Last night the Social Science Research Council launched Bailouts: Public Money, Private Profits last night at the Museum of American Finance. Below is the text of my short remarks.
Bailouts: Public Money, Private Profit
This book fits into the Social Science Research Council’s Privatization of Risk series because it is about how government bailouts, particularly bailouts of the financial system, shift the risk of speculative finance onto individual taxpayers. Such a transfer might not be such a bad thing if those taxpayers also reaped the benefits of that increased risk burden. But clearly they don’t. They are below the security market line, which is to say in the Sucker Land of high risks and low returns. They are certainly not in Warren Buffett-ville, which lies above the said line, and is where returns are high and risks low. I’m so certain that taxpayers are taking it hard and dry because nobody but nobody argues that we were better off economically for having a crisis and a bailout. Rather, the choice offered taxpayers was bailouts or breadlines, gratification of greed or Great Depression, transfer of wealth from the many to the few or poverty for all. Taxpayers were told to lose half their nest eggs or all of them. Yipee!
And that was the best case scenario. In their contribution to this volume, political scientists Guerillmo Rosas and Nathan Jensen statistically analyzed the economic effects of bailout activity worldwide since 1970. The subject is a difficult one to be sure but, in the end, they concluded that they could not reject the hypothesis that bailouts do not speed economic recovery. In plainer terms, they found no econometric evidence that bailouts help economies to rebound any faster than they would in the absence of bailouts. In other words, taxpayers may have just taken on a bunch of risk for no return at all, not even in the amorphous form of a quicker return to robust economic growth.
Their study concludes with the year 2007. At this moment, the most recent wave of bailouts appear to have worked in the United States and most other places but of course the situation remains fragile and fraught. It’s quite possible that we are experiencing a temporary lull in a protracted period of crisis, similar to the 1830s, 1890s, and 1930s. In fact, the most recent bailouts may have simply set the stage for the next crisis, which could take the form of another leveraged asset bubble gone kaplewy, a fiscal slash exchange rate slash inflation crisis, or both. If a dollar collapse sounds far fetched to you, check out page 32 of the October 5 issue of Forbes magazine, which I was somehow able to buy at O’Hare last Friday. It shows that earlier this year investors were paying as much as $100 to insure against the default of $10,000 worth of U.S. Treasuries. Before the failure of Bear Stearns, the going rate was only $10.
This Museum formed in reaction to the stock market crash of 1987. For many years thereafter, Fed chairman Alan Greenspan was lauded for saving the day. Almost a quarter of a century later, however, his actions now appear to have initiated a pernicious cycle of crisis followed by federal rescue in the form of low interest rates, easy loans, and other government interventions, with each crisis looming larger than the last. Over the past several decades, central bankers have proven that they can stop financial panics by indiscriminately lowering interest rates and flooding markets with cash. What they have not shown the ability to do is to prevent such actions from increasing moral hazard, which in this context means risk-taking on the part of financial institutions. The book therefore suggests that central banks ought to consider resuscitating Hamilton’s nee Bagehot’s rule and lend only on good collateral and at a penalty rate. That rule has the virtue of protecting the interests of taxpayers and limiting moral hazard. Of course its implementation would be more difficult than lowering some overnight interest rate target.
It’s true that the U.S. government has tried in the past to approximate Hamilton’s Rule but nearly all major bailout efforts throughout its history have run afoul political boobytraps and bureaucratic infighting. In his contribution to the book, financial economist Joseph Mason details the problems encountered by the Federal Reserve and the Reconstruction Finance Corporation or RFC during the Depression. Under Hoover, the RFC’s lending policies were conservative to a fault. Major reforms implemented under Roosevelt improved it, but according to Mason the RFC did not stop fresh banking panics from exacerbating the debt deflation spiral at the center of the downturn. At best, the RFC allowed for the more orderly liquidation of failed banks. The whole story sounds quite TARP-ish if you ask me.
Such pessimism about the efficacy of bailouts led Benton Gup in his contribution to this volume to call for the government to work harder and smarter, much harder and smarter, to prevent financial panics in the first place. We know in general terms why panics occur but foreseeing the triggers of the next crisis is devilishly difficult. Gup does a masterful job of describing the causes of past panics and the dubious effects of bailouts large and small, financial and non-financial, but doesn’t provide concrete guidelines for preventing future fiascos, which would be a daunting task.
In my contribution to the volume, I argue that we will not be able to make much headway on preventing panics until we learn to see that a wide gamut of dysfunctional economic activities, including those that led to the most recent crisis, were not caused by governments. Or markets. Instead, they were hybrid failures, or market failures like asymmetric information, externalities, market power, and public goods, complexly combined and intertwined over decades with government failures like inappropriate and ineffective regulation and highly distortionary taxation.
The biggest market failure was of course the housing bubble and it was a whopper. The major government failures were the mortgage interest deduction combined with retirement savings tax breaks, various affordable housing initiatives, and Too Big To Fail policy. None in and of them themselves were economy breakers but combined and magnified by time they became quite potent toxins indeed. Finally, the government-sponsored enterprises colloquially known as Fannie and Freddie, the cartelized credit rating agencies, and our nebbish-like corporate governance system epitomize hybrid failures as they lie squarely at the nexus of the government and the economy, of Leviathan and the market’s innumerable tentacles.
I don’t have the time to go into all the details now but feel free to explore hybrid failures in the q&a period and in the book itself.
Wednesday, September 30, 2009
Wednesday, August 19, 2009
Health Insurance Debate Fiasco
Judging by the coverage on CNN the past couple of mornings, I am chagrined to say that the healthcare debate has veered down an unproductive back alley. The discussion appears to focus on the organizational form that health insurers should take: private, government, and/or co-op. We've been down these paths before people! Bone up by reading Melissa Thomasson's excellent (and free) intro. to the history of U.S. health insurance here. Then move on to John Murray's recent book.
My own work on the subject is still forthcoming, in a book on the history of insurance and in Fubarnomics (Prometheus, 2010).
I'm not saying the organizational form is inconsequential. If conditions are right, a government-owned insurer might prove as efficient as a privately-owned one. (See my January 2009 post, "Adam Smith, Profitability, and Efficiency".) More likely, however, it will bloat into a giant, inefficient bureaucracy that will serve mostly to redistribute healthcare consumption in devious, opaque ways. Co-ops (non-profits) are unlikely to innovate much. Mutuals might but then again they might not if the incentive structure between them and their sales forces is not just right. (See Mutually Beneficial for details.) Enough has already been said about the advantages and disadvantages of the for-profit joint-stock companies.
The problem with the debate is that none of those organization forms will make much of a difference regarding healthcare price and hence availability. The root problem is that we pay healthcare professionals (HCPs) for seeing rather than for curing patients. It seems like a simple thing but it's not, it's crucial, especially in the realm of healthcare.
Suppose the automobile repair market were as dysfunctional as the market for healthcare. Would you keep bringing your car to garages, spend hundreds or thousands of dollars, only to get back a car that still did not run right? Not if you were paying for it out of pocket, that's for sure. You'd use every legal lever you could to get the repair dudes to abide by the original estimate ... and in fact many states have laws requiring auto repair companies to honor their estimates within certain parameters, lemon laws, etc. If legal recourse were unavailable, you would at some point sell the car and take public transportation or learn to repair it yourself. (And no I don't think we should fiddle with repair costs to cut down on carbon emissions. Two wrongs don't make a right, says Wright.) Of course there is no substitute for your health so we pay and pay and pay and the law, if anything, protects HCPs' right to bill for merely treating you.
Throw employer-provided insurance into this mix and matters get even worse due to the lack of portability, which is the biggest cause of under- and uninsured persons in the U.S.A., and the dearth of price competition. Insured people don't much care how much their doctors, hospitals, etc. charge or even the fact that they pay for treatment rather than for success. So costs spiral ever upward, usually much faster than inflation.
What should the government be doing, then? Very simply:
1) phase out employer-provided health insurance;
2) reform regulation to encourage the development of "all of life" individual health insurance policies, perhaps linked to life insurance policies;
3) force HCPs to base their fees on results (output), not treatment time (input).
And please, no b.s. comments saying "well then nobody would want to treat the chronically/terminally ill." It just ain't so. HCPs will create balanced portfolios of high volume/low margin easy to cure patients all the way up the risk-return line to 1% chance of curing but a big payday at the end if successful. True, nobody will take patients with absolutely no hope of recovery but then again they shouldn't be treated anyway.
Yes, many details still have to be sorted out like who will judge whether a doctor has cured or helped a patient and close attention will have to be paid to the incentive structures created in the process but THAT is precisely the debate we should be having right now, not the best organizational form for insurers to take.
My own work on the subject is still forthcoming, in a book on the history of insurance and in Fubarnomics (Prometheus, 2010).
I'm not saying the organizational form is inconsequential. If conditions are right, a government-owned insurer might prove as efficient as a privately-owned one. (See my January 2009 post, "Adam Smith, Profitability, and Efficiency".) More likely, however, it will bloat into a giant, inefficient bureaucracy that will serve mostly to redistribute healthcare consumption in devious, opaque ways. Co-ops (non-profits) are unlikely to innovate much. Mutuals might but then again they might not if the incentive structure between them and their sales forces is not just right. (See Mutually Beneficial for details.) Enough has already been said about the advantages and disadvantages of the for-profit joint-stock companies.
The problem with the debate is that none of those organization forms will make much of a difference regarding healthcare price and hence availability. The root problem is that we pay healthcare professionals (HCPs) for seeing rather than for curing patients. It seems like a simple thing but it's not, it's crucial, especially in the realm of healthcare.
Suppose the automobile repair market were as dysfunctional as the market for healthcare. Would you keep bringing your car to garages, spend hundreds or thousands of dollars, only to get back a car that still did not run right? Not if you were paying for it out of pocket, that's for sure. You'd use every legal lever you could to get the repair dudes to abide by the original estimate ... and in fact many states have laws requiring auto repair companies to honor their estimates within certain parameters, lemon laws, etc. If legal recourse were unavailable, you would at some point sell the car and take public transportation or learn to repair it yourself. (And no I don't think we should fiddle with repair costs to cut down on carbon emissions. Two wrongs don't make a right, says Wright.) Of course there is no substitute for your health so we pay and pay and pay and the law, if anything, protects HCPs' right to bill for merely treating you.
Throw employer-provided insurance into this mix and matters get even worse due to the lack of portability, which is the biggest cause of under- and uninsured persons in the U.S.A., and the dearth of price competition. Insured people don't much care how much their doctors, hospitals, etc. charge or even the fact that they pay for treatment rather than for success. So costs spiral ever upward, usually much faster than inflation.
What should the government be doing, then? Very simply:
1) phase out employer-provided health insurance;
2) reform regulation to encourage the development of "all of life" individual health insurance policies, perhaps linked to life insurance policies;
3) force HCPs to base their fees on results (output), not treatment time (input).
And please, no b.s. comments saying "well then nobody would want to treat the chronically/terminally ill." It just ain't so. HCPs will create balanced portfolios of high volume/low margin easy to cure patients all the way up the risk-return line to 1% chance of curing but a big payday at the end if successful. True, nobody will take patients with absolutely no hope of recovery but then again they shouldn't be treated anyway.
Yes, many details still have to be sorted out like who will judge whether a doctor has cured or helped a patient and close attention will have to be paid to the incentive structures created in the process but THAT is precisely the debate we should be having right now, not the best organizational form for insurers to take.
Friday, July 24, 2009
National Credit, National Debt
This is the text of a speech I gave at Mt. Vernon this week. The whole affair was lovely. I woke up in the house of Abraham Lincoln (well, a hotel named after him a few blocks from his home in Springfield, Ill.) and went to bed in the home of George Washington (well, his slave quarters, but they have been upgraded since then and are now quite nice):
National Credit, National Debt
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College S.D.
