From Washington DC to my little prairie hamlet (Sioux Falls, actually a thriving small city of 160k, give or take), politicians are talking about using the government to "create jobs." Obama has a plan, of sorts, and so does Sioux Falls's esteemed mayor, Mike Huether, who thinks that a new "event center" he has been pushing will create 1,100 construction jobs.
Can the government really create jobs? I'm often asked. Absolutely, I respond, but should it? Aren't we really interested in prosperity, not jobs?
The government can create jobs directly by employing people or contracting with businesses and it can do so indirectly through its policies. Huether has the former in mind, Obama some of both. But neither will deliver what Americans really want, which is prosperity. The JOBS mantra is a load of bunk: American economic history is about working fewer hours at easier work for more and better stuff, not about employment. (And claims by the New York Times to the contrary, we are working less for more compensation and more and better stuff. More technically, real hourly compensation has increased markedly in both business and manufacturing.)
The federal government, for example, could ensure that every American would have work to do 18 hours a day, 7 days a week, 365 days a year by simply outlawing farm machinery and food imports. We could all work picking and shucking corn, milking cows by hand, etc. We'd be impoverished, but we would all have jobs. No politician would dare implement such a policy, of course, but tens of thousands of rules and regs have the same cumulative effect: creating work that need not be done. Reversing such policies would eliminate jobs but actually be good for the economy, especially after the workers freed from the bondage of un- or counterproductive work find value-producing work. I'm not saying that ALL regulations should be eliminated, just pointing out that they come with costs that are rarely understood or directly measured.
What about when governments hire employees or contract with private construction companies or other businesses that then make hires? Most people seem to have the sense that expanding government employment probably isn't a very good thing, at least not the way such employment is currently constituted (high pay and benes based on seniority rather than productivity). Surely the latter type, though, is beneficial? Only, I respond, if one forgets about Bastiat's window, or "that which is seen, and that which is not seen." What is seen are the burly men fixing a bridge or building an events center. What is not seen are the costs, the income that is diverted (through taxation) from one purpose to another. It isn't clear how such reallocation can add to the total number of jobs (unless they are lower paying than the ones they replace), but it is clear that it creates very salient jobs that politicians up for re-election can point to proudly and that it makes it difficult for their opponents and critics to point to the jobs lost due to the taxes. But we know that they were lost: the $1,000 or $10,000 that you paid in taxes did not go to the corner coffee shop, to the auto or boat manufacturer, etc.
If a government can somehow increase wages more than it decreases it, its ability to create prosperity with those wages must be limited in scope because communist nations like the former USSR that had nothing but government employment stagnated economically. They created plenty of jobs, in other words, but little prosperity. Why do the Obamas and Huethers believe that they can do any better?
How, then, can government promote prosperity? The quick and easy answer is by protecting life, liberty, and property because that will enhance incentives for improving productivity, for making more with less. What is meant by life, liberty, and property, and how government can best protect them, afford no easy answers but we can't even begin to have that conversation if politicians fixate discussion on "jobs.
Wednesday, September 14, 2011
Friday, September 09, 2011
Is Rick Perry Right about Social Security?
During the debate on Wednesday night, Republican presidential candidate Rick Perry has taken som flak for calling Social Security a Ponzi scheme. Who's right?
On page 163 of Fubarnomics, I call Social Security a quasi-Ponzi scheme. I hedged because Ponzi schemes, pyramids, and related scams and flim flams are by definition illegal. Social Security isn't illegal and can't be unless declared unconstitutional, something SCOTUS has not done and is unlikely to do at this or any future juncture. Also, as Stephen Colbert hinted at last night in his critique of Perry's claim (sorry Parry's claim for Colbert -- the A is for AmericA and IowA), Social Security is not designed to enrich just one or a few people at the top, it is designed to provide modest annuities to millions of superannuated individuals (and in some cases their spouses and dependent children).
Social Security is like a pyramid scheme because it worked by increasing the number of taxpayers at the bottom of the pyramid. Demographics (the Baby Boom) helped at first, as did enlargements to the program. But now there are no new groups of any size (with the possible exception of immigrants) to add to the program and the demographics have reversed. Instead of a pyramid with a few at the top garnering benefits and a lot at the bottom each paying a little for their support, Social Security is more like a rectangle with the number of taxpayers not far outnumbering the recipients. Soon, the remaining taxpayers may feel the burden of taking care of so many beneficiaries too much to bear. In that sense, the Ponzi scheme metaphor is apt.
Interestingly, the government does seem to be following some of the recommendations I made in Fubarnomics, especially shifting Social Security from a special, highly regressive tax to the general fund. Obama apparently wants to continue the transition. The next step would be to tell everyone older than some age (I've volunteered mine) that they will receive Social Security payments as promised and everyone younger (including myself) that they had better start saving now because they will not receive any Social Security retirement benefits (and that the life insurance and disability components will phase out over the next few years). The final step would be to improve the regulation of our private security system: retirement plans, disability insurance carriers, and life insurers.
On page 163 of Fubarnomics, I call Social Security a quasi-Ponzi scheme. I hedged because Ponzi schemes, pyramids, and related scams and flim flams are by definition illegal. Social Security isn't illegal and can't be unless declared unconstitutional, something SCOTUS has not done and is unlikely to do at this or any future juncture. Also, as Stephen Colbert hinted at last night in his critique of Perry's claim (sorry Parry's claim for Colbert -- the A is for AmericA and IowA), Social Security is not designed to enrich just one or a few people at the top, it is designed to provide modest annuities to millions of superannuated individuals (and in some cases their spouses and dependent children).
Social Security is like a pyramid scheme because it worked by increasing the number of taxpayers at the bottom of the pyramid. Demographics (the Baby Boom) helped at first, as did enlargements to the program. But now there are no new groups of any size (with the possible exception of immigrants) to add to the program and the demographics have reversed. Instead of a pyramid with a few at the top garnering benefits and a lot at the bottom each paying a little for their support, Social Security is more like a rectangle with the number of taxpayers not far outnumbering the recipients. Soon, the remaining taxpayers may feel the burden of taking care of so many beneficiaries too much to bear. In that sense, the Ponzi scheme metaphor is apt.
Interestingly, the government does seem to be following some of the recommendations I made in Fubarnomics, especially shifting Social Security from a special, highly regressive tax to the general fund. Obama apparently wants to continue the transition. The next step would be to tell everyone older than some age (I've volunteered mine) that they will receive Social Security payments as promised and everyone younger (including myself) that they had better start saving now because they will not receive any Social Security retirement benefits (and that the life insurance and disability components will phase out over the next few years). The final step would be to improve the regulation of our private security system: retirement plans, disability insurance carriers, and life insurers.
Monday, August 22, 2011
Our Government's Confidence Deficit
The following appeared in the local newspaper, the Argus Leader, on Saturday.
August 20, 2011
My Voice: Our government's confidence deficit
Robert E. Wright
People in Sioux Falls and nationwide have a low opinion of the federal government right now, and justifiably so. Recent declines in the stock market have more to do with that "confidence deficit" and the uncertainty it spawns than Standard & Poors' recent downgrading of U.S. bonds (which actually rallied on the news of the downgrade). Sioux Falls city government also is suffering from a confidence deficit that threatens to negatively affect the local economy.
Thankfully, Sioux Falls is better governed than the nation, but residents whom I have spoken to note that their city government is far from perfect. So I decided to put the city government to a small test and am chagrined to report that it failed miserably. I chose the simplest issue that I could find - the lawn watering restrictions - on the presumption that if the government can't fix a minor problem undefended by any obvious entrenched interests, it won't be able to fix a major one defended by big bucks. (Like, say, construction delays on a $100 million plus events center.) The City Council not only did not resolve the minor issue that I raised, it did not even show that it understood it and instead made a series of ad hominem attacks!
What I pointed out to the council was that limiting lawn watering to every other day was not likely to conserve water, the ostensible goal of the restriction, because lawns can be watered without limit every other day, and nobody monitors nighttime watering. The local water authority admitted that there is no evidence that the restrictions, in place since 2008, have conserved any water. The effects of the restrictions are difficult to parse because it has been fairly rainy since then (so lawn watering has been less necessary) and water prices have increased a little (so people are conserving to save money). But absent any logical reason for the restriction to limit consumption, it is safe to say that, like low-flow toilets that simply induce more flushes, the city's restrictions might make some people feel good but have no real effect on water consumption.
Instead of removing the restriction as an unnecessary intrusion on residents' civil liberties, as I suggested, the council retorted with claims so outrageous that I will not repeat them here for fear of not being believed. I will note, however, that the council thinks the restrictions are a serious matter: one council member went so far as to relate how Harrisburg almost ran out of water "on a hot Sunday night a few years ago." Unfortunately, it never responded to my assertion that the best way to ration water is by price, not by making arbitrary decisions about what types of consumption are more important than others. I personally believe that homeowners should keep their lawns just green enough not to spontaneously combust but, unlike the city, I am unwilling to force my values onto others. Rationing by price allows people to decide whether they want to use more of their income for water use or whether they want to conserve, and if so how, be it by reducing lawn watering, closing the family pool or showering only once a week.
If the city ever shows that it can fix the many little annoyances such as the watering restriction, more residents might find a city-sponsored events center a project that they can support. In the meantime, however, many wonder why the city should take the lead on the project. If private investors cannot raise full money for the events center in a low-interest environment, can the project really be expected to turn an actual profit?
Moreover, even if Sioux Falls truly needs an events center, and even if the city government is the only entity that can create it, why should that particular need take priority over the city's many other needs? Many of its residents, for example, really need low interest mortgages so that they can find a buyer for their home, afford to buy a new one, avoid defaulting on an existing mortgage, or extricate themselves from lawsuits vigorously pursued by the same rapacious banks that received TARP money in 2008-09. Shouldn't such a need be fulfilled before the city launches into the entertainment business? I can't answer that because, again, unlike the city, I am unwilling to force my values onto others. But I suspect if a poll were to ask whether Sioux Falls residents would rather have a better-functioning housing market or an events center, housing would win, probably pretty handily.
Also, I recently received the following email regarding my book Fubarnomics:
August 20, 2011
My Voice: Our government's confidence deficit
Robert E. Wright
People in Sioux Falls and nationwide have a low opinion of the federal government right now, and justifiably so. Recent declines in the stock market have more to do with that "confidence deficit" and the uncertainty it spawns than Standard & Poors' recent downgrading of U.S. bonds (which actually rallied on the news of the downgrade). Sioux Falls city government also is suffering from a confidence deficit that threatens to negatively affect the local economy.
Thankfully, Sioux Falls is better governed than the nation, but residents whom I have spoken to note that their city government is far from perfect. So I decided to put the city government to a small test and am chagrined to report that it failed miserably. I chose the simplest issue that I could find - the lawn watering restrictions - on the presumption that if the government can't fix a minor problem undefended by any obvious entrenched interests, it won't be able to fix a major one defended by big bucks. (Like, say, construction delays on a $100 million plus events center.) The City Council not only did not resolve the minor issue that I raised, it did not even show that it understood it and instead made a series of ad hominem attacks!
What I pointed out to the council was that limiting lawn watering to every other day was not likely to conserve water, the ostensible goal of the restriction, because lawns can be watered without limit every other day, and nobody monitors nighttime watering. The local water authority admitted that there is no evidence that the restrictions, in place since 2008, have conserved any water. The effects of the restrictions are difficult to parse because it has been fairly rainy since then (so lawn watering has been less necessary) and water prices have increased a little (so people are conserving to save money). But absent any logical reason for the restriction to limit consumption, it is safe to say that, like low-flow toilets that simply induce more flushes, the city's restrictions might make some people feel good but have no real effect on water consumption.
