting spending and many economists provide them with theoretical support by arguing that increasing taxes while cutting government spending is a recipe for recession. Sequestration, therefore, was a political ploy to cut spending and raise taxes without anyone getting blamed for it, or getting caught in the Congressional Record voting for a serious dose of fiscal austerity.

Other topics that may reappear in the news in the next few years are government bailouts, corporate governance, and corporate influence on politics and government. Bailouts were big news during the 2008 fiasco and will become so again when, not if, there is another financial crisis. Some observers are already warning of another looming breakdown. Corporate governance was an important component of the 2008 crisis and also about a decade ago when Enron, WorldCom, and other presumably multi-billion dollar corporations evaporated overnight. The Sarbanes-Oxley and Dodd-Frank reforms have not helped matters so it is only a matter of time before a big corporation falters and corporate governance is again big news. And the Citizens’ United decision remains wildly unpopular and may be challenged in court or by new legislation. The founding generation, and Hamilton in particular, have much to say about all three issues.

In early 1792, the United States suffered from a financial panic, a period when the prices of financial assets, like government bonds and bank stocks, plummeted quickly, leading to panicked selling, widespread credit distress, sky-high interest rates, and bankruptcies that interacted in a nasty negative feedback loop or downward cycle like the circling of water in a toilet bowl. Working in conjunction with the Bank of New York and the Bank of the United States, Hamilton squelched the panic by inventing a rule that would later become known as Bagehot’s rule. During a panic, the lender of last resort, Hamilton and later Bagehot said, should lend freely at a penalty rate to all borrowers who can post good collateral. The effect of the rule is two-fold: first, it quiets panic because all solvent individuals and companies are assured of being able to borrow if they have to, so they stop selling assets at distressed prices for cash and thereby short-circuit the feedback loop slash stop the toilet flush. The penalty rate ensures that borrowers will go to the lender of last resort only when they cannot find a private lender. Second, the rule forces insolvent individuals and companies into bankruptcy so it does not increase what economists call moral hazard and what mere mortals like us call excessive risk-taking.

Hamilton’s nee Bagehot’s Rule is a much different policy from that followed by the Federal Reserve today, which responds to panics by lowering interest rates for everybody, including poor depositors and bondholders, and lending on flimsy collateral and only to banks. The Fed’s actions as lender of last resort are part of the reason that Rand Paul and others have tried to audit it and talk of eliminating or drastically reforming the century-old institution is the loudest it has been since the Great Inflation of the 1970s or even the Great Depression of the 1930s.

Assumption of state debts was also a type of bailout of state governments. Hamilton made clear, however, that the bailout was justified only by the origins of the debt in the common cause of the Revolution and by the Constitution’s prohibition of state tariffs, long a major source of revenue for colonial governments. He also made clear that he opposed future federal bailouts of state government debts for fear it would render them profligate and for the most part his advice has been heeded. The states that defaulted on their bonds after the Panic of 1837 received no federal aid and the debts of the Confederate government and the rebel states were disavowed by Constitutional amendment. The connection here is to states with large deficits like California and also to the Europe Union and its pigs problem. That problem, by the way, is pigs spelled P I I G G S, which is short for Portugal, Ireland, Italy, Greece, Great Britain, and Spain.

Corporate governance usually makes the news in the form of failed corporations or high executive pay. Today, stockholders have very little say in how corporations are managed because executives control proxy votes and/or shares with super voting rights and stockholders have little legal recourse. Unsurprisingly, big businesses are essentially run by executives, for executives, and that leads to “Heads I win big, tails I win bigger” contracts: huge bonuses, stock options that reset when conditions become unfavorable, and golden parachutes that reward executives for failing with more money than we will make in our entire lifetimes – everyone in this room combined in some cases. Washington and Hamilton were involved in the formation of several early corporations, foresaw the possibility of such shenanigans, and put effective checks and balances against them in place. One was capped or prudent mean voting rules that ensured minority stockholders had some say in how corporations were run. Another was the concept of ultra vires – corporations were chartered or associated to operate in specific industries thus limiting managerial discretion. Perhaps most importantly, executives were beholden to a board of directors, the members of which were truly independent and compensated solely by the company’s bona fide economic performance. Stockholders could inspect the company’s books, order independent audits, and oust directors and officers that tried to expropriate corporate wealth. The system was imperfect, as all things of the flesh are, but far superior to what passes for corporate governance today. Due to policies that bar their active participation in governance and that have limited their ability to buy out underperforming companies, most institutional investors that discern governance problems at corporations in their portfolios simply sell out, passing the problem onto unsuspecting individual investors.

Corporate governance has not been improved partly because the issues involved are arcane ones for most Americans, not topics regularly discussed in college courses much less high school ones or even informally around water coolers. Another reason that governance problems persist is that corporations, or rather the executives that run them, have considerable political influence, influence enhanced by the Supreme Court’s ruling in the 2010 Citizens’ United case. In its infinitesimal wisdom, SCOTUS held that corporations were just agglomerations of people and hence that their political speech is protected by the First Amendment. That opened the door to the SuperPACs and what not so thoroughly satirized by Stephen Colbert and his Report and elsewhere. Of course Washington, Hamilton, and the other Founders did not consider corporations people in any sense of the term but rather referred to them as a corporate body or a body politic. When John Marshall used the term person in connection with corporations he did not mean a natural person, or human being, but rather what we would today call an entity. Even the conservative Cato think tank concedes this but ignores the implication that entities created solely to influence elections are anathema to most Americans now and the Founders to a man, and I suspect to a woman too, but you should ask Cokie Roberts about that. Early corporations – through the Civil War at least – were clearly creatures of the state and suffered only because the state could dismantle them at will if they threatened the public good. Nobody asserted the right to incorporate to influence elections and if they had they would have been burned in effigy or given a nice bath of tar and feathers. Now there is a nice hands-on activity for your students.

Seriously, how to get any of these ideas across to your students is beyond me, unless you happen to teach AP American History. As I conceded earlier, connecting past and present is not easy to do at all and is really hard to do well. If you would invest a summer and a few hundred dollars you could read all my books and articles and talk glibly about all of these subjects. A few dozen more summers spent reading the work of some other policy historians and you’ll be all set to begin thinking about the pedagogy involved. That is completely tongue in cheek, of course. The best approach, I think, is for those of you who enjoy these topics to develop lesson plans, have them vetted, solely for accuracy of content, by somebody like me, and then share them widely with other educators.

I hope you have questions; we certainly have time left for me to try to address them.