Once upon a time, in a land not so far away, a subjugated but enlightened people cast off a great tyrant. But their liberty, won with promises as well as with the blood of patriots, came at a high price. Burdened by debt, weak government, a pressing scarcity of money, and an uncertain future, the people wallowed in idleness and rebellion. Men of brilliance met, theorized, compromised, and, over some weighty objections, soon constituted a new type of government, one that was powerful yet benign, led by the ablest but dedicated to protect all. Taxes were collected, new loans procured, and old debts repaid. The details flummoxed some but most people understood, and applauded. Throughout the land, they bought the new government’s promises at high prices and sold them at will, sometimes to people in distant lands eager for good investments. Through such trading, the interests of the governed and the government became one. The debt blessed the nation as bankruptcy turned to honor and despair transformed into hope. The fruits of their labors now secure, the people worked hard and smart. Not all of their innovations succeeded, but all told their farms flourished, as did their factories and ports. The nation’s debt dwindled according to plan, only to rise to new heights in a second war against tyranny. Hard work, intelligent taxation, and disciplined leadership again combined forces to tame the fiscal beast. The debt, rightly considered an imposition on the unborn, soon disappeared completely.
But the people, not as enlightened as they once were, did not live happily ever after. Their leaders, now mere politicians instead of statesmen, began to accumulate massive new debts to ensure their popularity rather than to fend off encroachments upon liberty. As foretold, the blessings of debt became a great curse, one that looms larger every second of every day, threatening the people’s happiness and the productivity of their raucous economy. This is their story and it is an important one because within it dwells a great truth about happiness and sullenness, progress and regress, prosperity and poverty.
With those words, I began my book One Nation Under Debt: Hamilton, Jefferson and the History of What We Owe. I penned them … well, clacked them on my laptop … months before the book appeared in March 2008, which was right about when Bear Stearns bit the dust, and they came to me a full year before Fannie and Freddie, Lehman and Merrill, WaMu and AIG joined Pearl Harbor, 9/11, and a handful of other dirty words in infamy. Since I wrote, the national debt has ballooned to $11.5 trillion dollars, enough in $1 dollar bills laid end to end to stretch for 1 billion miles, give or take. That’s from Washington, D.C. to Saturn, and by that I mean the planet, not the former GM subsidiary, though I’m told Saturn was always about a billion miles away from profitability. I kid; I own two of them. [Pause, with head down slowly shaking it.]
In any event, I’m not here today to discuss the causes of the financial crisis or the many problems caused by the subsequent bailouts. To learn of my views on those subjects, Google me or, better yet, read my book Bailouts: Public Money, Private Profit, just out from Columbia University Press and the Social Science Research Council, and Fubarnomics, which should be out from Prometheus early next year. Today I am here to suggest that the Founders, especially Thomas Jefferson and Alexander Hamilton, and by extension their boss, George Washington, had some very important things to say about the national debt, that mighty sword of two edges.
Jefferson thought the national debt a monstrous fraud on posterity, an intergenerational wealth redistribution scheme of dubious morality. The retort is that there is nothing intrinsically wrong with passing a debt along to the next generation if the youngins’ receive something of value in exchange, like a smoothly functioning central bank, growth-enhancing transportation infrastructure, or, most compellingly of all, a free country. Of course the next generation might not desire specific investments, as in the case of a disastrous, unpopular little war waged mainly due to faulty information. And yes my last statement could refer to the War of 1812 or the Iraq War.
So more important -- in my view – was Jefferson’s warning that politicians would find the temptation to borrow and spend as irresistible as a toddler finds sugar or a frat boy finds Natty Light. Taxing and spending has its own natural limit, at least in a democracy. Borrowing and spending, however, can be a winning political strategy for a long time because it allows politicians to appear to provide public services to their constituents at no cost. In reality, of course, more borrowing today means higher taxes tomorrow. Two centuries ago, the brilliant British political economist David Ricardo formally showed that if capital markets are efficient, and they appear to have been in both the United States and Britain in the late eighteenth and early nineteeth centuries, borrowing and taxation are economically equivalent. Americans of the Early Republic had already intuited that and behaved appropriately at the polls. As a result, most early American politicians talked about increasing absolute government budget surpluses ASAP, not merely maybe reducing deficits as a percentage of GDP some years hence.
Unfortunately, Jefferson’s worse fears have come true; We the People were vigilant for a long time, but not eternally. Until the Third Millennium, the history of the U.S. national debt was the history of wars. The debt as a percentage of GDP increased during wars, higher during bigger wars, but it trended downward in peacetime, usually to quite low levels. It rose in the Reagan years but arguably to win the Cold War against the evil communist specter that had so long haunted the planet. During the 1990s, you may recall, the federal government made concerted efforts to reduce the rate of budget growth below the rate of economic growth. The result fit the usual pattern, rapid reductions in the ratio of debt-to-GDP and even a few years of primary surplus.
I can scarcely believe that just a decade ago, when I was lecturing in Money and Banking at the University of Virginia, one of the key policy questions was how the Federal Reserve would conduct open market operations when there were no more Treasury bonds to buy and sell. That was one problem the Bush administration solved handily! Instead of asking Americans to sacrifice for the war effort, which would have ensured his defeat at the polls in 2004, technically his second straight loss, Bush borrowed and spent, then borrowed and spent some more. As a result, the government’s ongoing bailout of the financial system appears much larger and more ominous than it would have if the national debt had not grown so obese after 9/11.
Imagine the economy is a boat and the national debt is a guy in the boat. The ratio of the guy’s weight to the boat’s size is the key determinate of the boat’s continued buoyancy, which is to say of the economy’s ability to withstand unexpected waves or shocks. Cognizant of that, American politicians put the guy on a strict diet even when the boat grew bigger each year. The Bush administration, by contrast, force-fed the guy Krispy Kreme donuts drenched in lard. The guy grew faster than the boat, making it sit ever lower in the water. Due to the financial crisis and bailouts, the boat is currently shrinking while the guy has surpassed Homer Simpson in size and is rapidly approaching the combined girth of Comic Book Guy and Barney. And yes Barney could mean the Springfield town drunk or the purple dinosaur.
Even more damning, the flabberlanche is going to be difficult to reverse anytime soon. About a month ago Christina Romer, the chairwoman of Obama’s Council of Economic Advisers, told readers of The Economist that her biggest goal is to avoid repeating the mistake of the 1937-38, the Roosevelt Recession, by turning off the stimulus spigot too soon. By the end of Obama’s first term the national debt could equal 100 percent of GDP. There is nothing magical about that number – it was higher after World War II. But the figure began heading downward immediately after the war as it had in all periods of peace and prosperity until the current millennium.
Although we have been headed in the wrong direction for almost a decade now, very few voter-taxpayers appear concerned and the government has been getting a substantial amount of cover from economists of a certain ilk who claim that the debt is nothing to worry about. To be frank, they sound an awful lot like the economists who told us not to worry about rapidly rising home values, subprime mortgages, and credit default swaps! Here’s a hint: just because somebody has a Ph.D. in something doesn’t mean that he or she knows anything about it. Some doctors turn out to be quacks, some Major League pitchers can’t throw a strike – they seem strangely attracted to this region for some reason – and some economists don’t understand the economy as a system.
Don’t get me wrong, I’m sure they are great at solving arcane mathematical problems but that isn’t what we need now. What we need is economic statesmanship and one Founding Father in particular can provide some, if only posthumously. I think Alexander Hamilton had it exactly right, X-ACT-LY right, when he said that QUOTE a national debt, if it is not excessive, will be to us a national blessing UNQUOTE. The qualifying clause “if it is not excessive” is of course crucial to understanding Hamilton’s view of the debt; it is strange how often the clause is elided, especially by his detractors. It was not a throwaway line or a bone to those in his own time who dogged him. Hamilton actually specified how big he thought was too big. A debt is too big if:
ONE: The government cannot honor its contracts and pay the principal or interest when promised. Hamilton wrote when the government did not have the power to create money out of thin air. Today he might say a debt is too big if the government cannot honor its contracts without causing inflation, which is known in the biz as a “soft default” as opposed to the “hard default” Hamilton so feared and deprecated. Today, many fear a serious bout of inflation a year or two out.
A debt is also too big if it:
TWO: raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. Again, this is a major fear at present as yields on longer dated Treasuries and mortgages have risen even as the Fed continues to flood the markets with money.
A debt is too big if it:
THREE: necessitates a high level of taxation. Like Adam Smith before him and David Ricardo after him, Hamilton understood that taxes are necessary evils best minimized. Today, Obama appears poised to increase the taxes of the richest Americans and many fear the middle class cannot be far behind. Higher payroll taxes for Social Security and health insurance also appear well neigh inevitable.
So our national debt proper is clearly headed into territory Hamilton would call excessive and the government’s contingent liabilities for entitlements, valued at $50 to $100 trillion dollars depending on the various assumptions made in the calculation, are already there. Of course the situation was much, much worse when Washington asked Hamilton to serve as the new nation’s first Treasury Secretary on September Eleventh … 1789. Washington had met Hamilton in 1776 and came to know him intimately as they experienced the trials and travails of the Revolution together. The two became so close that some speculated they were father and son. That was utter balderdash but Washington and Hamilton clearly knew how to work together in the face of adversity. They prevailed against long odds during the war against the Redcoats and again during the heated political struggles of the 1790s.
To win its independence, America had instituted a so-called currency tax that took the form of depreciation of Continental paper currency and state-issued paper money called bills of credit. It also borrowed prodigiously abroad and at home. In the latter instance, it sold bonds to willing purchasers but also forced bonds upon some of its creditors. Moreover, the army got in the habit of taking the provisions it needed in exchange for hastily composed, hand written IOUs. Before we judge it too harshly, it is important to note that most armies throughout history have taken without giving anything in return and that by the war’s end the soldiers too were paid primarily in IOUs.
By the war’s end, the national government, such as it was under the Articles of Confederation, and the state governments were essentially broke. Most simply defaulted on their obligations or paid interest on their IOUs with yet more IOUs. One, today nicknamed Taxachusetts, enacted and forced the collection of high levels of taxation. It enjoyed a relatively good credit rating but at the cost of strangling its economy and fomenting a rebellion in its western hinterlands. The silver lining was that Shay’s Rebellion and other uprisings enabled Hamilton, Washington, James Madison, Ben Franklin, and other leading lights to forge a new frame of government in Philadelphia in the summer of 1787.
In and of itself, the Constitution did nothing to ameliorate a debt growing ever larger through the power of compound interest. Its ratification, however, did provide Hamilton the tools he needed to reverse the trend. First, he got the government’s tariff revenue flowing by quickly organizing an efficient collection system. Coffee in hand, Hamilton had a knack for running large, complex organizations with the utmost efficiency. Properly caffeinated, he was a great administrator and also a first-rate policymaker and statesman, a combination as rare as an albino moose. Most people who can pay meticulous attention to detail can do little else of import, like see the forest for the trees. If thrown into a policy role they drown in a quicksand of minutia. Not so Hamilton, whose mind and actions constantly flowed between policy and implementation, mundane detail and stroke of genius.
Improvements that Hamilton made to tariff rates, basically the heavier taxation of demand inelastic luxury goods like fine spirits and fancy horse carriages, also improved the national government’s revenues, which increased from almost zero in 1788 to over $10 million dollars – a weighty sum for the day -- in 1800.
The customs system and tariff reforms made it possible to restructure the nation’s foreign debt. Between 1790 and 1794, the U.S. government borrowed millions of dollars, mostly in Holland’s capital market, and used it to pay off its wartime obligations to France, Spain, and earlier Dutch investors. It serviced the new bonds religiously, paying them off when due in the first decade of the nineteenth century. A memorandum penned by Hamilton in 1794 made Washington’s role in the restructuring quite explicit:
QUOTE
From the special connection of the President with the Subject, owing to the authority to borrow being immediately vested in him from the circumstance of the existence of a particular discretion to be exercised by the President as to the anticipated payments of the foreign debt, and from the official relation of each head of a department to the President, the Secretary of the Treasury considered it as his duty from time to time to submit the disposition of each Loan to the consideration of the President, with his reasons for such disposition, and to obtain the sanction of the President previous to carrying it into effect, which was always had. The communication to the President and his sanctions were, for the most part, verbal. UNQUOTE
And hence lost to history I should add. Clearly, the buck stopped with Washington, who delegated the details to Little Hammie.