Instead of removing the restriction as an unnecessary intrusion on residents' civil liberties, as I suggested, the council retorted with claims so outrageous that I will not repeat them here for fear of not being believed. I will note, however, that the council thinks the restrictions are a serious matter: one council member went so far as to relate how Harrisburg almost ran out of water "on a hot Sunday night a few years ago." Unfortunately, it never responded to my assertion that the best way to ration water is by price, not by making arbitrary decisions about what types of consumption are more important than others. I personally believe that homeowners should keep their lawns just green enough not to spontaneously combust but, unlike the city, I am unwilling to force my values onto others. Rationing by price allows people to decide whether they want to use more of their income for water use or whether they want to conserve, and if so how, be it by reducing lawn watering, closing the family pool or showering only once a week.
If the city ever shows that it can fix the many little annoyances such as the watering restriction, more residents might find a city-sponsored events center a project that they can support. In the meantime, however, many wonder why the city should take the lead on the project. If private investors cannot raise full money for the events center in a low-interest environment, can the project really be expected to turn an actual profit?
Moreover, even if Sioux Falls truly needs an events center, and even if the city government is the only entity that can create it, why should that particular need take priority over the city's many other needs? Many of its residents, for example, really need low interest mortgages so that they can find a buyer for their home, afford to buy a new one, avoid defaulting on an existing mortgage, or extricate themselves from lawsuits vigorously pursued by the same rapacious banks that received TARP money in 2008-09. Shouldn't such a need be fulfilled before the city launches into the entertainment business? I can't answer that because, again, unlike the city, I am unwilling to force my values onto others. But I suspect if a poll were to ask whether Sioux Falls residents would rather have a better-functioning housing market or an events center, housing would win, probably pretty handily.
Also, I recently received the following email regarding my book Fubarnomics:
Prof. Wright,
I have just completed reading ‘Fubarnomics’. Sir, a brilliant book, I laughed, I cried, I wet myself, I learned.
I learned and surmise, that our government and the governments of other nations will NOT try your ideas for a lasting change to ‘’’’’’economics’’’’’’.
As the individual is afraid of change, governments will only change if pushed to rebellion.
Per your suggestion, I want to read the book called ‘’ Nudge””.
Thank you for taking the time to write this book.
Friday, August 05, 2011
Whither now?
I've been run ragged the last two days doing 4 interviews for local TV news reporters interested in where the economy will head next given the recent drop in the Dow, the debt/spending non-decision, etc. Of course I point them to my Wall Street Journal Guide ... but here I want to suggest something a little deeper. As I argued in my Mt. Vernon speech a few weeks ago, I think what Congress needs to do is to pass an array of taxes that automatically kick in should government revenues prove inadequate to cover current expenditures. That will prevent the need for the government to borrow substantially more (under normal circumstances) and direct attention to where it belongs, on the expenditure side of the government's income statement. Such a policy would not require the passage of a balanced budget amendment and would be more flexible than any balance budget requirement because it could be limited in various ways. Most importantly of all, it would follow Alexander Hamilton's dictum that whenever the government incurs an obligation (be it a bond, a contract, or an entitlement) it also creates the means for paying it. Only then will public credit be secure and not subject to the political brinkmanship witnessed during the recent crisis.
What should the proposed tax panoply look like? The easiest thing would be to pass a national sales tax, the rate of which would automatically increase to cover any projected budget deficits. Once its effectiveness is proven in the real world, such a tax could replace our current income tax system, which wastes billions of dollars each year on forms, receipt management, etc. Sales taxes are inherently regressive -- they fall more heavily on the poor -- but that disadvantage could be obviated by an income policy or by charging higher RATES on higher priced goods of the same weight and class. For example, a $1 12 oz. bottle of soda might be taxed at 15% but a $2 12 oz. bottle might be taxed at 30%. Similarly, a $10,000 sedan might be taxed at 10% but a $100,000 one at 50%. In other words, progressivity can be built into sales taxes too.
What should the proposed tax panoply look like? The easiest thing would be to pass a national sales tax, the rate of which would automatically increase to cover any projected budget deficits. Once its effectiveness is proven in the real world, such a tax could replace our current income tax system, which wastes billions of dollars each year on forms, receipt management, etc. Sales taxes are inherently regressive -- they fall more heavily on the poor -- but that disadvantage could be obviated by an income policy or by charging higher RATES on higher priced goods of the same weight and class. For example, a $1 12 oz. bottle of soda might be taxed at 15% but a $2 12 oz. bottle might be taxed at 30%. Similarly, a $10,000 sedan might be taxed at 10% but a $100,000 one at 50%. In other words, progressivity can be built into sales taxes too.
Thursday, August 04, 2011
Identifying Asset Bubbles Before They Get Dangerously Big
Several years ago, I considered trying to obtain funding for a project aimed at providing policymakers with tools to identify bubbles before they grow to dangerous proportions. For a variety of reasons I did not pursue the project but I have mentioned the basic ideas several times and they have taken on a cyber life of their own. I therefore post below my notions on the subject as I wrote them back in 2008-9.
Ex Ante Identification of Asset Bubbles
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD
Perhaps some readers will turn their attention to developing empirical tests that can reliably distinguish between bubbles and other phenomena that affect asset prices, of which there is now a shortage (LeRoy 2004).
Crises, major and minor, litter financial history. Most crises, including the most recent one, occurred when rapidly declining asset values caused the failure of highly leveraged investors, leading to credit constraints that negatively impacted the financial system and aggregate output (Kindleberger 2000). The frequency and severity of financial crises would be diminished if asset bubbles could be identified ex ante, to wit before they become large enough to pose a major threat to macroeconomic stability. U.S. policymakers admit that bubbles (“rational” or otherwise) are possible and potentially destabilizing but believe that they cannot be identified ex ante (Raines et al 2007). Even if they were detectable, the proper policy response would remain far from clear (Barlevy 2007). Academic economists debate whether bubbles can be identified econometrically even ex post (Gurkaynak 2008; Bhattacharya and Yu 2008)!
Contrary to O’Hara’s (2008) claim that no clear “operational way to establish empirically the existence of a bubble” exists, this paper hypothesizes that the likelihood of bubble formation in specific markets can be estimated ex ante and that regulators can implement inexpensive policies to minimize them. Building on Allen et al (1993), bubbles are more likely to form in markets for assets that:
a) can be shorted or otherwise arbitraged only at great expense (Abreu and Brunnermeier 2003; Brunnermeier 2007);
b) can be purchased with cheap borrowed money;
c) are subject to high agency costs, including poor corporate governance (Benmelech et al 2008);
d) have recently attracted numerous (Tirole 1982)[1] inexperienced participants (Porter and Smith 2003; Greenwood and Nagel 2008);
e) are subject to higher levels of risk-taking due to the moral hazard created by repeated recent bailouts (Hetzel 2009).
The paper will formalize the model then test it empirically using evidence from a wide range of markets spanning the globe and several centuries. Shorting costs will be proxied by a new index, borrowing costs with appropriate interest rates (using Homer and Sylla 2005 for historical markets) compared to the Taylor Rule (McKinnon 2008), corporate governance with an index such as Nicolo 2008, new market participants by market entry costs, and moral hazard by the number and nature of government bailouts in the period prior to bubble formation (Reinhart and Rogoff 2008a, b). Bubbles are assumed to have caused all financial crises without obvious non-bubble causes, such as military defeats (e.g. the sack of Washington, D.C. in August 1814, which triggered the suspension of payments in banks south and west of the Hudson river) and natural disasters (e.g. the Kanto earthquake of 1923, which caused a Japanese banking crisis).
An initial literature survey suggests that the model will receive ample empirical support. From alpacas to sugar beets to thoroughbred racehorses, agricultural markets are particularly prone to asset bubble formation because shorting is impossible (except in the limited sense of selling the asset) and investor entry barriers low (Saitone and Sexton 2007). As an example of agency costs, hedge funds and mutual funds knowingly invested in overvalued stocks in the late 1990s when investors compensated them to achieve short-term returns similar to other funds in the same class. When rewarded for longer term or above average returns, by contrast, funds invested much less in overvalued stocks (Dass et al 2008). Historically, many bubbles have involved real estate, which suffers from short sale constraints and entry barriers low enough that a significant number of traders may suffer from basic fallacies such as money illusion (Brunnermeier and Julliard 2008).
If bubbles can be identified ex ante, the appropriate regulators should monitor markets at high risk for bubble formation, ensure that participants are aware of that fact, and credibly warn them that government bailouts will not be available (Hetzel 2009) or that access to the safety net will be appropriately priced (Acharya and Richardson 2009). Government intervention in this manner is Pareto improving because short-circuiting the price-to-price feedback loop at the heart of most bubbles is inexpensive relative to blunter monetary policy options (e.g., increasing the Fed funds rate), limits the moral hazard and redistribution associated with bailouts (Wright 2009), and provides an information and analysis service that market participants are unable to provide or reliably obtain themselves. Agency ratings have again proven themselves impotent due to the conflict of interest at the heart of their current business model (namely, receiving the bulk of their revenue from issuers) and other problems (Partnoy 1999). Moreover, market participants apparently have difficulty incorporating highly relevant historical precedents into their market forecasting. For example, apparently no major investment bank executive knew that six earlier U.S. mortgage securitization schemes had failed due to incentive misalignments between originators and ultimate investors, a misalignment identically replicated in the 21st century (Snowden 1995). Similarly, many home buyers apparently did not realize that the long-term upward trend in house prices did not mean that prices were monotonic. In fact, the trend has been repeatedly punctuated with reversals (White 2008).
Regulators could also reduce the likelihood of bubbles by encouraging the development of inexpensive shorting mechanisms, enacting policies to improve corporate governance and investment fund contracts, and to limit access to markets by inexperienced participants more efficiently than is currently done. (For example, accredited investor status might best be subject to examination as well as asset and income limitations.) The paper will not address any of these complex areas in detail but will offer them as potential policy options requiring additional research.
REFERENCES
Abreu, Dilip and Markus Brunnermeier. (2003) “Bubbles and Crashes.” Econometrica 71:173-204.
Acharya, Viral and Matthew Richardson, ed. (2009) Restoring Financial Stability: How to Repair a Failed System. Hoboken: Wiley.
Allen, Franklin, Stephen Morris, and Andrew Postlewaite. (1993) “Finite Bubbles with Short Sale Constraints and Asymmetric Information.” Journal of Economic Theory 61:206-29.
Barlevy, Gadi. (2007) “Economic Theory and Asset Bubbles.” Economic Perspectives: Federal Reserve Bank of Chicago 3Q:44-59.
Benmelech, Efraim, Eugene Kandel, and Pietro Veronesi. (2008) “Stock-Based Compensation and CEO (Dis)incentives.” NBER Working Paper 13732.
Bhattacharya, Utpal and Xiaoyun Yu. (2008) “The Causes and Consequences of Recent Financial Market Bubbles: An Introduction.” Review of Financial Studies 21:3-10.
Brunnermeier, Markus. (2007) “Bubbles.” In The New Palgrave Dictionary of Economics. New York: Oxford University Press.
Brunnermeier, Markus and Christian Julliard. (2008) “Money Illusion and Housing Frenzies.” Review of Financial Studies 21:135-180.
Dass, Nishant, Massimo Massa, and Rajdeep Patgiri (2008). “Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives.” Review of Financial Studies 21:51-99.
Greenwood, Robin and Stefan Nagel (2008) “Inexperience Investors and Bubbles.” NBER Working Paper #14111.
Gurkaynak, Refet. (2008) “Econometric Tests of Asset Price Bubbles: Taking Stock.” Journal of Economic Surveys 22:166-86.
Hetzel, Robert. (2009) “Government Intervention in Financial Markets: Stabilizing or Destabilizing?” Federal Reserve Bank of Richmond. Working Paper.
Homer, Sidney and Richard Sylla. (2005) A History of Interest Rates. 4th ed. Hoboken: Wiley.
Kindleberger, Charles. (2000) Manias, Panics, and Crashes: A History of Financial Crises. 4th ed. Hoboken: Wiley.
LeRoy, Stephen. (2004) “Rational Exuberance.” Journal of Economic Literature 42:783-804.
McKinnon, Ronald. (2008) “Bagehot’s Lessons for the Fed.” Wall Street Journal 25 April.
Nicolo, Gianni, Luc Laeven, and Kenichi Ueda. (2008) “Corporate Governance Quality: Trends and Real Effects.” Journal of Financial Intermediation 17:198-228.
O’Hara, Maureen (2008) “Bubbles: Some Perspectives (and Loose Talk) from History.” Review of Financial Studies 21:11-17.
Partnoy, Frank. (1999) “The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies.” Washington University Law Quarterly 77:619-714.
Porter, David and Vernon Smith (2003) “Stock Market Bubbles in the Laboratory.” Journal of Behavioral Finance 4:7-20.
Raines, J. Patrick, J. Ashley McLeod, and Charles Leathers. (2007) “Theories of Stock Prices and the Greenspan-Bernanke Doctrine on Stock Market Bubbles.” Journal of Post Keynesian Economics 29:393-408.
Reinhart, Carmen and Kenneth Rogoff. (2008a) “Banking Crises: An Equal Opportunity Menace.” NBER Working Paper 14587.
Reinhart, Carmen and Kenneth Rogoff. (2008b) “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises.” Working Paper, April.
Saitone, Tina and Richard Sexton. “Alpaca Lies? Speculative Bubbles in Agriculture: Whey They Happen and How to Recognize Them.” Review of Agricultural Economics 29:286-305.
Shiller, Robert J. (2003) New Financial Order: Risk in the 21st Century. Princeton: Princeton University Press.
Tirole, Jean. (1982) “On the Possibility of Speculation Under Rational Expectations.” Econometrica 50:1,163-81
White, Eugene. (2008) “The Great American Real Estate Bubble of the 1920s: Causes and Consequences.” Rutgers University Working Paper. October.
Wright, Robert E., ed. (2009) Bailouts: Public Money, Private Risk. New York: Columbia University Press.
[1] The number of investors need not be infinite, as some have argued, because that assumption is empirically fragile (Abel et al 1989). Rather, I’ll argue that the expected stream of new investors needs to grow fast enough to support expectations of rising prices. Bubbles burst when that condition is violated.
Monday, July 25, 2011
Why Deliberately Defaulting on the National Debt or Any Other Sums Owed Would be Unconstitutional
This speech was professionally taped by 3 cameras and will appear on TV TBD. Enjoy!
Washington, Hamilton, and Jefferson – Funding a Nation
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD for George Washington’s Mount Vernon Estate, Museum, and Gardens, 22 July 2011
Thanks for inviting me back to Mount Vernon to discuss the history of the U.S. national debt. The debt, and its consorts the deficit and the debt ceiling, are again in the news, and in very palpable ways. The present situation is very difficult to understand in a deep way without the historical context that I have tried to provide in two of my recent books, One Nation Under Debt and Fubarnomics. I’ll summarize the gist of those books in this talk, reserving time at the end for your questions.
The second clause of Article I, Section 8 of the U.S. Constitution states that quote Congress shall have Power … To borrow Money on the credit of the United States unquote. Initially this meant that Congress passed a law every time that the Treasury had to borrow, typically to fund wars or territorial acquisitions. By World War I, Treasury borrowed so frequently that the traditional system was overwhelmed. The solution that evolved was to pass a law authorizing Treasury to borrow up to some limit, now commonly referred to as the debt ceiling. Contrary to the claims of some journalists and ideologues, most other non-authoritarian governments also enact debt ceilings as a check against usurpation of the budget by the executive or treasury. Unlike the United States, however, almost all other nations link their debt ceilings to their projected budget deficits or in other words to the amount that they know that they will have to borrow for government to operate smoothly. In America, by contrast, budgets and the debt ceiling are not closely coupled. Hitherto, Congress has increased the debt ceiling whenever necessary but sometimes it has hesitated before doing so, leading to partial government shutdowns as in 1995 or to extraordinary exertions on the part of Treasury to avoid default, as occurred several times during the administration of George W. … Bush that is, not Washington.
In May of this year, I argued in an op ed published on the History News Network that the debt ceiling is constitutional but that purposely defaulting on the national debt is not. In other words, the debt ceiling needs to be closely tied to projected budget deficits as it is in most other responsible nations in order to prevent it from becoming a tool that could cause irreparable damage to the nation’s finances and hence to the government’s ability to defend itself and American citizens from foes foreign and domestic. A default could send bond prices down which would increase the government’s debt service, the percent of the budget paid as interest to bondholders, potentially enough to force the government to print money to meet its obligations, a response that would lead to levels of inflation not seen in decades if not centuries. The depreciation of the dollar vis-Ã -vis other nations’ currencies that would occur as a consequence of such an inflation could lead to the replacement of the dollar as the world’s primary reserve currency. That would greatly complicate the nation’s ability to borrow abroad and raise the truly horrifying specter of the national government issuing debt denominated in a currency other than US dollars. A default or bout of inflation would also raise interest rates for businesses and consumers and thus slow or even stall an already anemic economic recovery.
In another, even graver scenario, a government default causes enough policy uncertainty to directly throttle an economy still gasping for breath following the 2008 crisis. With no way to finance a bailout or stimulus package, the government can only watch as the economy sinks into a debt deflation similar to that experienced in the Great Depression and Americans soon pine for the days when unemployment was only 10 percent.
These are not predictions per se mind you, just worst case scenarios highlighting the gravity of the situation we now face. Our salvation may be that matters are even worse in Europe and Japan, Canada is too small to provide the world’s currency, and that nobody really trusts China, Russia, or other so-called emerging economies.
Some other observers agree that a purposeful default would be unconstitutional and make good textual arguments to support their positions. Amendment 14, Section 4, clearly states that quote “the validity of the public debt of the United States, authorized by law … shall not be questioned” unquote. My argument, by contrast, relies on original intent. The Constitution as ratified did not explicitly rule out the possibility of a purposeful default but James Madison’s notes on the convention debates show that the delegates to the Philadelphia convention initially agreed that the Constitution should explicitly mandate that Congress quote shall discharge the debts & fulfil the engagements of the U. States unquote. (All quotations in this part of the talk, by the way, can be verified in Adrienne Koch’s 1966 edition of Madison’s notes, pages 511-12, 519, and 528-30.) Madison and Elbridge Gerry quote thought it essential that some explicit provision should be made on this subject, so that no pretext might remain for getting rid of the public engagements unquote. Delegate Pierce Butler later questioned that precise language quote lest it should compel payment as well to the Blood-suckers who had speculated on the distresses of others, as to those who had fought & bled for their country unquote. Two days later, George Mason raised the same objection, warning that quote the use of the term shall will beget speculations and increase the pestilent practice of stock-jobbing unquote. A debate on the specifics of debt repayment ensued until Edmund Randolph suggested language that did not commit Congress to a specific debt repayment policy. Randolph’s wording passed ten states to one and ended up as the first clause of Article 6, which states quote All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation unquote.
In other words, the Constitution did not explicitly state that Congress shall pay the debts the nation incurred after ratification only because the delegates were divided over the so-called issue of discrimination, or the question of who the government should pay, original or current bondholders. The original bondholders were largely farmers and soldiers while the current ones were generally perceived to be wealthy, urban speculators, a group despised even more than lawyers were, believe it or not, though there was some overlap between the two groups. The Constitutional Convention was of course called in large part to give the national government the means to repay its debts. The will to do so was taken for granted. The Framers believed, as Gouverneur Morris put it, that quote the New Government would be bound of course unquote to pay the national debt. Of course! And I should point out that the Founders made no distinction between bondholders and other types of creditors. For the government to pay Peter but not Paul would not establish public credit but only enrage Paul and make people wonder why Peter should be so favored.
After Ratification, purposefully defaulting on the debts owed to all domestic creditors was mentioned by a few radicals but never seriously considered and almost everyone believed that foreign creditors had to be repaid in all events. The Founders understood that defaulting on sums owed to foreigners would make it difficult to borrow abroad in the future and also would strengthen foreign incentives to invade the fledgling republic. The best way to avoid invasion is to owe large sums to foreigners but to pay the interest on the debt punctually, a point that is often lost in the handwringing over the trillion-ish dollars the federal government owes to a still communist China.
In sum, the early debates over the U.S. national debt were not about whether to pay, but rather who to pay, when to pay them, how much to pay them, and how the government should raise the necessary sums. As we will see, sharp differences existed on those latter questions, with Washington and Hamilton on one side and Jefferson and Madison on the other, but not over whether the government should honor its debts or not.
The questions of who, when, how much, and how to pay were crucially important ones because by the end of the Revolutionary War the national and state governments were such fiscal wrecks that they actually impeded economic development in the 1780s. Only after passage of the Constitution and implementation of Hamilton’s reforms in the 1790s did real, which is to say inflation-adjusted, per capita incomes grow consistently at modern rates and only then did the American economy show signs of development or modernization. Before the Constitutional Convention, the financial system consisted of just three small banks, a handful of securities brokers, and a coterie of suboptimal individual insurance underwriters. By the end of 1795, 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges were in operation.
Aided by the rapidly developing financial system, entrepreneurs teemed in both the cities and the growing agricultural hinterland and some engaged in increasingly large-scale enterprises. Very few for-profit business corporations formed in the colonial period because of British policies. After the war, a few such corporations formed but in the 1790s the formation of joint-stock corporations accelerated ten-fold, launching the rise of what has been described as a corporation nation. By the Civil War over 22,000 business corporations had been chartered by special legislation and thousands of others by general acts of incorporation, far more than any other country on earth. Today, it is difficult to imagine what a developed economy would look like without the widespread use of the corporate form or some other mechanism for providing investors with perpetual succession and limited liability.
To fully understand Hamilton’s accomplishment, we must first understand the precise nature of the very serious difficulties that the young republic faced. The rebel governments, by which I mean the Continental Congress and the new state governments, successfully funded the opening years of the Revolution by issuing bills of credit, badly printed pieces of paper that circulated as cash similar to those used to fund the many wars of the colonial period. At first, the bills stimulated an economy that had become severely under-monetized after the French and Indian War due to the effective enforcement of British trade laws and severe restrictions on the issuance of bills of credit placed on colonial governments by London bureaucrats. The absolute dearth of monetary instruments caused by those policies greatly impeded colonial economic activity and were, scholars are increasingly beginning to recognize, lingering sores that set off the Stamp Act controversy and that soured Anglo-American relations throughout the Imperial Crisis that led to the Declaration of Independence, which in the section delineating the quote History of repeated Injuries and Usurpations unquote blamed the British quote FOR cutting off our Trade with all Parts of the World unquote and for refusing to pass laws, including bills of credit emissions, quote the most wholesome and necessary for the public Good unquote.