Under Washington’s aegis, Hamilton also restructured the domestic debt, a tangled mess of literally scores of different types of obligations many of which even the nation’s nascent stock brokers knew little about. Like Alexander the Great cutting the Gordian Knot with his sword, the great Alexander Hamilton cut through the knotty problem of the debt by offering to take old IOUs, those of the states as well as those of the national government, as payments for just three ingenious new ones. Sixes were the most valuable because they paid one and a half percent interest at the end of each quarter, or six percent annually. Threes, by contrast, paid only three-quarters of a percent interest quarterly, or three percent per year. Deferreds paid no interest until 1801, when they became Sixes. By exchanging a blend of the new bonds for older obligations that generally promised six percent, Hamilton reduced the nation’s debt burden with the voluntary consent of its domestic creditors. Much more of a libertarian than most observers today give him credit for, Hamilton did not force people to make the exchange and some indeed hesitated, hoping to receive their full six percent interest. The vast majority ended up making the exchange, however, because the new bonds were safer and much more liquid than the Revolution-era bonds. In other words, Sixes, Threes, and Deferreds were quickly, easily, and cheaply sold to other investors at widely reported prices, a valuable characteristic, and were backed or funded by dedicated tax revenues.
Despite much rhetoric, then and now, to the contrary, Hamilton did NOT, repeat did NOT, want to make the national debt perpetual. He simply wanted to pay it off more slowly than Jefferson and his followers did, partly because he did not want to stymie economic growth with high taxes and partly because he saw some beneficial aspects of the debt. Historians have missed the best evidence of his desire to pay off the debt slowly because it is somewhat technical and buried deep in the bonds themselves. Basically, Hamilton built a contract feature into Sixes that gave the government the option, but not the obligation, to return 2 percent of the principal of each bond annually. That turned them into something akin to a 30-year amortizing mortgage. As soon as it was financially able to make the payments, the government began doing so and by that mechanism completely extinguished the original Sixes circa 1820.
Threes did not have an amortization feature because they did not need one. Three percent was cheap money under the specie standard then controlling the domestic money supply. If it saw fit, the government could extinguish Threes by purchasing them in the open market. Hamilton created an institution, called the Sinking Fund, to facilitate those purchases and to provide a resource the government could use to help stabilize the economy after a financial panic, a use to which Hamilton actually put it to help stem the Panic of 1792. A pernicious myth to the contrary notwithstanding, Hamilton did not believe that the Sinking Fund sped up retirement of the debt, an illusion that some of his contemporaries did hold. Rather, he saw it as a symbol of European-style fiscal orthodoxy and a commitment device that signaled the government’s desire to pay down the national debt. As with the foreign debt, the President was ultimately responsible for the Sinking Fund and again Washington appears to have deferred to the decisions of the Sinking Fund Committee, which during much of his first term was composed of John Adams as V.P., John Jay as chief justice, Jefferson as Secretary of State, and Hamilton as Treasury Secretary.
That is not to say, however, that Washington’s role was always a passive one. A clear instance of Washington’s guiding hand came during the brouhaha over the Bank of the United States, a largely privately-owned and privately-operated central bank. Hamilton argued the bank was necessary, and hence constitutional, because it would provide temporary loans to cover any government revenue shortfalls as well as provide the government with other important financial services. When Jefferson and Attorney General Edmund Randolph, both Virginians, urged a veto of the bank’s charter on constitutional grounds, Washington could not with propriety ignore their entreaties. So he asked them to write out their arguments, which he then turned over to Hamilton. The Little Lion, as Hamilton was known, roared ferociously and famously in response and Washington signed the bill. In a similar incident, Washington referred to Hamilton for his comment 21 of Jefferson’s biggest complaints about the funding system.
Overall, Hamilton’s program appeared to please Washington immensely. The Father of Our Country, after all, was a fiscal conservative: “As a very important source of strength and security,” he once wrote, “cherish Public Credit.” In a private letter to David Humphries penned in March 1791, Washington lambasted those who questioned the new government’s credit. The derogatory remarks of a certain European Count, he wrote, QUOTE are such as do no credit to his judgment and as little to his heart UNQUOTE. He then enumerated the steps taken by Congress, at Hamilton’s behest, to bolster public credit: the tariff reforms, the Bank of the United States, and the establishment of a mint. He noted that the southern and eastern states divided on those issues but added that the government conducted business QUOTE with great harmony and cordiality UNQUOTE. Five years later, Washington wrote that it was acceptable to accumulate debt for good causes, like fighting an unavoidable war, provided the government paid the debt down QUOTE by vigorous exertions, in time of peace UNQUOTE.
It is not surprising to learn, therefore, that Hamilton and Washington also worked together to keep expenditures in check. It is wrong to think of the Federalists as the party of big government and the Republicans as the party of small government. By today’s standards, the Federalists were the party of tiny government and the Republicans the party of teensy-weensy government. Both parties thought the national government should do little more than regulate international and interstate trade, define the dollar in terms of gold and silver, and protect the country from domestic rebels and foreign powers. The Federalists believed the best way to keep the country at peace was to make some preparations for war. Better to spend moderate sums and appear formidable to potential foes than to scrimp by and appear an easy target. The stakes were high because the biggest threat to Hamilton’s financial program, even bigger than the political challenge posed by the Jeffersonian wing of the emerging Democratic-Republican party, was war with a major power. That’s why the administration sought commercial ties to Britain and why Washington’s Farewell address, which Hamilton drafted, advocated neutrality. Both men knew that military victory was glorious but expensive and would also pinch government tariff revenues, as it had during the Revolution and would again during the War of 1812.
To diversify the national government’s income stream in time of peace and war and also to minimize protection of domestic distillers, Hamilton induced Congress to pass an excise tax on whiskey. Yes, I said to minimize protection. That Hamilton was a protectionist – by which I mean an advocate of high tariffs – is one of the most perfidious myths about his policies. He sought to maximize government revenues not to protect infant industries, particularly the distillers of cheap swill. As you probably know, the distillers were not happy about it and although Hamilton and Washington successfully snuffed out a minor rebellion in western Pennsylvania the whiskey excise never brought in much net income. The same could be said of other direct taxes, like those implemented during the Adams administration, which also touched off some agrarian rebellions. Federal land sales were also minimal.
In short, the tariff was the key to public credit. While it strains credulity to call any tax popular, taxation of imports for revenue purposes was then sufficiently politically palatable, especially compared to the distrust of the national debt instilled in Americans by Adam Smith and their colonial experience with Mother England’s massive obligations, that it caused no rebellions. That only large merchants directly paid it helped immensely. They passed the cost onto their customers in the form of higher prices, of course, but unlike sales taxes today, reminders of the toll were not embedded in receipts, bills of sale, and so forth, rendering the incidence of the tariff opaque if not invisible.
In Washington’s world tariffs were ubiquitous and hence justifiable, especially in a nation that did not take kindly to other forms of taxation. Unfortunately, tariffs can’t come to our aid now, as today they are a dirty word and rightly so. However, I think it would behoove us to think about new taxes, perhaps one on producers of greenhouse gases, that might prove politically palatable due to the nature of the levy and the obscurity of the incidence. I’m not saying, I’m just saying.
In any event, Hamilton’s financial program was a smashing success. Before the Constitutional Convention in 1787, the national government was bankrupt, the state governments were bankrupt or scarred by rebellion, and the economy languished. The financial system consisted of three small banks, a handful of securities brokers, and a coterie of inefficient individual insurance underwriters. By the end of 1795, the year Hamilton left office, there were in operation 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges. Entrepreneurs teemed in both the cities and the growing agricultural hinterland. The nominal level of the debt was unchanged but the rapidly growing economy and burgeoning population had shrunk its burden from about $20 per person to about $15. Perhaps most importantly of all, yields on government bonds dropped from high double and low triple digits in 1787 to around six percent in 1795. Just two years later, in March 1797, yields on U.S. Threes actually dipped below yields on British Consols in London. Yes, in London, due to the threat of a French invasion combined with the high esteem British investors now held of their erstwhile colony’s creditworthiness.
Over the years, foreign ownership of U.S. government bonds waxed and waned but was always a significant percentage of the national debt. Critics complained that foreign owners siphoned off substantial sums each year but Hamilton retorted that entrepreneurs put the foreigners’ principal to good use clearing forests, building roads, ships, and other transportation infrastructure, and running banks and insurance companies. So long as we borrowed at 6 percent to fund projects that returned 8, 10, 12 or even higher, it was all good. That’s a paraphrase, by the way.
The national debt was a national blessing in other ways as well. The debt made direct contributions to the creation of America’s transcontinental empire. The government’s strong credit abroad made possible the purchase of Louisiana in 1803 and its strong credit at home allowed it to tangle effectively with Amerindians, French frigates, and Barbary pirates and to fight Britain to a draw in the War of 1812.
Perhaps more importantly, the price of the debt signaled confidence in the government and its policies. If you want, you can go to EH.Net and download the early U.S. bond price data that some of my colleagues and I collected about a decade ago. We have at least weekly data on Threes, Sixes, and Deferreds after 1791 in Boston, New York, and Philadelphia, and later for B-more, Alexandria, Richmond, Charleston, N’Awlins, and London. We took them from public newspapers so it is clear that any early American who wanted to know the capital market’s view of the nation’s long-term prospects needed only to look up from his or her morning coffee … or afternoon tea or rum punch.
Wannabe entrepreneurs who saw Sixes trading consistently right around par could forge ahead with their business ideas safe in the knowledge that the young government was on the right path and political and expropriation risks were very low. And forge they did. By the Civil War, over 20,000 corporations formed in the United States, including some sixty-five hundred in the South. Many thousands more formed manufacturing and mercantile sole proprietorships and partnerships. And the nation’s farmers, still the bulk of the population, became the most efficient and adventurous in the world. Many businesses failed and the agricultural sector was prone to asset bubbles, including one in sugar beets that I detail in One Nation Under Debt, but the vigorous spirit of enterprise evinced by early American entrepreneurs created one of the world’s most vibrant and fastest growing economies.
The national debt was also a great boon to entrepreneurs and investors because it provided them with a safe, liquid investment option. Financial institutions and large mercantile firms held U.S. government bonds as remunerative secondary reserves. Widows, orphans, trustees, and non-profit organizations bought them as long-term investments certain to make interest payments on time. Planters bought them as hedges against bad harvests and urban artisans to mute the pain of periodic periods of unemployment. Speculators purchased them in the hopes of a rapid price change in the correct direction, up for longs and down for shorts. Lawyers, doctors, and professors owned them too, for a multitude of reasons.
I can make these generalizations because I spent a month at the Virginia Historical Society in Richmond tracing the lives of a hundred Virginia bondholders. Many interesting stories emerged, including that of Charles Dabney. The son of a prominent planter, Dabney served his parish as a vestryman, his county as a justice of the peace, and his colony on important commissions. By the late colonial period he was already a prominent Hanover County planter and co-partner in a blacksmith shop. Dabney conceived of Virginia, not Britain, as his homeland and so was an ardent Patriot, first as the captain of a company of minutemen, then as the lieutenant colonel of his own eponymous legion. In September 1782, the large and athletic Dabney put down a small mutiny, probably by brandishing his trademark weapon, a large bore rifle that bore his name. Dabney nevertheless wrote QUOTE unless the troops get money soon, I fear it will be out of my power to keep them in service. UNQUOTE He somehow succeeded until mustering out at the end of April 1783.
In 1791, Dabney converted some £1,900 pounds of Virginia IOUs into federal bonds under Hamilton’s funding program. By that mechanism and further purchases, Dabney accumulated federal bonds between January 1791 and September 1802 –over 14 thousand dollars of Sixes, Threes, and Deferreds in 21 transactions, some of which he stashed under the books on the left hand side of his bookcase. The money for his 1795 bond purchases came directly from the proceeds of the sale of some of the western lands his military service entitled him to. In 1812, Dabney began to divest. In 1818 he sold almost $9,000 of his Sixes and in 1824, 5 years before his death, the government redeemed the balance of his portfolio.