In an economy short of cash, the new money issued by the rebel governments at first lowered interest rates and facilitated the extension of credit, thus stimulating economic activity above and beyond the stimulus provided by mobilization for war. As the Revolution dragged on, however, the rebel governments had to issue more bills of credit than Americans believed they would be able to redeem at face value via specie redemption or taxation after the war, a valid perception exacerbated by a large influx of British-made counterfeits said to be distinguishable from the original only by virtue of their being of superior physical quality. Because there were eventually more bills of credit in circulation than were needed at the prevailing price level, bills of credit began to depreciate, by which I mean that they lost purchasing power vis-Ã -vis other goods, including gold, silver, land, food, and sundry services. As the War wore on, the depreciation became more serious until by early 1781 both state bills of credit and the Continentals issued by the national government were almost valueless.
Long before then, the rebel governments incurred other sorts of debts as well. They managed to sell some bonds and lottery tickets early in the conflict but by the late 1770s anemic tax receipts forced them to take the provisions they needed directly from American farmers, iron makers, and so forth. Many soldiers continued fighting in exchange for IOUs promising future payment but they had to be fed, clothed, housed, and armed if they were to remain effective in the field. Rebel governments could not very well seize private property and retain the affections of the citizenry so they gave handwritten promissory notes or IOUs for goods taken from Patriots. Outright confiscation was also resorted to, but the rebels tried to seize the estates only of known Loyalists. Though seemingly simple, direct requisitioning was inefficient because farmers could not always supply enough of everything that was needed to support the military units active in their regions and remain viable. If the army took a farmer’s last mare and the area’s last stallion, for example, no spring foals would be born to replenish his stable.
The Yorktown operation in fall 1781 and the war’s final years were partially financed with the aid of the private fortunes of the new Superintendent of Finance, Robert Morris, and subscribers to the new Bank of North America, a quasi-central bank that issued notes and deposits convertible into gold and silver. Most market participants believed the bank money to be more reliable than discredited government bills of credit so the bank helped to increase the supply of money, which after the collapse of bills of credit had shrunk to the point of being too thin to support normal economy activity. The new bank also made loans to the government and to businesses large and small. When peace finally came, however, the national and state governments remained in rough shape financially because the economy in most places remained extremely soft due to the disruption of prewar trading patterns, the wartime destruction of human and physical capital, and tremendous uncertainty about the future of the fragile new confederation.
The biggest challenge facing the new national and state governments was how to begin repaying their wartime debts. Some governments aroused the ire of bondholders by refusing to increase taxes and defaulting on their obligations. Other states, most notoriously Massachusetts, sparked rebellions by increasing taxes too high, too quickly. Both tactics played into the hands of nationalists, men like Madison and Hamilton who wanted to create a more powerful central government capable of repaying the nation’s war debts and thus of better protecting Americans from foreign invasion and domestic unrest. Such men, self-styled small “f” federalists, succeeded in establishing such a government when the Constitution was ratified in 1788. Many tricky details, however, remained to be worked out before public credit, wrecked by the depreciation of bills of credit and the inability of most governments to pay interest on their wartime IOUs, was finally and firmly re-established.
It is of course widely known that Hamilton, America’s first Treasury Secretary and the trusted confidante of Washington, who wisely supported first the military career and then the public policies of the brash young West Indian bastard, played the most important role in the reformation of the government’s fiscal situation and the economy’s remarkable growth in the first half of the 1790s. Many of the details, however, remain misunderstood or completely unknown. First and foremost, Hamilton helped the nation to build an effective tax regime, based largely on an efficient tariff collection system engineered by Hamilton himself, that lasted until the Civil War. Land sales, bank dividends, and excise taxes added to government revenues to some extent but the mainstay of the system, especially in peacetime, were taxes on imports. Contrary to myth, Hamilton did not advocate protective tariffs designed to aid American manufacturing interests but instead created a nuanced system of revenue tariffs designed to maximize the national government’s net income. Hamilton understood that high tariffs would hurt tax receipts by encouraging smuggling and corruption. He also understood that what people considered a high tariff depended on the nature of the good being imported so he charged higher rates on luxury and status goods and allowed many non-native raw materials to enter the country free of charge.
I should point out here that the excise on whiskey that led to the infamous Whiskey Rebellion was merely a tax designed to offset the tariff on foreign rum. Rather than protect domestic whiskey producers with that tariff, Hamilton wanted them to compete on a level playing field. One day, I hope, NYU’s Richard Sylla will finally publish his book explicating, among other topics, the details of Hamilton’s ingenious tariff system. Tariff is a dirty word today, at least among most economists, but it was certainly the most efficient means of taxation available in the eighteenth and first half of the nineteenth centuries in a world still dominated by mercantilist policies. Hamilton’s views on tariffs have been misunderstood because his Report on Manufactures has been misconstrued as a series of policy proposals rather than as a primer on the microeconomics of the effects of different types of government policies, including tariffs and export bounties, on market prices and quantities.
In any event, Hamilton used tariff revenues to pay the debts incurred by the national government during and after the Revolution and also to assume, or take over and fund, the debts incurred by the several states. He did so by reducing the face values of the scores of IOUs issued by the national and state governments during the war – a potpourri of instruments with different maturities and interest rates with names like indents, Hillegas notes, and Long Bobs – to their approximate value in gold and silver at their issuance. He then accepted them as payment for three new types of bonds called Threes, Sixes, and Deferreds. Threes were redeemable at the pleasure of the government and paid 3/4ths of one percent interest at the end of each fiscal quarter: March, June, September, and December – or 3 percent annually. Sixes paid 1.5 percent interest quarterly, or six percent annually, and contained an annuity feature that gave the government the option to repay part of the principal each year much like an amortized mortgage today. Deferreds paid no interest but turned into Sixes at the end of 1800. By issuing Deferreds and Threes in addition to Sixes, Hamilton reduced the government’s total debt interest charge from 6 to around 4 percent, quite a feat for a nation essentially bankrupt just a few years before.
To ensure that the government would not default on its new bonds if revenues proved temporarily insufficient, Hamilton also established a central bank, the Bank of the United States, partially owned by the government but essentially owned and operated by private stockholders. Run by the nation’s most experienced banker, Philadelphian Thomas Willing, the Bank of the United States held most of the government’s deposits, paid interest on the government’s bonds when they fell due, transferred government funds from city to city as necessary, acted as a lender of last resort during financial panics, and, most importantly of all, lent money to Treasury when the government’s revenues temporarily fell short of expenditures.
Finally, Hamilton also established the U.S. Mint and, in the most important part of the legislation, defined the U.S. dollar in terms of gold and silver, thus anchoring the new currency’s real value over the long term. The definition wedded the nation to a bimetallic standard and thereby ensured that the early U.S. government could not deliberately inflate away its debts.
Jefferson, Madison, and others disliked many of Hamilton’s policies and therefore split from Washington and his large “F” Federalist followers to form the Democratic-Republican party. Scholars sympathetic to that latter party often cast Hamilton’s policies in a negative, Jeffersonian-like light but most of their criticisms are unfounded. For starters, Hamilton did not want the national debt to be large as his detractors claimed. He clearly stated that the national debt would be a national blessing only IF IT WAS NOT EXCESSIVE. His claim that public debts were public benefits, he clearly explained, was quote liable to dangerous abuse unquote and should not invite what he termed “prodigality.” He believed it a quote fundamental maxim [that] the creation of debt should always be accompanied with the means of extinguishment unquote. He argued that such a maxim, one now unfortunately forgotten in the debt ceiling debate, would render public credit, and I quote, “immortal.”
Hamilton has been criticized for not specifying when a large national debt became excessive but he did in fact offer several criteria. A debt was too large, he explained, if the government could not honor its debts and pay the principal or interest when promised. As mentioned previously, Hamilton wrote when the government did not have the power to create money out of thin air. Today he would say that 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” because bondholders and other creditors receive less in real money, in purchasing power in other words, than they were promised or expected. Today, many observers fear that a serious bout of inflation is inevitable and the only question remaining is when it will rear its ugly, economy-damaging head. Federal Reserve chairman Ben Bernanke’s recent comments about further stimulating the economy should it continue to show weakness were comforting in the short term but further fueled fears that a big inflation will occur in the next few years.
Hamilton also considered too big a debt that led to a political impasse and deliberate default. Sound familiar? He also argued that a debt is too big if it raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. By that criteria, our national debt also currently teeters on the brink of being excessive.
Finally, Hamilton considered excessive a national debt that 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, higher tax revenues are fiscally necessary – the only question is upon whom they should fall, a very tricky issue politically but also economically due to the complex nature of tax incidence or discerning who actually pays taxes of different types.
The most quizzical thing about debates over taxation today, IMHO, is that politicians dicker over questions like the effect of higher tax rates on government revenues. The silly thing about such dickering is that nobody can know what receipts will be – the U.S. economy is too large, complex, and variable to predict with precision. What politicians ought to do is decide how much they need to spend and then create taxes that automatically adjust until the needed amount is in the Treasury. That would obviate the need for significant additional borrowing and move the tax debate to where it belongs – what should the government do and what shouldn’t it do? Hamilton never created such a system because it would have been technologically impossible to do so in an era of quill pens and paper ledgers. That excuse, however, is no longer valid. Hamilton, by the way, was no advocate of big government. What he and Washington envisioned was a government larger than that desired by Jefferson but one far, far smaller than what we have today.
Hamilton fought for the assumption of state debts by the national government for four practical reasons: first, the Constitution stripped the states of the best tax then available to them, the tariff, so it was only right that the national government should reduce their fiscal burdens; second, having just three types of bonds meant that the markets for each would be liquid, fancy finance talk for efficient and convenient, rendering the bonds more attractive for investors and hence less expensive to the government; third, due to economies of scale the federal government was able to collect tariffs and make payments on the debt more cheaply than numerous small state governments could; fourth, the debt helped to cement the union together.
Hamilton was right on all four points, especially the fourth one. As I show in One Nation Under Debt, government bonds were widely held not only in the North but also here in the Old Dominion – including in the portfolios of large planters -- and in Charleston, South Carolina. Most of the state governments also owned substantial amounts of federal government bonds. I do not think it a coincidence that the Nullification and Secession crises occurred at times and places when the federal government owed nothing to state governments or to prominent citizens. The detailed data supporting those claims, by the way, are available free of charge on EH.NET.
Hamilton opposed discrimination, the Jeffersonian idea of compensating the original holders, the soldiers and farmers who took government IOUs in lieu of cash during the war, for practical reasons as well: first, it would have been extremely difficult to ascertain who the original holders were, where they currently resided, when they sold their IOUs, and how much they received in exchange; second, while agreeing that most of the original holders who sold their bonds did so for pennies on the dollar, Hamilton found no evidence that the original holders received anything less than the going market rate when they sold, the dark years following Yorktown when repayment was a distant prospect and interest rates were in double and triple digits. As Hamilton and other opponents of discrimination argued, the speculators who bought up government IOUs helped public credit because the only way that they could profit would be by supporting the reforms necessary to fix the government’s financial situation. From that perspective, speculators were just as patriotic as the original holders and perhaps more optimistic about the young republic’s eventual success. As I mentioned previously, it was the supporters of discrimination at the Philadelphia convention who unwittingly blocked language that would have prevented use of the national debt as a political football today.