A Federalist, the immorality Dabney saw in Virginia’s cities, particularly Williamsburg and Richmond, disgusted him to such an extent that he refused to leave the area around his home in Hanover. He had one of his young relatives, Billy Dabney, draw the interest for him in Richmond. Although not highly formally educated, Dabney had in the words of a contemporary an excellent “natural understanding” and a “large stock of valuable knowledge,” a claim that Dabney’s commonplace books certainly bear out. For instance, he knew of a simple cure for piles, more commonly known as hemorrhoids today, that entailed applying a ¾ inch long piece of cold, wet, strong British alum to the affected area morning and evening for seven days. Those attributes – the knowledge and understanding, not the piles -- made him a natural leader in war as well as in peace. Dabney was also said to possess QUOTE a thorough knowledge of human nature UNQUOTE and nowhere did that show more than in his unusual relationships with his slaves. He understood that slaves did not respond well to physical punishment so instead of whipping them, he credited them wages for the year, making deductions whenever they slacked or misbehaved and settling balances due in cash each Christmas season. Also, he paid his overseer on a salary plus commission basis rather than a salary only, an astute tactic designed to mitigate overseer slacking. Dabney’s descendants claimed that his unorthodox methods did not work but then again they had ideological reasons to question them. The productivity of his plantation certainly did not seem to suffer.
As Hamilton predicted, men like Dabney helped to keep the young nation together. The debt served as a so-called cement of union because public creditors like Dabney did not want to suffer a loss on their investments. They therefore would not countenance systemic tax evasion, talk of secession, or rebellion. Although only about 1 in 200 Americans directly held federal government bonds at one time, they tended to be more substantial citizens, like Dabney. And as I show in One Nation Under Debt they were spread throughout the country, even in seemingly unlikely places like Central Virginia. Moreover, many other Americans owned indirect stakes in the government through their ownership of corporate stock, bank deposits, or insurance policies or through their interests in churches, municipalities, or other non-profit holders of government bonds.
Today, many Americans fear the fact that the Chinese government owns over $700 billion dollars worth of U.S. government bonds. I don’t. In fact, I think it a shame that North Korea, Cuba, and Iran don’t own more of our debt. Nobody looks out for you more than your creditors do, and that includes Mom. It’s not like bondholders of an insolvent corporation; they can’t dictate terms to us. The worst they can do is sell. If that is what it takes to give rise to a new economic statesman, then so be it.
Thank you.
National Credit, National Debt
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College S.D.
Once upon a time, in a land not so far away, a subjugated but enlightened people cast off a great tyrant. But their liberty, won with promises as well as with the blood of patriots, came at a high price. Burdened by debt, weak government, a pressing scarcity of money, and an uncertain future, the people wallowed in idleness and rebellion. Men of brilliance met, theorized, compromised, and, over some weighty objections, soon constituted a new type of government, one that was powerful yet benign, led by the ablest but dedicated to protect all. Taxes were collected, new loans procured, and old debts repaid. The details flummoxed some but most people understood, and applauded. Throughout the land, they bought the new government’s promises at high prices and sold them at will, sometimes to people in distant lands eager for good investments. Through such trading, the interests of the governed and the government became one. The debt blessed the nation as bankruptcy turned to honor and despair transformed into hope. The fruits of their labors now secure, the people worked hard and smart. Not all of their innovations succeeded, but all told their farms flourished, as did their factories and ports. The nation’s debt dwindled according to plan, only to rise to new heights in a second war against tyranny. Hard work, intelligent taxation, and disciplined leadership again combined forces to tame the fiscal beast. The debt, rightly considered an imposition on the unborn, soon disappeared completely.
But the people, not as enlightened as they once were, did not live happily ever after. Their leaders, now mere politicians instead of statesmen, began to accumulate massive new debts to ensure their popularity rather than to fend off encroachments upon liberty. As foretold, the blessings of debt became a great curse, one that looms larger every second of every day, threatening the people’s happiness and the productivity of their raucous economy. This is their story and it is an important one because within it dwells a great truth about happiness and sullenness, progress and regress, prosperity and poverty.
With those words, I began my book One Nation Under Debt: Hamilton, Jefferson and the History of What We Owe. I penned them … well, clacked them on my laptop … months before the book appeared in March 2008, which was right about when Bear Stearns bit the dust, and they came to me a full year before Fannie and Freddie, Lehman and Merrill, WaMu and AIG joined Pearl Harbor, 9/11, and a handful of other dirty words in infamy. Since I wrote, the national debt has ballooned to $11.5 trillion dollars, enough in $1 dollar bills laid end to end to stretch for 1 billion miles, give or take. That’s from Washington, D.C. to Saturn, and by that I mean the planet, not the former GM subsidiary, though I’m told Saturn was always about a billion miles away from profitability. I kid; I own two of them. [Pause, with head down slowly shaking it.]
In any event, I’m not here today to discuss the causes of the financial crisis or the many problems caused by the subsequent bailouts. To learn of my views on those subjects, Google me or, better yet, read my book Bailouts: Public Money, Private Profit, just out from Columbia University Press and the Social Science Research Council, and Fubarnomics, which should be out from Prometheus early next year. Today I am here to suggest that the Founders, especially Thomas Jefferson and Alexander Hamilton, and by extension their boss, George Washington, had some very important things to say about the national debt, that mighty sword of two edges.
Jefferson thought the national debt a monstrous fraud on posterity, an intergenerational wealth redistribution scheme of dubious morality. The retort is that there is nothing intrinsically wrong with passing a debt along to the next generation if the youngins’ receive something of value in exchange, like a smoothly functioning central bank, growth-enhancing transportation infrastructure, or, most compellingly of all, a free country. Of course the next generation might not desire specific investments, as in the case of a disastrous, unpopular little war waged mainly due to faulty information. And yes my last statement could refer to the War of 1812 or the Iraq War.
So more important -- in my view – was Jefferson’s warning that politicians would find the temptation to borrow and spend as irresistible as a toddler finds sugar or a frat boy finds Natty Light. Taxing and spending has its own natural limit, at least in a democracy. Borrowing and spending, however, can be a winning political strategy for a long time because it allows politicians to appear to provide public services to their constituents at no cost. In reality, of course, more borrowing today means higher taxes tomorrow. Two centuries ago, the brilliant British political economist David Ricardo formally showed that if capital markets are efficient, and they appear to have been in both the United States and Britain in the late eighteenth and early nineteeth centuries, borrowing and taxation are economically equivalent. Americans of the Early Republic had already intuited that and behaved appropriately at the polls. As a result, most early American politicians talked about increasing absolute government budget surpluses ASAP, not merely maybe reducing deficits as a percentage of GDP some years hence.
Unfortunately, Jefferson’s worse fears have come true; We the People were vigilant for a long time, but not eternally. Until the Third Millennium, the history of the U.S. national debt was the history of wars. The debt as a percentage of GDP increased during wars, higher during bigger wars, but it trended downward in peacetime, usually to quite low levels. It rose in the Reagan years but arguably to win the Cold War against the evil communist specter that had so long haunted the planet. During the 1990s, you may recall, the federal government made concerted efforts to reduce the rate of budget growth below the rate of economic growth. The result fit the usual pattern, rapid reductions in the ratio of debt-to-GDP and even a few years of primary surplus.
I can scarcely believe that just a decade ago, when I was lecturing in Money and Banking at the University of Virginia, one of the key policy questions was how the Federal Reserve would conduct open market operations when there were no more Treasury bonds to buy and sell. That was one problem the Bush administration solved handily! Instead of asking Americans to sacrifice for the war effort, which would have ensured his defeat at the polls in 2004, technically his second straight loss, Bush borrowed and spent, then borrowed and spent some more. As a result, the government’s ongoing bailout of the financial system appears much larger and more ominous than it would have if the national debt had not grown so obese after 9/11.
Imagine the economy is a boat and the national debt is a guy in the boat. The ratio of the guy’s weight to the boat’s size is the key determinate of the boat’s continued buoyancy, which is to say of the economy’s ability to withstand unexpected waves or shocks. Cognizant of that, American politicians put the guy on a strict diet even when the boat grew bigger each year. The Bush administration, by contrast, force-fed the guy Krispy Kreme donuts drenched in lard. The guy grew faster than the boat, making it sit ever lower in the water. Due to the financial crisis and bailouts, the boat is currently shrinking while the guy has surpassed Homer Simpson in size and is rapidly approaching the combined girth of Comic Book Guy and Barney. And yes Barney could mean the Springfield town drunk or the purple dinosaur.
Even more damning, the flabberlanche is going to be difficult to reverse anytime soon. About a month ago Christina Romer, the chairwoman of Obama’s Council of Economic Advisers, told readers of The Economist that her biggest goal is to avoid repeating the mistake of the 1937-38, the Roosevelt Recession, by turning off the stimulus spigot too soon. By the end of Obama’s first term the national debt could equal 100 percent of GDP. There is nothing magical about that number – it was higher after World War II. But the figure began heading downward immediately after the war as it had in all periods of peace and prosperity until the current millennium.
Although we have been headed in the wrong direction for almost a decade now, very few voter-taxpayers appear concerned and the government has been getting a substantial amount of cover from economists of a certain ilk who claim that the debt is nothing to worry about. To be frank, they sound an awful lot like the economists who told us not to worry about rapidly rising home values, subprime mortgages, and credit default swaps! Here’s a hint: just because somebody has a Ph.D. in something doesn’t mean that he or she knows anything about it. Some doctors turn out to be quacks, some Major League pitchers can’t throw a strike – they seem strangely attracted to this region for some reason – and some economists don’t understand the economy as a system.
Don’t get me wrong, I’m sure they are great at solving arcane mathematical problems but that isn’t what we need now. What we need is economic statesmanship and one Founding Father in particular can provide some, if only posthumously. I think Alexander Hamilton had it exactly right, X-ACT-LY right, when he said that QUOTE a national debt, if it is not excessive, will be to us a national blessing UNQUOTE. The qualifying clause “if it is not excessive” is of course crucial to understanding Hamilton’s view of the debt; it is strange how often the clause is elided, especially by his detractors. It was not a throwaway line or a bone to those in his own time who dogged him. Hamilton actually specified how big he thought was too big. A debt is too big if:
ONE: The government cannot honor its contracts and pay the principal or interest when promised. Hamilton wrote when the government did not have the power to create money out of thin air. Today he might say a debt is too big if the government cannot honor its contracts without causing inflation, which is known in the biz as a “soft default” as opposed to the “hard default” Hamilton so feared and deprecated. Today, many fear a serious bout of inflation a year or two out.
A debt is also too big if it:
TWO: raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. Again, this is a major fear at present as yields on longer dated Treasuries and mortgages have risen even as the Fed continues to flood the markets with money.
A debt is too big if it:
THREE: necessitates a high level of taxation. Like Adam Smith before him and David Ricardo after him, Hamilton understood that taxes are necessary evils best minimized. Today, Obama appears poised to increase the taxes of the richest Americans and many fear the middle class cannot be far behind. Higher payroll taxes for Social Security and health insurance also appear well neigh inevitable.
So our national debt proper is clearly headed into territory Hamilton would call excessive and the government’s contingent liabilities for entitlements, valued at $50 to $100 trillion dollars depending on the various assumptions made in the calculation, are already there. Of course the situation was much, much worse when Washington asked Hamilton to serve as the new nation’s first Treasury Secretary on September Eleventh … 1789. Washington had met Hamilton in 1776 and came to know him intimately as they experienced the trials and travails of the Revolution together. The two became so close that some speculated they were father and son. That was utter balderdash but Washington and Hamilton clearly knew how to work together in the face of adversity. They prevailed against long odds during the war against the Redcoats and again during the heated political struggles of the 1790s.
To win its independence, America had instituted a so-called currency tax that took the form of depreciation of Continental paper currency and state-issued paper money called bills of credit. It also borrowed prodigiously abroad and at home. In the latter instance, it sold bonds to willing purchasers but also forced bonds upon some of its creditors. Moreover, the army got in the habit of taking the provisions it needed in exchange for hastily composed, hand written IOUs. Before we judge it too harshly, it is important to note that most armies throughout history have taken without giving anything in return and that by the war’s end the soldiers too were paid primarily in IOUs.