The Jeffersonian claim that Hamilton sought to make the national debt perpetual was also seriously mistaken. By making Threes, Sixes, and Deferreds repayable at the government’s pleasure rather than on specific dates, Hamilton ensured that the government could not experience a debt crisis brought on by the maturation of bonds at an unpropitious moment. Hamilton wanted to see the national debt shrink in real terms, and in per capita and percent of GDP terms it did decline during the 1790s, from about $20 to $15 dollars per person and from about 30 to 15 percent of GDP. That progress was not enough for the Jeffersonians, however, who wanted the debt paid down quickly in nominal terms as well. As Hamilton noted, however, increasing taxes enough to generate the revenues necessary to pay the debt off quickly and completely would cause the economy to stall and perhaps foment rebellions even more serious than Whiskey and Fries’s. Growing out of the debt was the most prudent path and hopefully will be the one the U.S. follows in the immediate future. Only the Jeffersonians and their political heirs, the Jacksonians, paid off the national debt completely. From then until recently, the government has simply maintained balanced budgets in peacetime and allowed the burden of the debt to shrink as the population and economy grew. That tactic will work again and minimize the economic pain incurred as a result of the sundry economic and policy disasters of the first decade of the 21st century.
But inducing politicians to run balanced budgets has become difficult of late and was never easy. As Jefferson astutely noted, elected officials have little incentive to tax and spend, especially in a country filled with people who believe that that government which governs best governs least, at least when it comes to issues that don’t personally concern them. Rather, politicians have incentives to borrow and spend, which allows them to offer constituents vote-garnering services now and to put the taxes off until later. Only when voters are astute enough to understand British economist David Ricardo’s point that borrowing today is simply higher taxes tomorrow can they hope to hold politicians in check. The most comforting thing about the current debt ceiling impasse is that it shows that the American people are again awakening to the dangers inherent in an excessive level of government debt. It is a shame, however, that they were not alert enough before 2004 to thwart the ominous trend in government deficits that some observers then warned about.
At this point, you may wonder what budget reforms I would advocate. As I argued in my 2010 book Fubarnomics, I think that Social Security, healthcare, education, and construction are ripe for radical change. To that list I will add the military. The key is to make each of those areas more efficient without breaking promises or increasing taxes more than absolutely necessary.
The government wastes billions of dollars each year by paying construction and military contractors too much. The problems here are rooted in the nature of contracts and markets. Governments should hire the best bidders, not the lowest ones. That would require carefully tracking contractor performance over time, information that would also help private parties to make better decisions and greatly improve the efficiency of the construction industry, the productivity of which has been stagnant for half a century now. The government should also encourage more entry into markets where it is tempted to resort to no-bid contracts, as in military procurement. Even if we significantly scale back the military, the Pentagon will still have many billions of dollars at its disposal each year, ensuring vigorous market competition if only the government would allow it to take place. Inefficient defense contractors, even large ones, should be allowed to fail as newer, better ones will surely emerge soon after.
The same goes for transportation contractors. Funding transportation improvements with a tax on gasoline is a flawed approach because it gives the government a vested interest in gas guzzlers and because gas mileage and wear and tear on road surfaces are not strongly related. If the government cannot make the necessary reforms, it should lease the interstate highway system to the best bidders and essentially re-privatize the nation’s roads and passenger railways. Think of it as reverse eminent domain – if the government does not put an asset to best use, the courts should allow private parties to make a fair offer for it.
Social Security has been a tough nut to crack, just as FDR predicted. What needs to be made clear is that the system is not based on actuarial data and its payroll tax is regressive so Social Security is patently unfair to some groups, especially minority males. The payroll tax should be abolished and payments slowly phased out as annuity recipients pass away. Everyone over age 45 – I’m 42 by the way – should receive the benefits they have been promised out of general tax revenues and everyone 45 or younger should be told to start purchasing private security products unless they want to work until they perish, an option that is increasingly possible in our service-oriented economy. The financial system should also be reformed to ensure the continued development of disability and life insurance, annuities, mutual funds, and other forms of private security. Products with so-called nudges designed to counteract known, common human foibles built into them should be encouraged. The only reasons we adopted Social Security were the economic trauma caused by the Great Depression and the regulatory repression that ensued. Had the Depression not occurred, and it was by no means inevitable, one of the great albatross’s currently astride the economy’s neck would never have landed.
And neither would the elephant-sized albatross called Medicare. Prior to the Depression, health insurance was evolving toward personal prepaid doctor and hospital systems that incentivized doctors and other healthcare professionals to heal patients rather than to merely treat them. The Depression and some ill-conceived tax policies changed that, laying the seeds of the problems, like large numbers of uninsured individuals, that led to passage of controversial healthcare legislation last year. By repealing that legislation and allowing new types of health insurance policies to emerge, ones that better align the incentives of doctors and their patients, trillions of dollars can be saved in the coming decades.
By reforming higher education, hundreds of billions more can be saved. The current system favors specialized research, leaving many undergraduates ill prepared for the work force or citizenship and many thousands of dollars in debt. A much better system would subsidize students rather than schools, inducing the latter to focus more attention on teaching undergraduates and less on publishing hack scholarship in obscure journals. If coupled with a GI Bill-like service obligation – which could include service in Homeland Security, FEMA, schools, hospitals, parks, and so forth in addition to traditional military service – the subsidy could be rendered budget neutral while simultaneously building the character and maturity of our young adults, thus rendering them better students and better citizens.
In sum, America still has plenty of what some call “dry powder” in its arsenal. Instead of raising taxes or slashing expenditures, policymakers and entrepreneurs need to think about how to make the government and the economy more efficient. We can’t ever have our cake and eat it too, but we can bake a larger or a better tasting cake in less time and for less money than we currently do. That is something that Washington, Hamilton, and Jefferson would all agree upon.
Thanks for your time and attention and I will now entertain your questions.
Washington, Hamilton, and Jefferson – Funding a Nation
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD for George Washington’s Mount Vernon Estate, Museum, and Gardens, 22 July 2011
Thanks for inviting me back to Mount Vernon to discuss the history of the U.S. national debt. The debt, and its consorts the deficit and the debt ceiling, are again in the news, and in very palpable ways. The present situation is very difficult to understand in a deep way without the historical context that I have tried to provide in two of my recent books, One Nation Under Debt and Fubarnomics. I’ll summarize the gist of those books in this talk, reserving time at the end for your questions.
The second clause of Article I, Section 8 of the U.S. Constitution states that quote Congress shall have Power … To borrow Money on the credit of the United States unquote. Initially this meant that Congress passed a law every time that the Treasury had to borrow, typically to fund wars or territorial acquisitions. By World War I, Treasury borrowed so frequently that the traditional system was overwhelmed. The solution that evolved was to pass a law authorizing Treasury to borrow up to some limit, now commonly referred to as the debt ceiling. Contrary to the claims of some journalists and ideologues, most other non-authoritarian governments also enact debt ceilings as a check against usurpation of the budget by the executive or treasury. Unlike the United States, however, almost all other nations link their debt ceilings to their projected budget deficits or in other words to the amount that they know that they will have to borrow for government to operate smoothly. In America, by contrast, budgets and the debt ceiling are not closely coupled. Hitherto, Congress has increased the debt ceiling whenever necessary but sometimes it has hesitated before doing so, leading to partial government shutdowns as in 1995 or to extraordinary exertions on the part of Treasury to avoid default, as occurred several times during the administration of George W. … Bush that is, not Washington.
In May of this year, I argued in an op ed published on the History News Network that the debt ceiling is constitutional but that purposely defaulting on the national debt is not. In other words, the debt ceiling needs to be closely tied to projected budget deficits as it is in most other responsible nations in order to prevent it from becoming a tool that could cause irreparable damage to the nation’s finances and hence to the government’s ability to defend itself and American citizens from foes foreign and domestic. A default could send bond prices down which would increase the government’s debt service, the percent of the budget paid as interest to bondholders, potentially enough to force the government to print money to meet its obligations, a response that would lead to levels of inflation not seen in decades if not centuries. The depreciation of the dollar vis-Ã -vis other nations’ currencies that would occur as a consequence of such an inflation could lead to the replacement of the dollar as the world’s primary reserve currency. That would greatly complicate the nation’s ability to borrow abroad and raise the truly horrifying specter of the national government issuing debt denominated in a currency other than US dollars. A default or bout of inflation would also raise interest rates for businesses and consumers and thus slow or even stall an already anemic economic recovery.
In another, even graver scenario, a government default causes enough policy uncertainty to directly throttle an economy still gasping for breath following the 2008 crisis. With no way to finance a bailout or stimulus package, the government can only watch as the economy sinks into a debt deflation similar to that experienced in the Great Depression and Americans soon pine for the days when unemployment was only 10 percent.
These are not predictions per se mind you, just worst case scenarios highlighting the gravity of the situation we now face. Our salvation may be that matters are even worse in Europe and Japan, Canada is too small to provide the world’s currency, and that nobody really trusts China, Russia, or other so-called emerging economies.
Some other observers agree that a purposeful default would be unconstitutional and make good textual arguments to support their positions. Amendment 14, Section 4, clearly states that quote “the validity of the public debt of the United States, authorized by law … shall not be questioned” unquote. My argument, by contrast, relies on original intent. The Constitution as ratified did not explicitly rule out the possibility of a purposeful default but James Madison’s notes on the convention debates show that the delegates to the Philadelphia convention initially agreed that the Constitution should explicitly mandate that Congress quote shall discharge the debts & fulfil the engagements of the U. States unquote. (All quotations in this part of the talk, by the way, can be verified in Adrienne Koch’s 1966 edition of Madison’s notes, pages 511-12, 519, and 528-30.) Madison and Elbridge Gerry quote thought it essential that some explicit provision should be made on this subject, so that no pretext might remain for getting rid of the public engagements unquote. Delegate Pierce Butler later questioned that precise language quote lest it should compel payment as well to the Blood-suckers who had speculated on the distresses of others, as to those who had fought & bled for their country unquote. Two days later, George Mason raised the same objection, warning that quote the use of the term shall will beget speculations and increase the pestilent practice of stock-jobbing unquote. A debate on the specifics of debt repayment ensued until Edmund Randolph suggested language that did not commit Congress to a specific debt repayment policy. Randolph’s wording passed ten states to one and ended up as the first clause of Article 6, which states quote All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation unquote.
In other words, the Constitution did not explicitly state that Congress shall pay the debts the nation incurred after ratification only because the delegates were divided over the so-called issue of discrimination, or the question of who the government should pay, original or current bondholders. The original bondholders were largely farmers and soldiers while the current ones were generally perceived to be wealthy, urban speculators, a group despised even more than lawyers were, believe it or not, though there was some overlap between the two groups. The Constitutional Convention was of course called in large part to give the national government the means to repay its debts. The will to do so was taken for granted. The Framers believed, as Gouverneur Morris put it, that quote the New Government would be bound of course unquote to pay the national debt. Of course! And I should point out that the Founders made no distinction between bondholders and other types of creditors. For the government to pay Peter but not Paul would not establish public credit but only enrage Paul and make people wonder why Peter should be so favored.
After Ratification, purposefully defaulting on the debts owed to all domestic creditors was mentioned by a few radicals but never seriously considered and almost everyone believed that foreign creditors had to be repaid in all events. The Founders understood that defaulting on sums owed to foreigners would make it difficult to borrow abroad in the future and also would strengthen foreign incentives to invade the fledgling republic. The best way to avoid invasion is to owe large sums to foreigners but to pay the interest on the debt punctually, a point that is often lost in the handwringing over the trillion-ish dollars the federal government owes to a still communist China.
In sum, the early debates over the U.S. national debt were not about whether to pay, but rather who to pay, when to pay them, how much to pay them, and how the government should raise the necessary sums. As we will see, sharp differences existed on those latter questions, with Washington and Hamilton on one side and Jefferson and Madison on the other, but not over whether the government should honor its debts or not.
The questions of who, when, how much, and how to pay were crucially important ones because by the end of the Revolutionary War the national and state governments were such fiscal wrecks that they actually impeded economic development in the 1780s. Only after passage of the Constitution and implementation of Hamilton’s reforms in the 1790s did real, which is to say inflation-adjusted, per capita incomes grow consistently at modern rates and only then did the American economy show signs of development or modernization. Before the Constitutional Convention, the financial system consisted of just three small banks, a handful of securities brokers, and a coterie of suboptimal individual insurance underwriters. By the end of 1795, 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges were in operation.
Aided by the rapidly developing financial system, entrepreneurs teemed in both the cities and the growing agricultural hinterland and some engaged in increasingly large-scale enterprises. Very few for-profit business corporations formed in the colonial period because of British policies. After the war, a few such corporations formed but in the 1790s the formation of joint-stock corporations accelerated ten-fold, launching the rise of what has been described as a corporation nation. By the Civil War over 22,000 business corporations had been chartered by special legislation and thousands of others by general acts of incorporation, far more than any other country on earth. Today, it is difficult to imagine what a developed economy would look like without the widespread use of the corporate form or some other mechanism for providing investors with perpetual succession and limited liability.
To fully understand Hamilton’s accomplishment, we must first understand the precise nature of the very serious difficulties that the young republic faced. The rebel governments, by which I mean the Continental Congress and the new state governments, successfully funded the opening years of the Revolution by issuing bills of credit, badly printed pieces of paper that circulated as cash similar to those used to fund the many wars of the colonial period. At first, the bills stimulated an economy that had become severely under-monetized after the French and Indian War due to the effective enforcement of British trade laws and severe restrictions on the issuance of bills of credit placed on colonial governments by London bureaucrats. The absolute dearth of monetary instruments caused by those policies greatly impeded colonial economic activity and were, scholars are increasingly beginning to recognize, lingering sores that set off the Stamp Act controversy and that soured Anglo-American relations throughout the Imperial Crisis that led to the Declaration of Independence, which in the section delineating the quote History of repeated Injuries and Usurpations unquote blamed the British quote FOR cutting off our Trade with all Parts of the World unquote and for refusing to pass laws, including bills of credit emissions, quote the most wholesome and necessary for the public Good unquote.
In an economy short of cash, the new money issued by the rebel governments at first lowered interest rates and facilitated the extension of credit, thus stimulating economic activity above and beyond the stimulus provided by mobilization for war. As the Revolution dragged on, however, the rebel governments had to issue more bills of credit than Americans believed they would be able to redeem at face value via specie redemption or taxation after the war, a valid perception exacerbated by a large influx of British-made counterfeits said to be distinguishable from the original only by virtue of their being of superior physical quality. Because there were eventually more bills of credit in circulation than were needed at the prevailing price level, bills of credit began to depreciate, by which I mean that they lost purchasing power vis-Ã -vis other goods, including gold, silver, land, food, and sundry services. As the War wore on, the depreciation became more serious until by early 1781 both state bills of credit and the Continentals issued by the national government were almost valueless.
Long before then, the rebel governments incurred other sorts of debts as well. They managed to sell some bonds and lottery tickets early in the conflict but by the late 1770s anemic tax receipts forced them to take the provisions they needed directly from American farmers, iron makers, and so forth. Many soldiers continued fighting in exchange for IOUs promising future payment but they had to be fed, clothed, housed, and armed if they were to remain effective in the field. Rebel governments could not very well seize private property and retain the affections of the citizenry so they gave handwritten promissory notes or IOUs for goods taken from Patriots. Outright confiscation was also resorted to, but the rebels tried to seize the estates only of known Loyalists. Though seemingly simple, direct requisitioning was inefficient because farmers could not always supply enough of everything that was needed to support the military units active in their regions and remain viable. If the army took a farmer’s last mare and the area’s last stallion, for example, no spring foals would be born to replenish his stable.
The Yorktown operation in fall 1781 and the war’s final years were partially financed with the aid of the private fortunes of the new Superintendent of Finance, Robert Morris, and subscribers to the new Bank of North America, a quasi-central bank that issued notes and deposits convertible into gold and silver. Most market participants believed the bank money to be more reliable than discredited government bills of credit so the bank helped to increase the supply of money, which after the collapse of bills of credit had shrunk to the point of being too thin to support normal economy activity. The new bank also made loans to the government and to businesses large and small. When peace finally came, however, the national and state governments remained in rough shape financially because the economy in most places remained extremely soft due to the disruption of prewar trading patterns, the wartime destruction of human and physical capital, and tremendous uncertainty about the future of the fragile new confederation.
The biggest challenge facing the new national and state governments was how to begin repaying their wartime debts. Some governments aroused the ire of bondholders by refusing to increase taxes and defaulting on their obligations. Other states, most notoriously Massachusetts, sparked rebellions by increasing taxes too high, too quickly. Both tactics played into the hands of nationalists, men like Madison and Hamilton who wanted to create a more powerful central government capable of repaying the nation’s war debts and thus of better protecting Americans from foreign invasion and domestic unrest. Such men, self-styled small “f” federalists, succeeded in establishing such a government when the Constitution was ratified in 1788. Many tricky details, however, remained to be worked out before public credit, wrecked by the depreciation of bills of credit and the inability of most governments to pay interest on their wartime IOUs, was finally and firmly re-established.
It is of course widely known that Hamilton, America’s first Treasury Secretary and the trusted confidante of Washington, who wisely supported first the military career and then the public policies of the brash young West Indian bastard, played the most important role in the reformation of the government’s fiscal situation and the economy’s remarkable growth in the first half of the 1790s. Many of the details, however, remain misunderstood or completely unknown. First and foremost, Hamilton helped the nation to build an effective tax regime, based largely on an efficient tariff collection system engineered by Hamilton himself, that lasted until the Civil War. Land sales, bank dividends, and excise taxes added to government revenues to some extent but the mainstay of the system, especially in peacetime, were taxes on imports. Contrary to myth, Hamilton did not advocate protective tariffs designed to aid American manufacturing interests but instead created a nuanced system of revenue tariffs designed to maximize the national government’s net income. Hamilton understood that high tariffs would hurt tax receipts by encouraging smuggling and corruption. He also understood that what people considered a high tariff depended on the nature of the good being imported so he charged higher rates on luxury and status goods and allowed many non-native raw materials to enter the country free of charge.
I should point out here that the excise on whiskey that led to the infamous Whiskey Rebellion was merely a tax designed to offset the tariff on foreign rum. Rather than protect domestic whiskey producers with that tariff, Hamilton wanted them to compete on a level playing field. One day, I hope, NYU’s Richard Sylla will finally publish his book explicating, among other topics, the details of Hamilton’s ingenious tariff system. Tariff is a dirty word today, at least among most economists, but it was certainly the most efficient means of taxation available in the eighteenth and first half of the nineteenth centuries in a world still dominated by mercantilist policies. Hamilton’s views on tariffs have been misunderstood because his Report on Manufactures has been misconstrued as a series of policy proposals rather than as a primer on the microeconomics of the effects of different types of government policies, including tariffs and export bounties, on market prices and quantities.
In any event, Hamilton used tariff revenues to pay the debts incurred by the national government during and after the Revolution and also to assume, or take over and fund, the debts incurred by the several states. He did so by reducing the face values of the scores of IOUs issued by the national and state governments during the war – a potpourri of instruments with different maturities and interest rates with names like indents, Hillegas notes, and Long Bobs – to their approximate value in gold and silver at their issuance. He then accepted them as payment for three new types of bonds called Threes, Sixes, and Deferreds. Threes were redeemable at the pleasure of the government and paid 3/4ths of one percent interest at the end of each fiscal quarter: March, June, September, and December – or 3 percent annually. Sixes paid 1.5 percent interest quarterly, or six percent annually, and contained an annuity feature that gave the government the option to repay part of the principal each year much like an amortized mortgage today. Deferreds paid no interest but turned into Sixes at the end of 1800. By issuing Deferreds and Threes in addition to Sixes, Hamilton reduced the government’s total debt interest charge from 6 to around 4 percent, quite a feat for a nation essentially bankrupt just a few years before.
To ensure that the government would not default on its new bonds if revenues proved temporarily insufficient, Hamilton also established a central bank, the Bank of the United States, partially owned by the government but essentially owned and operated by private stockholders. Run by the nation’s most experienced banker, Philadelphian Thomas Willing, the Bank of the United States held most of the government’s deposits, paid interest on the government’s bonds when they fell due, transferred government funds from city to city as necessary, acted as a lender of last resort during financial panics, and, most importantly of all, lent money to Treasury when the government’s revenues temporarily fell short of expenditures.
Finally, Hamilton also established the U.S. Mint and, in the most important part of the legislation, defined the U.S. dollar in terms of gold and silver, thus anchoring the new currency’s real value over the long term. The definition wedded the nation to a bimetallic standard and thereby ensured that the early U.S. government could not deliberately inflate away its debts.
Jefferson, Madison, and others disliked many of Hamilton’s policies and therefore split from Washington and his large “F” Federalist followers to form the Democratic-Republican party. Scholars sympathetic to that latter party often cast Hamilton’s policies in a negative, Jeffersonian-like light but most of their criticisms are unfounded. For starters, Hamilton did not want the national debt to be large as his detractors claimed. He clearly stated that the national debt would be a national blessing only IF IT WAS NOT EXCESSIVE. His claim that public debts were public benefits, he clearly explained, was quote liable to dangerous abuse unquote and should not invite what he termed “prodigality.” He believed it a quote fundamental maxim [that] the creation of debt should always be accompanied with the means of extinguishment unquote. He argued that such a maxim, one now unfortunately forgotten in the debt ceiling debate, would render public credit, and I quote, “immortal.”
Hamilton has been criticized for not specifying when a large national debt became excessive but he did in fact offer several criteria. A debt was too large, he explained, if the government could not honor its debts and pay the principal or interest when promised. As mentioned previously, Hamilton wrote when the government did not have the power to create money out of thin air. Today he would say that 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” because bondholders and other creditors receive less in real money, in purchasing power in other words, than they were promised or expected. Today, many observers fear that a serious bout of inflation is inevitable and the only question remaining is when it will rear its ugly, economy-damaging head. Federal Reserve chairman Ben Bernanke’s recent comments about further stimulating the economy should it continue to show weakness were comforting in the short term but further fueled fears that a big inflation will occur in the next few years.
Hamilton also considered too big a debt that led to a political impasse and deliberate default. Sound familiar? He also argued that a debt is too big if it raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. By that criteria, our national debt also currently teeters on the brink of being excessive.
Finally, Hamilton considered excessive a national debt that 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, higher tax revenues are fiscally necessary – the only question is upon whom they should fall, a very tricky issue politically but also economically due to the complex nature of tax incidence or discerning who actually pays taxes of different types.