By the war’s end, the national government, such as it was under the Articles of Confederation, and the state governments were essentially broke. Most simply defaulted on their obligations or paid interest on their IOUs with yet more IOUs. One, today nicknamed Taxachusetts, enacted and forced the collection of high levels of taxation. It enjoyed a relatively good credit rating but at the cost of strangling its economy and fomenting a rebellion in its western hinterlands. The silver lining was that Shay’s Rebellion and other uprisings enabled Hamilton, Washington, James Madison, Ben Franklin, and other leading lights to forge a new frame of government in Philadelphia in the summer of 1787.
In and of itself, the Constitution did nothing to ameliorate a debt growing ever larger through the power of compound interest. Its ratification, however, did provide Hamilton the tools he needed to reverse the trend. First, he got the government’s tariff revenue flowing by quickly organizing an efficient collection system. Coffee in hand, Hamilton had a knack for running large, complex organizations with the utmost efficiency. Properly caffeinated, he was a great administrator and also a first-rate policymaker and statesman, a combination as rare as an albino moose. Most people who can pay meticulous attention to detail can do little else of import, like see the forest for the trees. If thrown into a policy role they drown in a quicksand of minutia. Not so Hamilton, whose mind and actions constantly flowed between policy and implementation, mundane detail and stroke of genius.
Improvements that Hamilton made to tariff rates, basically the heavier taxation of demand inelastic luxury goods like fine spirits and fancy horse carriages, also improved the national government’s revenues, which increased from almost zero in 1788 to over $10 million dollars – a weighty sum for the day -- in 1800.
The customs system and tariff reforms made it possible to restructure the nation’s foreign debt. Between 1790 and 1794, the U.S. government borrowed millions of dollars, mostly in Holland’s capital market, and used it to pay off its wartime obligations to France, Spain, and earlier Dutch investors. It serviced the new bonds religiously, paying them off when due in the first decade of the nineteenth century. A memorandum penned by Hamilton in 1794 made Washington’s role in the restructuring quite explicit:
QUOTE
From the special connection of the President with the Subject, owing to the authority to borrow being immediately vested in him from the circumstance of the existence of a particular discretion to be exercised by the President as to the anticipated payments of the foreign debt, and from the official relation of each head of a department to the President, the Secretary of the Treasury considered it as his duty from time to time to submit the disposition of each Loan to the consideration of the President, with his reasons for such disposition, and to obtain the sanction of the President previous to carrying it into effect, which was always had. The communication to the President and his sanctions were, for the most part, verbal. UNQUOTE
And hence lost to history I should add. Clearly, the buck stopped with Washington, who delegated the details to Little Hammie.
Under Washington’s aegis, Hamilton also restructured the domestic debt, a tangled mess of literally scores of different types of obligations many of which even the nation’s nascent stock brokers knew little about. Like Alexander the Great cutting the Gordian Knot with his sword, the great Alexander Hamilton cut through the knotty problem of the debt by offering to take old IOUs, those of the states as well as those of the national government, as payments for just three ingenious new ones. Sixes were the most valuable because they paid one and a half percent interest at the end of each quarter, or six percent annually. Threes, by contrast, paid only three-quarters of a percent interest quarterly, or three percent per year. Deferreds paid no interest until 1801, when they became Sixes. By exchanging a blend of the new bonds for older obligations that generally promised six percent, Hamilton reduced the nation’s debt burden with the voluntary consent of its domestic creditors. Much more of a libertarian than most observers today give him credit for, Hamilton did not force people to make the exchange and some indeed hesitated, hoping to receive their full six percent interest. The vast majority ended up making the exchange, however, because the new bonds were safer and much more liquid than the Revolution-era bonds. In other words, Sixes, Threes, and Deferreds were quickly, easily, and cheaply sold to other investors at widely reported prices, a valuable characteristic, and were backed or funded by dedicated tax revenues.
Despite much rhetoric, then and now, to the contrary, Hamilton did NOT, repeat did NOT, want to make the national debt perpetual. He simply wanted to pay it off more slowly than Jefferson and his followers did, partly because he did not want to stymie economic growth with high taxes and partly because he saw some beneficial aspects of the debt. Historians have missed the best evidence of his desire to pay off the debt slowly because it is somewhat technical and buried deep in the bonds themselves. Basically, Hamilton built a contract feature into Sixes that gave the government the option, but not the obligation, to return 2 percent of the principal of each bond annually. That turned them into something akin to a 30-year amortizing mortgage. As soon as it was financially able to make the payments, the government began doing so and by that mechanism completely extinguished the original Sixes circa 1820.
Threes did not have an amortization feature because they did not need one. Three percent was cheap money under the specie standard then controlling the domestic money supply. If it saw fit, the government could extinguish Threes by purchasing them in the open market. Hamilton created an institution, called the Sinking Fund, to facilitate those purchases and to provide a resource the government could use to help stabilize the economy after a financial panic, a use to which Hamilton actually put it to help stem the Panic of 1792. A pernicious myth to the contrary notwithstanding, Hamilton did not believe that the Sinking Fund sped up retirement of the debt, an illusion that some of his contemporaries did hold. Rather, he saw it as a symbol of European-style fiscal orthodoxy and a commitment device that signaled the government’s desire to pay down the national debt. As with the foreign debt, the President was ultimately responsible for the Sinking Fund and again Washington appears to have deferred to the decisions of the Sinking Fund Committee, which during much of his first term was composed of John Adams as V.P., John Jay as chief justice, Jefferson as Secretary of State, and Hamilton as Treasury Secretary.
That is not to say, however, that Washington’s role was always a passive one. A clear instance of Washington’s guiding hand came during the brouhaha over the Bank of the United States, a largely privately-owned and privately-operated central bank. Hamilton argued the bank was necessary, and hence constitutional, because it would provide temporary loans to cover any government revenue shortfalls as well as provide the government with other important financial services. When Jefferson and Attorney General Edmund Randolph, both Virginians, urged a veto of the bank’s charter on constitutional grounds, Washington could not with propriety ignore their entreaties. So he asked them to write out their arguments, which he then turned over to Hamilton. The Little Lion, as Hamilton was known, roared ferociously and famously in response and Washington signed the bill. In a similar incident, Washington referred to Hamilton for his comment 21 of Jefferson’s biggest complaints about the funding system.
Overall, Hamilton’s program appeared to please Washington immensely. The Father of Our Country, after all, was a fiscal conservative: “As a very important source of strength and security,” he once wrote, “cherish Public Credit.” In a private letter to David Humphries penned in March 1791, Washington lambasted those who questioned the new government’s credit. The derogatory remarks of a certain European Count, he wrote, QUOTE are such as do no credit to his judgment and as little to his heart UNQUOTE. He then enumerated the steps taken by Congress, at Hamilton’s behest, to bolster public credit: the tariff reforms, the Bank of the United States, and the establishment of a mint. He noted that the southern and eastern states divided on those issues but added that the government conducted business QUOTE with great harmony and cordiality UNQUOTE. Five years later, Washington wrote that it was acceptable to accumulate debt for good causes, like fighting an unavoidable war, provided the government paid the debt down QUOTE by vigorous exertions, in time of peace UNQUOTE.
It is not surprising to learn, therefore, that Hamilton and Washington also worked together to keep expenditures in check. It is wrong to think of the Federalists as the party of big government and the Republicans as the party of small government. By today’s standards, the Federalists were the party of tiny government and the Republicans the party of teensy-weensy government. Both parties thought the national government should do little more than regulate international and interstate trade, define the dollar in terms of gold and silver, and protect the country from domestic rebels and foreign powers. The Federalists believed the best way to keep the country at peace was to make some preparations for war. Better to spend moderate sums and appear formidable to potential foes than to scrimp by and appear an easy target. The stakes were high because the biggest threat to Hamilton’s financial program, even bigger than the political challenge posed by the Jeffersonian wing of the emerging Democratic-Republican party, was war with a major power. That’s why the administration sought commercial ties to Britain and why Washington’s Farewell address, which Hamilton drafted, advocated neutrality. Both men knew that military victory was glorious but expensive and would also pinch government tariff revenues, as it had during the Revolution and would again during the War of 1812.
To diversify the national government’s income stream in time of peace and war and also to minimize protection of domestic distillers, Hamilton induced Congress to pass an excise tax on whiskey. Yes, I said to minimize protection. That Hamilton was a protectionist – by which I mean an advocate of high tariffs – is one of the most perfidious myths about his policies. He sought to maximize government revenues not to protect infant industries, particularly the distillers of cheap swill. As you probably know, the distillers were not happy about it and although Hamilton and Washington successfully snuffed out a minor rebellion in western Pennsylvania the whiskey excise never brought in much net income. The same could be said of other direct taxes, like those implemented during the Adams administration, which also touched off some agrarian rebellions. Federal land sales were also minimal.
In short, the tariff was the key to public credit. While it strains credulity to call any tax popular, taxation of imports for revenue purposes was then sufficiently politically palatable, especially compared to the distrust of the national debt instilled in Americans by Adam Smith and their colonial experience with Mother England’s massive obligations, that it caused no rebellions. That only large merchants directly paid it helped immensely. They passed the cost onto their customers in the form of higher prices, of course, but unlike sales taxes today, reminders of the toll were not embedded in receipts, bills of sale, and so forth, rendering the incidence of the tariff opaque if not invisible.
In Washington’s world tariffs were ubiquitous and hence justifiable, especially in a nation that did not take kindly to other forms of taxation. Unfortunately, tariffs can’t come to our aid now, as today they are a dirty word and rightly so. However, I think it would behoove us to think about new taxes, perhaps one on producers of greenhouse gases, that might prove politically palatable due to the nature of the levy and the obscurity of the incidence. I’m not saying, I’m just saying.
In any event, Hamilton’s financial program was a smashing success. Before the Constitutional Convention in 1787, the national government was bankrupt, the state governments were bankrupt or scarred by rebellion, and the economy languished. The financial system consisted of three small banks, a handful of securities brokers, and a coterie of inefficient individual insurance underwriters. By the end of 1795, the year Hamilton left office, there were in operation 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges. Entrepreneurs teemed in both the cities and the growing agricultural hinterland. The nominal level of the debt was unchanged but the rapidly growing economy and burgeoning population had shrunk its burden from about $20 per person to about $15. Perhaps most importantly of all, yields on government bonds dropped from high double and low triple digits in 1787 to around six percent in 1795. Just two years later, in March 1797, yields on U.S. Threes actually dipped below yields on British Consols in London. Yes, in London, due to the threat of a French invasion combined with the high esteem British investors now held of their erstwhile colony’s creditworthiness.
Over the years, foreign ownership of U.S. government bonds waxed and waned but was always a significant percentage of the national debt. Critics complained that foreign owners siphoned off substantial sums each year but Hamilton retorted that entrepreneurs put the foreigners’ principal to good use clearing forests, building roads, ships, and other transportation infrastructure, and running banks and insurance companies. So long as we borrowed at 6 percent to fund projects that returned 8, 10, 12 or even higher, it was all good. That’s a paraphrase, by the way.
The national debt was a national blessing in other ways as well. The debt made direct contributions to the creation of America’s transcontinental empire. The government’s strong credit abroad made possible the purchase of Louisiana in 1803 and its strong credit at home allowed it to tangle effectively with Amerindians, French frigates, and Barbary pirates and to fight Britain to a draw in the War of 1812.
Perhaps more importantly, the price of the debt signaled confidence in the government and its policies. If you want, you can go to EH.Net and download the early U.S. bond price data that some of my colleagues and I collected about a decade ago. We have at least weekly data on Threes, Sixes, and Deferreds after 1791 in Boston, New York, and Philadelphia, and later for B-more, Alexandria, Richmond, Charleston, N’Awlins, and London. We took them from public newspapers so it is clear that any early American who wanted to know the capital market’s view of the nation’s long-term prospects needed only to look up from his or her morning coffee … or afternoon tea or rum punch.
Wannabe entrepreneurs who saw Sixes trading consistently right around par could forge ahead with their business ideas safe in the knowledge that the young government was on the right path and political and expropriation risks were very low. And forge they did. By the Civil War, over 20,000 corporations formed in the United States, including some sixty-five hundred in the South. Many thousands more formed manufacturing and mercantile sole proprietorships and partnerships. And the nation’s farmers, still the bulk of the population, became the most efficient and adventurous in the world. Many businesses failed and the agricultural sector was prone to asset bubbles, including one in sugar beets that I detail in One Nation Under Debt, but the vigorous spirit of enterprise evinced by early American entrepreneurs created one of the world’s most vibrant and fastest growing economies.
The national debt was also a great boon to entrepreneurs and investors because it provided them with a safe, liquid investment option. Financial institutions and large mercantile firms held U.S. government bonds as remunerative secondary reserves. Widows, orphans, trustees, and non-profit organizations bought them as long-term investments certain to make interest payments on time. Planters bought them as hedges against bad harvests and urban artisans to mute the pain of periodic periods of unemployment. Speculators purchased them in the hopes of a rapid price change in the correct direction, up for longs and down for shorts. Lawyers, doctors, and professors owned them too, for a multitude of reasons.
I can make these generalizations because I spent a month at the Virginia Historical Society in Richmond tracing the lives of a hundred Virginia bondholders. Many interesting stories emerged, including that of Charles Dabney. The son of a prominent planter, Dabney served his parish as a vestryman, his county as a justice of the peace, and his colony on important commissions. By the late colonial period he was already a prominent Hanover County planter and co-partner in a blacksmith shop. Dabney conceived of Virginia, not Britain, as his homeland and so was an ardent Patriot, first as the captain of a company of minutemen, then as the lieutenant colonel of his own eponymous legion. In September 1782, the large and athletic Dabney put down a small mutiny, probably by brandishing his trademark weapon, a large bore rifle that bore his name. Dabney nevertheless wrote QUOTE unless the troops get money soon, I fear it will be out of my power to keep them in service. UNQUOTE He somehow succeeded until mustering out at the end of April 1783.
In 1791, Dabney converted some £1,900 pounds of Virginia IOUs into federal bonds under Hamilton’s funding program. By that mechanism and further purchases, Dabney accumulated federal bonds between January 1791 and September 1802 –over 14 thousand dollars of Sixes, Threes, and Deferreds in 21 transactions, some of which he stashed under the books on the left hand side of his bookcase. The money for his 1795 bond purchases came directly from the proceeds of the sale of some of the western lands his military service entitled him to. In 1812, Dabney began to divest. In 1818 he sold almost $9,000 of his Sixes and in 1824, 5 years before his death, the government redeemed the balance of his portfolio.
A Federalist, the immorality Dabney saw in Virginia’s cities, particularly Williamsburg and Richmond, disgusted him to such an extent that he refused to leave the area around his home in Hanover. He had one of his young relatives, Billy Dabney, draw the interest for him in Richmond. Although not highly formally educated, Dabney had in the words of a contemporary an excellent “natural understanding” and a “large stock of valuable knowledge,” a claim that Dabney’s commonplace books certainly bear out. For instance, he knew of a simple cure for piles, more commonly known as hemorrhoids today, that entailed applying a ¾ inch long piece of cold, wet, strong British alum to the affected area morning and evening for seven days. Those attributes – the knowledge and understanding, not the piles -- made him a natural leader in war as well as in peace. Dabney was also said to possess QUOTE a thorough knowledge of human nature UNQUOTE and nowhere did that show more than in his unusual relationships with his slaves. He understood that slaves did not respond well to physical punishment so instead of whipping them, he credited them wages for the year, making deductions whenever they slacked or misbehaved and settling balances due in cash each Christmas season. Also, he paid his overseer on a salary plus commission basis rather than a salary only, an astute tactic designed to mitigate overseer slacking. Dabney’s descendants claimed that his unorthodox methods did not work but then again they had ideological reasons to question them. The productivity of his plantation certainly did not seem to suffer.
As Hamilton predicted, men like Dabney helped to keep the young nation together. The debt served as a so-called cement of union because public creditors like Dabney did not want to suffer a loss on their investments. They therefore would not countenance systemic tax evasion, talk of secession, or rebellion. Although only about 1 in 200 Americans directly held federal government bonds at one time, they tended to be more substantial citizens, like Dabney. And as I show in One Nation Under Debt they were spread throughout the country, even in seemingly unlikely places like Central Virginia. Moreover, many other Americans owned indirect stakes in the government through their ownership of corporate stock, bank deposits, or insurance policies or through their interests in churches, municipalities, or other non-profit holders of government bonds.
Today, many Americans fear the fact that the Chinese government owns over $700 billion dollars worth of U.S. government bonds. I don’t. In fact, I think it a shame that North Korea, Cuba, and Iran don’t own more of our debt. Nobody looks out for you more than your creditors do, and that includes Mom. It’s not like bondholders of an insolvent corporation; they can’t dictate terms to us. The worst they can do is sell. If that is what it takes to give rise to a new economic statesman, then so be it.
Thank you.
Sunday, July 12, 2009
In Answer to My Coz DP
Dr Wright
In the high school where I work I noticed pictures on the wall in a class room of moments in history. One picture says the American Revolution ended at Yorktown (somewhat untrue) and there was another that stated the Great Depression ended with FDR's social programs but I have read that World War II had an impact on the recovery, since you have wrote of the causes of it and other problems later in history could you comment on the recovery from the depression?.... signed (your cousin) DP
DP,
World War II rapidly brought the economy to full employment and beyond. It did not, repeat did not, bring the U.S. economy out of the Depression. FDR's social programs didn't either. What did the trick was loosening the gold standard (1 oz. gold to $35 from $20), which allowed the Fed to reflate the money supply, which lowered REAL (inflation adjusted) wages and interest rates, both of which had become far too high due to the deflation associated with the infamous bank panics and the stock market crash and subsequent decline in aggregate demand. 2H 1933 through 1936 were periods of strong growth (increases in per capita GDP). Unemployment decreased as well but more slowly. (As our beloved president recently noted, employment is a lagging indicator.) The unemployment rate would have been back near its normal low level by 1939, and certainly by 1941, even without the war had it not been for the so-called Roosevelt Recession of 1937-38, when FDR tried to balance the budget, in retrospect prematurely, and the Fed capriciously raised banks' reserve requirements for reasons only a central banker could "understand."
For more info., see a cute little volume I edited called Bailouts: Public Money, Private Profits due out from Columbia UP/SSRC shortly. It's only like 12 bucks on Amazon and my part of it is sort of a prequel to my Fubarnomics due out from Prometheus early next year.
In the high school where I work I noticed pictures on the wall in a class room of moments in history. One picture says the American Revolution ended at Yorktown (somewhat untrue) and there was another that stated the Great Depression ended with FDR's social programs but I have read that World War II had an impact on the recovery, since you have wrote of the causes of it and other problems later in history could you comment on the recovery from the depression?.... signed (your cousin) DP
DP,
World War II rapidly brought the economy to full employment and beyond. It did not, repeat did not, bring the U.S. economy out of the Depression. FDR's social programs didn't either. What did the trick was loosening the gold standard (1 oz. gold to $35 from $20), which allowed the Fed to reflate the money supply, which lowered REAL (inflation adjusted) wages and interest rates, both of which had become far too high due to the deflation associated with the infamous bank panics and the stock market crash and subsequent decline in aggregate demand. 2H 1933 through 1936 were periods of strong growth (increases in per capita GDP). Unemployment decreased as well but more slowly. (As our beloved president recently noted, employment is a lagging indicator.) The unemployment rate would have been back near its normal low level by 1939, and certainly by 1941, even without the war had it not been for the so-called Roosevelt Recession of 1937-38, when FDR tried to balance the budget, in retrospect prematurely, and the Fed capriciously raised banks' reserve requirements for reasons only a central banker could "understand."
For more info., see a cute little volume I edited called Bailouts: Public Money, Private Profits due out from Columbia UP/SSRC shortly. It's only like 12 bucks on Amazon and my part of it is sort of a prequel to my Fubarnomics due out from Prometheus early next year.
Monday, July 06, 2009
1929: The Sequel
This is the text of a webcast I did last week. To view the slides, etc:
http://www.complinet.com/connected/news-and-events/webcasts/great-crash/share/great-crash-slides.pdf
1929: The Sequel
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD
The Great Crash of 1929 did not literally repeat in 2008. As we will see, there is one crucial difference between the two episodes and it likely will be our savior. Nevertheless, striking similarities between the two crashes are evident. Foremost, as shown on slide 2, in both instances the economy was in recession BEFORE financial crisis struck and in that sense the financial system could not be said to CAUSE either economic downturn, only to exacerbate problems in the real economy like inventory gluts, softness in construction and real estate markets, and energy price spikes.
In both periods, the financial system proved to be EXTREMELY fragile due to the use of leverage, the purchase of speculative assets with borrowed money. In both periods the bursting of asset bubbles, real estate bubbles followed by corporate equities bubbles, led to the destructive processes illustrated on slide 3. When commercial and housing real estate markets softened in the 1920s and recently, corporate balance sheets weakened and mortgage default rates increased, which in turn increased asymmetric information, the great bane of financial institutions then and now.
In both crashes the “bank problems” listed second from the bottom were particularly potent. In the face of elevated default rates, damaged balance sheets, and high levels of uncertainty about future business conditions, banks raised the interest rates they charged some borrowers and stopped lending entirely to many others. That slowed business investment which led to further decreases in economic activity, even higher levels of default, and, ultimately, bank failures, and a massive degree of additional uncertainty.
Of course the crashes of 29 and “aught eight” are not identical. As Mark Twain once said, history rhymes rather than repeats. During the Depression, small banks bit the dust first, with the big ones staggering only in the later stages of the economy’s three-year death spiral. Today, it is the big boys who first fell but the pollution their crashing and burning creates is now suffocating smaller institutions. As summarized in slide 4, the changing but always inept nature of banking regulation explains why small banks gave way first during the Depression while big ones could not withstand last year’s crash. Prior to World War II, most Americans and their politicians possessed a morbid fear of large financial institutions. Andrew Jackson vetoed the re-charter of the Bank of the United States, pictured on slide 5, partly because he thought the institution had grown too large and powerful. Some 80 years later, a government fearful of the power accumulated by investment banker J.P. Morgan created a new central bank, the Federal Reserve System, but simultaneously tried to limit its influence by dividing it into 12 districts, also shown on slide 5. For similar reasons, throughout much of the nation regulators forbade banks to operate a branch across the street much less across state lines. As a result, most banks outside of the major money centers were tiny affairs that, even if conservatively run, were highly susceptible to local economic shocks. Places that allowed branch banking, including California and Canada, weathered the Depression much better than adjacent territories dominated by unit banks because they suffered many fewer failures.
That led regulators to conclude, erroneously, the bigger the better. In the years leading up to the current crisis, regulators not only allowed banks to grow large they actually strongly encouraged them to do so with the “Too Big to Fail” policy. Concocted in the aftermath of the Continental Illinois failure in 1984, TBTF policy promised that the government would prevent systemic financial crises by aiding the largest financial institutions should they face insolvency or bankruptcy. Because the government charged nothing for the guarantee and never made clear which companies were covered under it, many financiers used TBTF as an excuse for constant, rapid growth, mainly through the acquisition of smaller institutions. TBTF encouraged other types of excessive risk-taking as well by promising government aid in all events. Because risk and return are positively correlated, it essentially generated private profits with public money.
I am not, however, one of those folks who puts all the blame on the government. Properly understood, both the Depression and the current crisis are examples of a broader phenomenon I call “hybrid failures.” As slide 7 jokes, by this I do NOT mean a Prius that won’t start. Rather, as in slide 8, a hybrid failure is a combination of classic market failures like asymmetric information, asset bubbles, positive and negative externalities, and public goods INTRICATELY INTERTWINED with government failures like the creation of perverse incentives, misguided regulation, the inability to foresee and fix problems before they cause major economic disruptions, and implementing counterproductive bailouts.