The most quizzical thing about debates over taxation today, IMHO, is that politicians dicker over questions like the effect of higher tax rates on government revenues. The silly thing about such dickering is that nobody can know what receipts will be – the U.S. economy is too large, complex, and variable to predict with precision. What politicians ought to do is decide how much they need to spend and then create taxes that automatically adjust until the needed amount is in the Treasury. That would obviate the need for significant additional borrowing and move the tax debate to where it belongs – what should the government do and what shouldn’t it do? Hamilton never created such a system because it would have been technologically impossible to do so in an era of quill pens and paper ledgers. That excuse, however, is no longer valid. Hamilton, by the way, was no advocate of big government. What he and Washington envisioned was a government larger than that desired by Jefferson but one far, far smaller than what we have today.
Hamilton fought for the assumption of state debts by the national government for four practical reasons: first, the Constitution stripped the states of the best tax then available to them, the tariff, so it was only right that the national government should reduce their fiscal burdens; second, having just three types of bonds meant that the markets for each would be liquid, fancy finance talk for efficient and convenient, rendering the bonds more attractive for investors and hence less expensive to the government; third, due to economies of scale the federal government was able to collect tariffs and make payments on the debt more cheaply than numerous small state governments could; fourth, the debt helped to cement the union together.
Hamilton was right on all four points, especially the fourth one. As I show in One Nation Under Debt, government bonds were widely held not only in the North but also here in the Old Dominion – including in the portfolios of large planters -- and in Charleston, South Carolina. Most of the state governments also owned substantial amounts of federal government bonds. I do not think it a coincidence that the Nullification and Secession crises occurred at times and places when the federal government owed nothing to state governments or to prominent citizens. The detailed data supporting those claims, by the way, are available free of charge on EH.NET.
Hamilton opposed discrimination, the Jeffersonian idea of compensating the original holders, the soldiers and farmers who took government IOUs in lieu of cash during the war, for practical reasons as well: first, it would have been extremely difficult to ascertain who the original holders were, where they currently resided, when they sold their IOUs, and how much they received in exchange; second, while agreeing that most of the original holders who sold their bonds did so for pennies on the dollar, Hamilton found no evidence that the original holders received anything less than the going market rate when they sold, the dark years following Yorktown when repayment was a distant prospect and interest rates were in double and triple digits. As Hamilton and other opponents of discrimination argued, the speculators who bought up government IOUs helped public credit because the only way that they could profit would be by supporting the reforms necessary to fix the government’s financial situation. From that perspective, speculators were just as patriotic as the original holders and perhaps more optimistic about the young republic’s eventual success. As I mentioned previously, it was the supporters of discrimination at the Philadelphia convention who unwittingly blocked language that would have prevented use of the national debt as a political football today.
The Jeffersonian claim that Hamilton sought to make the national debt perpetual was also seriously mistaken. By making Threes, Sixes, and Deferreds repayable at the government’s pleasure rather than on specific dates, Hamilton ensured that the government could not experience a debt crisis brought on by the maturation of bonds at an unpropitious moment. Hamilton wanted to see the national debt shrink in real terms, and in per capita and percent of GDP terms it did decline during the 1790s, from about $20 to $15 dollars per person and from about 30 to 15 percent of GDP. That progress was not enough for the Jeffersonians, however, who wanted the debt paid down quickly in nominal terms as well. As Hamilton noted, however, increasing taxes enough to generate the revenues necessary to pay the debt off quickly and completely would cause the economy to stall and perhaps foment rebellions even more serious than Whiskey and Fries’s. Growing out of the debt was the most prudent path and hopefully will be the one the U.S. follows in the immediate future. Only the Jeffersonians and their political heirs, the Jacksonians, paid off the national debt completely. From then until recently, the government has simply maintained balanced budgets in peacetime and allowed the burden of the debt to shrink as the population and economy grew. That tactic will work again and minimize the economic pain incurred as a result of the sundry economic and policy disasters of the first decade of the 21st century.
But inducing politicians to run balanced budgets has become difficult of late and was never easy. As Jefferson astutely noted, elected officials have little incentive to tax and spend, especially in a country filled with people who believe that that government which governs best governs least, at least when it comes to issues that don’t personally concern them. Rather, politicians have incentives to borrow and spend, which allows them to offer constituents vote-garnering services now and to put the taxes off until later. Only when voters are astute enough to understand British economist David Ricardo’s point that borrowing today is simply higher taxes tomorrow can they hope to hold politicians in check. The most comforting thing about the current debt ceiling impasse is that it shows that the American people are again awakening to the dangers inherent in an excessive level of government debt. It is a shame, however, that they were not alert enough before 2004 to thwart the ominous trend in government deficits that some observers then warned about.
At this point, you may wonder what budget reforms I would advocate. As I argued in my 2010 book Fubarnomics, I think that Social Security, healthcare, education, and construction are ripe for radical change. To that list I will add the military. The key is to make each of those areas more efficient without breaking promises or increasing taxes more than absolutely necessary.
The government wastes billions of dollars each year by paying construction and military contractors too much. The problems here are rooted in the nature of contracts and markets. Governments should hire the best bidders, not the lowest ones. That would require carefully tracking contractor performance over time, information that would also help private parties to make better decisions and greatly improve the efficiency of the construction industry, the productivity of which has been stagnant for half a century now. The government should also encourage more entry into markets where it is tempted to resort to no-bid contracts, as in military procurement. Even if we significantly scale back the military, the Pentagon will still have many billions of dollars at its disposal each year, ensuring vigorous market competition if only the government would allow it to take place. Inefficient defense contractors, even large ones, should be allowed to fail as newer, better ones will surely emerge soon after.
The same goes for transportation contractors. Funding transportation improvements with a tax on gasoline is a flawed approach because it gives the government a vested interest in gas guzzlers and because gas mileage and wear and tear on road surfaces are not strongly related. If the government cannot make the necessary reforms, it should lease the interstate highway system to the best bidders and essentially re-privatize the nation’s roads and passenger railways. Think of it as reverse eminent domain – if the government does not put an asset to best use, the courts should allow private parties to make a fair offer for it.
Social Security has been a tough nut to crack, just as FDR predicted. What needs to be made clear is that the system is not based on actuarial data and its payroll tax is regressive so Social Security is patently unfair to some groups, especially minority males. The payroll tax should be abolished and payments slowly phased out as annuity recipients pass away. Everyone over age 45 – I’m 42 by the way – should receive the benefits they have been promised out of general tax revenues and everyone 45 or younger should be told to start purchasing private security products unless they want to work until they perish, an option that is increasingly possible in our service-oriented economy. The financial system should also be reformed to ensure the continued development of disability and life insurance, annuities, mutual funds, and other forms of private security. Products with so-called nudges designed to counteract known, common human foibles built into them should be encouraged. The only reasons we adopted Social Security were the economic trauma caused by the Great Depression and the regulatory repression that ensued. Had the Depression not occurred, and it was by no means inevitable, one of the great albatross’s currently astride the economy’s neck would never have landed.
And neither would the elephant-sized albatross called Medicare. Prior to the Depression, health insurance was evolving toward personal prepaid doctor and hospital systems that incentivized doctors and other healthcare professionals to heal patients rather than to merely treat them. The Depression and some ill-conceived tax policies changed that, laying the seeds of the problems, like large numbers of uninsured individuals, that led to passage of controversial healthcare legislation last year. By repealing that legislation and allowing new types of health insurance policies to emerge, ones that better align the incentives of doctors and their patients, trillions of dollars can be saved in the coming decades.
By reforming higher education, hundreds of billions more can be saved. The current system favors specialized research, leaving many undergraduates ill prepared for the work force or citizenship and many thousands of dollars in debt. A much better system would subsidize students rather than schools, inducing the latter to focus more attention on teaching undergraduates and less on publishing hack scholarship in obscure journals. If coupled with a GI Bill-like service obligation – which could include service in Homeland Security, FEMA, schools, hospitals, parks, and so forth in addition to traditional military service – the subsidy could be rendered budget neutral while simultaneously building the character and maturity of our young adults, thus rendering them better students and better citizens.
In sum, America still has plenty of what some call “dry powder” in its arsenal. Instead of raising taxes or slashing expenditures, policymakers and entrepreneurs need to think about how to make the government and the economy more efficient. We can’t ever have our cake and eat it too, but we can bake a larger or a better tasting cake in less time and for less money than we currently do. That is something that Washington, Hamilton, and Jefferson would all agree upon.
Thanks for your time and attention and I will now entertain your questions.
Tuesday, July 19, 2011
Debt Ceiling Dilemma
Peter Klein of the Independent Institute says that he is "a bit surprised no one has brought up William English’s 1996 AER paper, “Understanding the Costs of Sovereign Default: American State Debts in the 1840′s,” which provides very interesting evidence on US state defaults." My response is that I'm VERY SURPRISED no one has bothered to look at the data freely available on EH.NET (gathered by myself, Dick Sylla, and Jack Wilson) that shows that the prices of Pennsylvania bonds (and other defaulting state bonds too) plummeted from the low 90s (par = 100) to the low 70s in just 6 weeks in early 1841. That was an era, btw, when banks did not have to mark to market and when state bonds were not an important part of the portfolios of most financial institutions. In other words, Klein is right that the default of state governments in the 1840s was not catastrophic but it was pretty bad and any significant drop in Treasury bond prices today would be much more severe.
Friday, July 15, 2011
Keep Your Student Loan Debts Under Control -- Know How: A Guest Post by Stewart Smith
Below is my first guest post. Written by Stewart Smith, the post is designed to help students to better understand and cope with their debt problems, an already large and growing problem. Readers of Fubarnomics (and Higher Education and the Common Weal in the India market) will understand why the topic appealed to me.
Keep Your Student Loan Debts under Control -- Know How
A study conducted by the National Center for Education recently stated that the student debts for the graduating class of 2011 are going to exceed the debts of the previous graduating classes. Statistics indicate students will be leaving college with at least $23,000 of debts. It will be an 8% increase from the last year record and a whopping 47% increase from the record over a decade ago. Graduates burdened with large student loan debts usually end up living with their parents longer and get married at a much later age. Why the rising costs? Some say it's the economic meltdown and post recession hangover, while others believe the cost of higher education is increasing because more people are keen to attend college and university now and there is a cutthroat competition for admission and scholarships. With no debt settlement around to help you out, student loan debts can put your finances in jeopardy in the long run. Read on to know how to deal with student loan debts and ensure a financially secure future ahead.
* Make sure you apply for federal student loans to pay tuition fees rather than seeking private loans with high interest. Federal loans have relatively lower interest rates than private ones and their repayment plans can save you big bucks, because you do not accrue interest while you are in school. Most private loan lenders have hidden rules that cause you to pay more fees in the long run if you don't read the fine print carefully.
*Attempt to understand the amount and type of student debt that you owe clearly. Determine exactly how much you have to repay on each loan and how much you will have to pay altogether each month. To gain a deeper comprehension of your financial obligations, visit http://www.projectonstudentdebt.org.
*Once you know the amount and type of debt you owe, request the lenders to prolong your repayment duration, if possible. This will enable you to make smaller payments right after school when you are hunting for jobs or as a fresher making less money. It's true that extended payment plans will cause more interest to accrue in the long run but the interest will be tax-deductible within certain limits.
*You can opt for an income-based repayment plan as well. Under this payment plan your monthly payment amount is limited to a specific percentage (depending on the lender) of your discretionary income each month. This certainly helps you to keep current on your payments more easily.
*During a period of unemployment if you are simply unable to make payments, request a forbearance or deferral on your loans. This will temporarily suspend your payments and give you enough time to discuss the repayment procedure with the lenders.