Slide 9 summarizes the hybrid failures at the heart of both the 1929 and 2008 crashes. You’ll quickly perceive that they are identical. If we zoom in more closely, however, differences appear. The 1920s real estate bubble was not as big as the recent one shown in Slide 10. The stock market bubble of the 1920s, however, was much bigger than the fluff that survived the dotcom bust. We’ve already seen that very different yet equally misguided banking regulations played a role in both crises, as did the inability of the government to foresee the perverse incentives those regulations gave rise to. The most maddening thing about the “aught eight” debacle was that it was the 7th time in American history that regulators allowed mortgage originators to take full commissions upon closing and the 7th time that a mortgage securitization scheme exploded in our faces.
Finally, and most importantly, while fiscal stimulus, TARP, and other recent bailout attempts have hardly been unqualified successes to date they do not appear to be as disastrous as some of the policies implemented during the early stages of the Depression. The Smoot-Hawley tariff was extremely destructive and is unlikely to be repeated. We are also unlikely to repeat the creation of a bad bank, which works better when it has to liquidate numerous small institutions, as the Reconstruction Finance Corporation and the Resolution Trust Corporation did during the Depression and the Savings and Loan crisis, respectively.
We will also likely avoid creating anything like the National Industrial Recovery Act, the infamous blue eagle of which is pictured on slide 11. The NRA sought, luckily in vain, to INCREASE real wages when the economy desperately needed lower real wages. Wages stuck at high levels due to deflation and the unwillingness of workers to accept nominal wage cuts were of course the proximate cause of the very high levels of unemployment that disrupted America’s social, political, and financial systems during the Depression. Even at 10 percent, the unemployment rate today is much less than half of that experienced during the hard winter of 1932-33.
Moving on to slide 12, the only government policy during the New Deal with a demonstrably positive effect on the economy was the devaluation of the dollar and the de facto abandonment of the classical gold standard. Because it had to defend the nation’s gold stocks, the Depression-era Federal Reserve could not appreciably lower interest rates or increase money growth in the aftermath of the stock market crash. It did not even replace the money destroyed when thousands of banks failed, paying just pennies on the dollar to depositors. As a result, the money supply actually shrank and the price level declined dramatically, effectively increasing real wages and real interest rates. By greatly loosening the link to gold, Roosevelt allowed re-flation and decreased real interest rates, thereby fueling the expansion of 1933 to 1937.
Loss of the gold standard cost us our long term price anchor but gave us in exchange tremendous domestic monetary policy flexibility. Today’s Federal Reserve does not need to maintain gold stocks or the value of the dollar in international markets. It can, if it wishes, decrease interest rates to zero, print prodigious quantities of money, and lend it to whomever it sees fit. In fact, after the failure of Bear Stearns the Fed kept a pretty tight reign on the money supply in order to support the value of the dollar in international markets. After the failure of Lehman, by contrast, it let out all the stops and, as illustrated on slide 13, essentially implemented one-half of Alexander Hamilton and Walter Bagehot’s famous rule of central banking and lent freely to all who could post solid collateral. In addition to its traditional discount window, the Fed now lends via seven new so-called term facilities. The only disappointment is that it provides the funds very cheaply, rather than at the penalty rate espoused by Hamilton and Bagehot, thus subsidizing private concerns with public money and increasing moral hazard and hence the probability of future crises.
Clearly, the Fed wishes to avoid the melancholy scenes depicted on slide 14 -- the dust bowl, the breadlines, and the public health crises that characterized the Depression. Thanks largely to its efforts, the sequel to the Crash of 1929 will turn out to have a much happier ending, at least in the immediate term.
Nevertheless, longer term, as indicated on slide 15, troubles loom. I was warning about the alarming growth of the national debt in 2007 and now of course am very concerned that the debt may cause interest rates to increase to levels that will hamper a robust recovery. Fears of a soft default or inflation are foremost as are concerns that foreigners will stop buying U.S. government bonds, at which point domestic crowding out may occur. I’m also concerned by the fact that the government has yet to price Too Big To Fail and other federal guarantees and backstops at anything close to market rates. That means, in effect, that the government is still subsidizing private risk taking with public money so it is only a matter of time before another financial crisis strikes. When and where it will occur I of course do not know but if the government doesn’t act decisively to force people to wager only their own money, I fear “The Great Crash III, They Did It Again” will be coming to an economy near you in the not-so-distant future.
I’m done. Thanks for your time and attention!
http://www.complinet.com/connected/news-and-events/webcasts/great-crash/share/great-crash-slides.pdf
1929: The Sequel
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD
The Great Crash of 1929 did not literally repeat in 2008. As we will see, there is one crucial difference between the two episodes and it likely will be our savior. Nevertheless, striking similarities between the two crashes are evident. Foremost, as shown on slide 2, in both instances the economy was in recession BEFORE financial crisis struck and in that sense the financial system could not be said to CAUSE either economic downturn, only to exacerbate problems in the real economy like inventory gluts, softness in construction and real estate markets, and energy price spikes.
In both periods, the financial system proved to be EXTREMELY fragile due to the use of leverage, the purchase of speculative assets with borrowed money. In both periods the bursting of asset bubbles, real estate bubbles followed by corporate equities bubbles, led to the destructive processes illustrated on slide 3. When commercial and housing real estate markets softened in the 1920s and recently, corporate balance sheets weakened and mortgage default rates increased, which in turn increased asymmetric information, the great bane of financial institutions then and now.
In both crashes the “bank problems” listed second from the bottom were particularly potent. In the face of elevated default rates, damaged balance sheets, and high levels of uncertainty about future business conditions, banks raised the interest rates they charged some borrowers and stopped lending entirely to many others. That slowed business investment which led to further decreases in economic activity, even higher levels of default, and, ultimately, bank failures, and a massive degree of additional uncertainty.
Of course the crashes of 29 and “aught eight” are not identical. As Mark Twain once said, history rhymes rather than repeats. During the Depression, small banks bit the dust first, with the big ones staggering only in the later stages of the economy’s three-year death spiral. Today, it is the big boys who first fell but the pollution their crashing and burning creates is now suffocating smaller institutions. As summarized in slide 4, the changing but always inept nature of banking regulation explains why small banks gave way first during the Depression while big ones could not withstand last year’s crash. Prior to World War II, most Americans and their politicians possessed a morbid fear of large financial institutions. Andrew Jackson vetoed the re-charter of the Bank of the United States, pictured on slide 5, partly because he thought the institution had grown too large and powerful. Some 80 years later, a government fearful of the power accumulated by investment banker J.P. Morgan created a new central bank, the Federal Reserve System, but simultaneously tried to limit its influence by dividing it into 12 districts, also shown on slide 5. For similar reasons, throughout much of the nation regulators forbade banks to operate a branch across the street much less across state lines. As a result, most banks outside of the major money centers were tiny affairs that, even if conservatively run, were highly susceptible to local economic shocks. Places that allowed branch banking, including California and Canada, weathered the Depression much better than adjacent territories dominated by unit banks because they suffered many fewer failures.
That led regulators to conclude, erroneously, the bigger the better. In the years leading up to the current crisis, regulators not only allowed banks to grow large they actually strongly encouraged them to do so with the “Too Big to Fail” policy. Concocted in the aftermath of the Continental Illinois failure in 1984, TBTF policy promised that the government would prevent systemic financial crises by aiding the largest financial institutions should they face insolvency or bankruptcy. Because the government charged nothing for the guarantee and never made clear which companies were covered under it, many financiers used TBTF as an excuse for constant, rapid growth, mainly through the acquisition of smaller institutions. TBTF encouraged other types of excessive risk-taking as well by promising government aid in all events. Because risk and return are positively correlated, it essentially generated private profits with public money.
I am not, however, one of those folks who puts all the blame on the government. Properly understood, both the Depression and the current crisis are examples of a broader phenomenon I call “hybrid failures.” As slide 7 jokes, by this I do NOT mean a Prius that won’t start. Rather, as in slide 8, a hybrid failure is a combination of classic market failures like asymmetric information, asset bubbles, positive and negative externalities, and public goods INTRICATELY INTERTWINED with government failures like the creation of perverse incentives, misguided regulation, the inability to foresee and fix problems before they cause major economic disruptions, and implementing counterproductive bailouts.
Slide 9 summarizes the hybrid failures at the heart of both the 1929 and 2008 crashes. You’ll quickly perceive that they are identical. If we zoom in more closely, however, differences appear. The 1920s real estate bubble was not as big as the recent one shown in Slide 10. The stock market bubble of the 1920s, however, was much bigger than the fluff that survived the dotcom bust. We’ve already seen that very different yet equally misguided banking regulations played a role in both crises, as did the inability of the government to foresee the perverse incentives those regulations gave rise to. The most maddening thing about the “aught eight” debacle was that it was the 7th time in American history that regulators allowed mortgage originators to take full commissions upon closing and the 7th time that a mortgage securitization scheme exploded in our faces.
Finally, and most importantly, while fiscal stimulus, TARP, and other recent bailout attempts have hardly been unqualified successes to date they do not appear to be as disastrous as some of the policies implemented during the early stages of the Depression. The Smoot-Hawley tariff was extremely destructive and is unlikely to be repeated. We are also unlikely to repeat the creation of a bad bank, which works better when it has to liquidate numerous small institutions, as the Reconstruction Finance Corporation and the Resolution Trust Corporation did during the Depression and the Savings and Loan crisis, respectively.
We will also likely avoid creating anything like the National Industrial Recovery Act, the infamous blue eagle of which is pictured on slide 11. The NRA sought, luckily in vain, to INCREASE real wages when the economy desperately needed lower real wages. Wages stuck at high levels due to deflation and the unwillingness of workers to accept nominal wage cuts were of course the proximate cause of the very high levels of unemployment that disrupted America’s social, political, and financial systems during the Depression. Even at 10 percent, the unemployment rate today is much less than half of that experienced during the hard winter of 1932-33.
Moving on to slide 12, the only government policy during the New Deal with a demonstrably positive effect on the economy was the devaluation of the dollar and the de facto abandonment of the classical gold standard. Because it had to defend the nation’s gold stocks, the Depression-era Federal Reserve could not appreciably lower interest rates or increase money growth in the aftermath of the stock market crash. It did not even replace the money destroyed when thousands of banks failed, paying just pennies on the dollar to depositors. As a result, the money supply actually shrank and the price level declined dramatically, effectively increasing real wages and real interest rates. By greatly loosening the link to gold, Roosevelt allowed re-flation and decreased real interest rates, thereby fueling the expansion of 1933 to 1937.
Loss of the gold standard cost us our long term price anchor but gave us in exchange tremendous domestic monetary policy flexibility. Today’s Federal Reserve does not need to maintain gold stocks or the value of the dollar in international markets. It can, if it wishes, decrease interest rates to zero, print prodigious quantities of money, and lend it to whomever it sees fit. In fact, after the failure of Bear Stearns the Fed kept a pretty tight reign on the money supply in order to support the value of the dollar in international markets. After the failure of Lehman, by contrast, it let out all the stops and, as illustrated on slide 13, essentially implemented one-half of Alexander Hamilton and Walter Bagehot’s famous rule of central banking and lent freely to all who could post solid collateral. In addition to its traditional discount window, the Fed now lends via seven new so-called term facilities. The only disappointment is that it provides the funds very cheaply, rather than at the penalty rate espoused by Hamilton and Bagehot, thus subsidizing private concerns with public money and increasing moral hazard and hence the probability of future crises.
Clearly, the Fed wishes to avoid the melancholy scenes depicted on slide 14 -- the dust bowl, the breadlines, and the public health crises that characterized the Depression. Thanks largely to its efforts, the sequel to the Crash of 1929 will turn out to have a much happier ending, at least in the immediate term.