Last but not the least, check your budget, embrace frugal living, curtail entertainment cost, take a part time job and make sure you do not end up incurring a six-figure amount of student loan debts. If you have to spend three to four years focusing on reducing your balance, there will be a delay in achieving your primary goals of life like marriage or buying a home.
Keep Your Student Loan Debts under Control -- Know How
A study conducted by the National Center for Education recently stated that the student debts for the graduating class of 2011 are going to exceed the debts of the previous graduating classes. Statistics indicate students will be leaving college with at least $23,000 of debts. It will be an 8% increase from the last year record and a whopping 47% increase from the record over a decade ago. Graduates burdened with large student loan debts usually end up living with their parents longer and get married at a much later age. Why the rising costs? Some say it's the economic meltdown and post recession hangover, while others believe the cost of higher education is increasing because more people are keen to attend college and university now and there is a cutthroat competition for admission and scholarships. With no debt settlement around to help you out, student loan debts can put your finances in jeopardy in the long run. Read on to know how to deal with student loan debts and ensure a financially secure future ahead.
* Make sure you apply for federal student loans to pay tuition fees rather than seeking private loans with high interest. Federal loans have relatively lower interest rates than private ones and their repayment plans can save you big bucks, because you do not accrue interest while you are in school. Most private loan lenders have hidden rules that cause you to pay more fees in the long run if you don't read the fine print carefully.
*Attempt to understand the amount and type of student debt that you owe clearly. Determine exactly how much you have to repay on each loan and how much you will have to pay altogether each month. To gain a deeper comprehension of your financial obligations, visit http://www.projectonstudentdebt.org.
*Once you know the amount and type of debt you owe, request the lenders to prolong your repayment duration, if possible. This will enable you to make smaller payments right after school when you are hunting for jobs or as a fresher making less money. It's true that extended payment plans will cause more interest to accrue in the long run but the interest will be tax-deductible within certain limits.
*You can opt for an income-based repayment plan as well. Under this payment plan your monthly payment amount is limited to a specific percentage (depending on the lender) of your discretionary income each month. This certainly helps you to keep current on your payments more easily.
*During a period of unemployment if you are simply unable to make payments, request a forbearance or deferral on your loans. This will temporarily suspend your payments and give you enough time to discuss the repayment procedure with the lenders.
Last but not the least, check your budget, embrace frugal living, curtail entertainment cost, take a part time job and make sure you do not end up incurring a six-figure amount of student loan debts. If you have to spend three to four years focusing on reducing your balance, there will be a delay in achieving your primary goals of life like marriage or buying a home.
Wednesday, July 06, 2011
Mismanagement of the Buffalo Marriott Niagara on Millersport Highway
The general manager of the Buffalo Marriott (the one on Millersport Highway near SUNY Buffalo's Amherst campus) needs to go to hotel school or something because he is running a wreck.
Here are the facts:
1) His front desk staff quoted my family and I $140 (per room, per night) but charged us $180 without verifying the charge. Worse, they did this on a LATE NIGHT check-in. I did not discover the over-bill until it was too late. I cannot prove that the hotel regularly takes advantage of weary travelers but it certainly did in this case.
2) The manager's staff did not advise us that the hotel was doing construction on our floor or that the hot tub was out of order. They also promised to send around a luggage cart but never did, forcing me to walk through the construction zone to retrieve it myself.
3) Two huge spiders and webs awaited us at the exit door upon our departure at 11 am the next morning. I have spent maybe 1,000 nights in hotels during my lifetime and do not recall seeing any spiders, even in cheap-o hunting lodges much less ones charging almost 2 bills a night in backwater Buffalo!
4) The room appearance and smell, TV, bathroom etc. were no better than $100/night hotels and my room was considerably noisier than most, perhaps due to the undisclosed construction activity.
5) When I called the GM to advise him of the dreadful experience we had, he:
a) got back to me some 24 hours later without researching my complaints;
b) acted very defensively and twisted everything I said;
c) refused to offer ANY compensation for our troubles.
Facts 1-3 could have been a string of bad luck, as the GM weakly claimed, but there is no excuse for 5 and I suspect 1-3 would not have occurred under better management. 4 is simply the state of the hotel and should be sufficient to prevent any but the most desperate souls from staying at the Buffalo Marriott Niagara on Millersport Highway in Amherst, NY (near SUNY Buffalo), even if management improves.
And one last thing: the website describes the hotel as "minutes away" from Niagara Falls but that is disingenuous as it suggests that most people would measure the time in minutes (say, 5 or 10) instead of fractions of an hour (half to three quarters depending on traffic unless you want to risk a speeding ticket on Grand Island).
Here are the facts:
1) His front desk staff quoted my family and I $140 (per room, per night) but charged us $180 without verifying the charge. Worse, they did this on a LATE NIGHT check-in. I did not discover the over-bill until it was too late. I cannot prove that the hotel regularly takes advantage of weary travelers but it certainly did in this case.
2) The manager's staff did not advise us that the hotel was doing construction on our floor or that the hot tub was out of order. They also promised to send around a luggage cart but never did, forcing me to walk through the construction zone to retrieve it myself.
3) Two huge spiders and webs awaited us at the exit door upon our departure at 11 am the next morning. I have spent maybe 1,000 nights in hotels during my lifetime and do not recall seeing any spiders, even in cheap-o hunting lodges much less ones charging almost 2 bills a night in backwater Buffalo!
4) The room appearance and smell, TV, bathroom etc. were no better than $100/night hotels and my room was considerably noisier than most, perhaps due to the undisclosed construction activity.
5) When I called the GM to advise him of the dreadful experience we had, he:
a) got back to me some 24 hours later without researching my complaints;
b) acted very defensively and twisted everything I said;
c) refused to offer ANY compensation for our troubles.
Facts 1-3 could have been a string of bad luck, as the GM weakly claimed, but there is no excuse for 5 and I suspect 1-3 would not have occurred under better management. 4 is simply the state of the hotel and should be sufficient to prevent any but the most desperate souls from staying at the Buffalo Marriott Niagara on Millersport Highway in Amherst, NY (near SUNY Buffalo), even if management improves.
And one last thing: the website describes the hotel as "minutes away" from Niagara Falls but that is disingenuous as it suggests that most people would measure the time in minutes (say, 5 or 10) instead of fractions of an hour (half to three quarters depending on traffic unless you want to risk a speeding ticket on Grand Island).
Tuesday, July 05, 2011
Self-Regulation of Hedge Funds
Hedge Fund Group is paying me a small stipend to blog about its Certified Hedge Fund Professional (CHP) designation. That's great because probably I would have done it for free! Here's why:
1) I believe that Americans have come to rely far too much on the government to solve (or more usually attempt to look like solving) problems that it is not designed to address, much less fix. Seriously, how can 100 Senators and a couple of hundred Reps, the vast majority of whom know little to nothing about finance, let alone an ever-changing beast as complex as the hedge fund industry, create effective regulatory legislation? The odds of success are vanishingly small.
2) The U.S. financial industry has a long history of successful self-regulation. I'm not kidding! The NYSE is probably the most famous of the many SROs (self-regulating organizations) that, though not without occasional lapses, have prevented the sort of investor expropriation that has short-circuited the development of numerous economies in Latin America, Africa, Central Asia, etc. Professional designations such as CPA, CFP, CFA, and so forth are part of the SRO apparatus because of the knowledge and technical expertise that holders must demonstrate, usually on rigorous blindly scored examinations, before becoming certified. During the healthcare/insurance debate of 2009-10, many Americans were outraged at the suggestion that government bureaucrats might replace the American Medical Association (AMA), the medical community's major SRO. They should also bristle at any attempt to weaken financial SROs and in fact should encourage pro-SRO legislation.
3) The CHP appears to be a worthy attempt to help hedge fund managers to self-regulate. Started in 2007 in Boston by experienced risk management expert Richard Wilson, HFG now has over 20,000 members because its CHP caters specifically to hedge fund professionals. To meet the needs of those professionals, HFG is growing quickly and also expanding its training programs and videos and will probably continue doing so in the future as its forebears in banking, insurance, and personal investing did. There is a demand for good people in every industry and HFG is doing a great job increasing the supply, both by increasing the knowledge of people in the industry and by allowing those with its designation to signal their knowledge more effectively to hedge fund managers.
4) Getting CHP designation empowers job applicants to land the positions they want, helps hedge funds to hire the best and the brightest, and, I believe, promotes financial sector stability. Many hedge fund strategies entail taking large amounts of risk. Although much of that risk is so-called "tail risk" (i.e., highly unlikely to occur), individual hedge funds and even entire hedge fund sectors could fail, roiling financial markets (e.g., your 401K). Government cannot really stop people from taking risks (look at the miserable job it has done eliminating pot, crack, murder, rape, and risky banks) but the hedge fund industry itself can minimize the risks and collateral damage by ensuring that the people working in the industry are as intelligent and well-trained as possible. One great signal of those attributes, and perhaps the best currently available, is CHP designation. So if you are in the hedge fund biz, know someone who is, or just want to help keep government waste in check, read this FAQ.
1) I believe that Americans have come to rely far too much on the government to solve (or more usually attempt to look like solving) problems that it is not designed to address, much less fix. Seriously, how can 100 Senators and a couple of hundred Reps, the vast majority of whom know little to nothing about finance, let alone an ever-changing beast as complex as the hedge fund industry, create effective regulatory legislation? The odds of success are vanishingly small.
2) The U.S. financial industry has a long history of successful self-regulation. I'm not kidding! The NYSE is probably the most famous of the many SROs (self-regulating organizations) that, though not without occasional lapses, have prevented the sort of investor expropriation that has short-circuited the development of numerous economies in Latin America, Africa, Central Asia, etc. Professional designations such as CPA, CFP, CFA, and so forth are part of the SRO apparatus because of the knowledge and technical expertise that holders must demonstrate, usually on rigorous blindly scored examinations, before becoming certified. During the healthcare/insurance debate of 2009-10, many Americans were outraged at the suggestion that government bureaucrats might replace the American Medical Association (AMA), the medical community's major SRO. They should also bristle at any attempt to weaken financial SROs and in fact should encourage pro-SRO legislation.
3) The CHP appears to be a worthy attempt to help hedge fund managers to self-regulate. Started in 2007 in Boston by experienced risk management expert Richard Wilson, HFG now has over 20,000 members because its CHP caters specifically to hedge fund professionals. To meet the needs of those professionals, HFG is growing quickly and also expanding its training programs and videos and will probably continue doing so in the future as its forebears in banking, insurance, and personal investing did. There is a demand for good people in every industry and HFG is doing a great job increasing the supply, both by increasing the knowledge of people in the industry and by allowing those with its designation to signal their knowledge more effectively to hedge fund managers.
4) Getting CHP designation empowers job applicants to land the positions they want, helps hedge funds to hire the best and the brightest, and, I believe, promotes financial sector stability. Many hedge fund strategies entail taking large amounts of risk. Although much of that risk is so-called "tail risk" (i.e., highly unlikely to occur), individual hedge funds and even entire hedge fund sectors could fail, roiling financial markets (e.g., your 401K). Government cannot really stop people from taking risks (look at the miserable job it has done eliminating pot, crack, murder, rape, and risky banks) but the hedge fund industry itself can minimize the risks and collateral damage by ensuring that the people working in the industry are as intelligent and well-trained as possible. One great signal of those attributes, and perhaps the best currently available, is CHP designation. So if you are in the hedge fund biz, know someone who is, or just want to help keep government waste in check, read this FAQ.
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