Nevertheless, longer term, as indicated on slide 15, troubles loom. I was warning about the alarming growth of the national debt in 2007 and now of course am very concerned that the debt may cause interest rates to increase to levels that will hamper a robust recovery. Fears of a soft default or inflation are foremost as are concerns that foreigners will stop buying U.S. government bonds, at which point domestic crowding out may occur. I’m also concerned by the fact that the government has yet to price Too Big To Fail and other federal guarantees and backstops at anything close to market rates. That means, in effect, that the government is still subsidizing private risk taking with public money so it is only a matter of time before another financial crisis strikes. When and where it will occur I of course do not know but if the government doesn’t act decisively to force people to wager only their own money, I fear “The Great Crash III, They Did It Again” will be coming to an economy near you in the not-so-distant future.
I’m done. Thanks for your time and attention!
Saturday, June 27, 2009
Cap, Cap and Trade, or Tax
As I mentioned in a recent post, many FUBAR areas of the economy got that way because of decades (and sometimes centuries) of government interference followed by market response. I call these hybrid failures to stress my non-partisan approach to the problem. Most other analysts take ideologically-colored views. Those from the Left jump at the market failure part of the cycle while those on the Right emphasize the government failure part of it. Pollution and its control is certainly a hybrid failure.
Initially, pollution of any sort is, by definition, a type of market failure called a negative externality. The externality is the costs (cleanup, disease, environmental, etc.) imposed by the pollution on society, or rather on innocent victims within societies. Because polluters do not pay the costs of the pollution but reap the benefits they produce more than the socially optimum amount.
The U.S. government reacted to this market failure by capping or limiting the emission of various types of nasties. Polluters responded by weighing the net costs (costs minus benefits) of compliance and cheating so, ultimately, the effectiveness of the cap-only system was a function of the government's diligence monitoring compliance and prosecuting cheaters. Over time, the government's zeal fluctuated. High levels of enforcement were unsustainable due to budget constraints and regulatory capture. In short, politicians found it in their own interest to spend public monies in other, more salient areas in order to garner votes and in order to attract campaign contributions from polluters.
Cap and trade is a modest improvement over straight caps because it offers polluters a third option: selling some or all of their pollution quotas to other polluters who value them more highly. That should induce polluters with a relatively low cost of pollution reduction to sell permits to polluters with a relatively high cost of pollution reduction. That should spur more compliance and a better use of resources. Of course political decisions still rule the system as the government will decide the size of the cap and the distribution of permits. Polluters will try to get an unfair proportion of permits and also to get the overall cap enlarged. And again politicians will see compliance as a drain on public resources that might be better spent elsewhere (like paying down the national debt ... yeah right!).
A tax, on the other hand, gives the government an incentive to enforce compliance, the payment of the tax. Cheating can and will occur but the IRS will try earnestly to minimize it. The government no longer directly decides how much pollution will be allowed but rather sets the tax rate. The market then determines how much pollution is cost effective at that rate. Roughly speaking, the higher the tax, the lower the tolerable quantity of pollution. Presumably, the government will try to maximize its revenue, so it won't increase the tax to the point of eliminating all pollution and hence all its revenue but at the same time it won't be easily swayed by calls for suboptimally low taxes either.
Finally, it would be technically possible to use such a tax to reduce pollution abroad as well by embedding the tax in tariffs. (That may run afoul of the WTO in which case I say then change WTO rules.) That will keep the playing field level and also dissuade polluters from outsourcing or outright moving to other countries to avoid the tax. Cheap imports from China won't look so cheap anymore.
As I noted in One Nation Under Debt, it would behoove us to find a politically tolerable tax to replace the tariffs that paid off the first national debt. A tax on pollution of various sorts might well fit the bill. Most people agree less carbon, mercury, PCBs, etc. would be a good thing. More taxes is a bad thing but if a pollution tax were tied to reductions in income taxes, even if they were less than 1 to 1 reductions, it could work politically, esp. if pushed by some popular, silver-tongued leader.
Initially, pollution of any sort is, by definition, a type of market failure called a negative externality. The externality is the costs (cleanup, disease, environmental, etc.) imposed by the pollution on society, or rather on innocent victims within societies. Because polluters do not pay the costs of the pollution but reap the benefits they produce more than the socially optimum amount.
The U.S. government reacted to this market failure by capping or limiting the emission of various types of nasties. Polluters responded by weighing the net costs (costs minus benefits) of compliance and cheating so, ultimately, the effectiveness of the cap-only system was a function of the government's diligence monitoring compliance and prosecuting cheaters. Over time, the government's zeal fluctuated. High levels of enforcement were unsustainable due to budget constraints and regulatory capture. In short, politicians found it in their own interest to spend public monies in other, more salient areas in order to garner votes and in order to attract campaign contributions from polluters.
Cap and trade is a modest improvement over straight caps because it offers polluters a third option: selling some or all of their pollution quotas to other polluters who value them more highly. That should induce polluters with a relatively low cost of pollution reduction to sell permits to polluters with a relatively high cost of pollution reduction. That should spur more compliance and a better use of resources. Of course political decisions still rule the system as the government will decide the size of the cap and the distribution of permits. Polluters will try to get an unfair proportion of permits and also to get the overall cap enlarged. And again politicians will see compliance as a drain on public resources that might be better spent elsewhere (like paying down the national debt ... yeah right!).
A tax, on the other hand, gives the government an incentive to enforce compliance, the payment of the tax. Cheating can and will occur but the IRS will try earnestly to minimize it. The government no longer directly decides how much pollution will be allowed but rather sets the tax rate. The market then determines how much pollution is cost effective at that rate. Roughly speaking, the higher the tax, the lower the tolerable quantity of pollution. Presumably, the government will try to maximize its revenue, so it won't increase the tax to the point of eliminating all pollution and hence all its revenue but at the same time it won't be easily swayed by calls for suboptimally low taxes either.
Finally, it would be technically possible to use such a tax to reduce pollution abroad as well by embedding the tax in tariffs. (That may run afoul of the WTO in which case I say then change WTO rules.) That will keep the playing field level and also dissuade polluters from outsourcing or outright moving to other countries to avoid the tax. Cheap imports from China won't look so cheap anymore.
As I noted in One Nation Under Debt, it would behoove us to find a politically tolerable tax to replace the tariffs that paid off the first national debt. A tax on pollution of various sorts might well fit the bill. Most people agree less carbon, mercury, PCBs, etc. would be a good thing. More taxes is a bad thing but if a pollution tax were tied to reductions in income taxes, even if they were less than 1 to 1 reductions, it could work politically, esp. if pushed by some popular, silver-tongued leader.
Friday, June 26, 2009
Obama's Health Insurance Proposal: You Didn't Know
If you like Obama's proposal to create a government health insurer don't feel bad. You didn't know. You didn't know that every major FUBAR (Fouled Up, ahem, Beyond All Recognition) or hyper-dysfunctional area of the economy -- health care, marriage, retirement, construction, higher education, mortgages, etc. -- has followed the same general pattern:
The market for some good doesn't work as well as some people would like. (Unsurprisingly, the FUBAR areas are characterized by asymmetric information, externalities, etc., i.e., information is imperfect so the markets are as well.) Some people can't afford to buy the good, some people get less value than they thought they would, etc. Politicians get wind of the problem and try to win over voters by trying to fix the problem with taxes or regulations. The intervention, however, actually makes matters worse, "necessitating" additional government interference. Eventually, as in the case of intercity passenger rail, private businesses are driven from the market entirely, leaving behind a bloated, inefficient, highly-subsidized government entity like Amtrak, or the public school system.
If the government is serious about helping to improve the value of health care services, it needs to help to promote competition. That means forcing doctors to disclose stats on how well they perform and encouraging businesses to collate, compare, and disseminate the information. It needs to divorce health insurance from employment by ending biz tax deductions on premium payments and encourage the development of individual policies by deregulating policy forms. But most of all, we need a system whereby doctors' compensation is based on their performance, not their time. The easiest way to do that is to develop a system where people pay when they are healthy but don't pay when they are sick. That will encourage doctors to focus on prevention and on outcomes, rather than inputs, as presently. Med mal would also be transformed as docs who messed up would be responsible for the patient until s/he recovered. A system of true competition -- competition on what is most important to people, the value proposition (trade off between cost and benefit) -- would quickly reduce quackery, unnecessary tests, and so forth.
Obama's government health insurer would do nothing to promote competition but would simply pump more money into the current health care system, allowing costs to soar higher still.
You didn't know. But now you do ... what are you going to do about it?
The market for some good doesn't work as well as some people would like. (Unsurprisingly, the FUBAR areas are characterized by asymmetric information, externalities, etc., i.e., information is imperfect so the markets are as well.) Some people can't afford to buy the good, some people get less value than they thought they would, etc. Politicians get wind of the problem and try to win over voters by trying to fix the problem with taxes or regulations. The intervention, however, actually makes matters worse, "necessitating" additional government interference. Eventually, as in the case of intercity passenger rail, private businesses are driven from the market entirely, leaving behind a bloated, inefficient, highly-subsidized government entity like Amtrak, or the public school system.
If the government is serious about helping to improve the value of health care services, it needs to help to promote competition. That means forcing doctors to disclose stats on how well they perform and encouraging businesses to collate, compare, and disseminate the information. It needs to divorce health insurance from employment by ending biz tax deductions on premium payments and encourage the development of individual policies by deregulating policy forms. But most of all, we need a system whereby doctors' compensation is based on their performance, not their time. The easiest way to do that is to develop a system where people pay when they are healthy but don't pay when they are sick. That will encourage doctors to focus on prevention and on outcomes, rather than inputs, as presently. Med mal would also be transformed as docs who messed up would be responsible for the patient until s/he recovered. A system of true competition -- competition on what is most important to people, the value proposition (trade off between cost and benefit) -- would quickly reduce quackery, unnecessary tests, and so forth.
Obama's government health insurer would do nothing to promote competition but would simply pump more money into the current health care system, allowing costs to soar higher still.
You didn't know. But now you do ... what are you going to do about it?
Keynote Speech at Augustana College, Sioux Falls, South Dakota, 3 June 2009
"Rebounding from Leveraged Asset Bubbles"
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College
I have good news, bad news, devastating news, and hopeful news. The good news is that the recession will end. The bad news is that I can’t predict when it will do so and I don’t think anyone else can either. The devastating news is that the economy may improve for a short time before plunging again into recession. The hopeful news is that the nation’s long-term economic outlook remains very good indeed.
Thank you!
Thank you!
Just kidding. That was my opening joke. I’m sure you’d like to know how I came to those conclusions. I know the recession will end eventually because they always do. According to the National Bureau of Economic Research or NBER, the United States since 1857 has suffered through 32 recessions including the one that began in December 2007. The longest to date lasted from October 1873 until March 1879, a total of 65 months. The Great Depression proper lasted a mere 43 months, from August 1929 until March 1933, but was quite deep. Since World War II the American economy has contracted 10 times and never for more than 16 months, as in the 1973-75 and 1981-82 downturns.
Well, until the current recession that is. Fact is, recessions differ considerably in ferocity and duration due to their underlying causes. Recessions caused by small, one-off shocks, temporary inventory gluts, and unleveraged asset bubbles tend to come and go quickly. Recessions stemming from leveraged asset bubbles, by contrast, tend to be long and nasty and until last year the United States hadn’t faced one since the early 1930s.
Bubbles originate in a soapy mixture of new technology and expected future demand of unprecedented proportions. Sometimes they are puffed up by the child’s breath of cheap credit, sometimes not. By their very nature they are unstable, sparkling and glistening as they magically float upward. Then they suddenly pop, leaving only toxins behind.
If a bubble is unleveraged, if in other words buyers of the inflated asset used their own money to speculate, the cleanup is relatively easy. In China’s Yunnan province a bubble in a special type of tea called Pu’er recently burst. The local farmers’ aspirations were shattered and their cash flows crimped but their balance sheets remained intact. They complain, for example, of owning fancy automobiles that they cannot afford to put gasoline into and having to shift production to corn and rice. Because they were largely free of debt, however, they still have their farms, much improved during the boom, and can sell their fuel-less cars for cash. By the way, I don’t mean to pick on the Chinese here; American farmers did not invent the agricultural bubble – and neither did the Dutch with their tulip mania – but they have concocted more than their fair share of them. I detail an early U.S. beet sugar bubble in my book One Nation Under Debt.
In any event, what saved the farmers was that they did not have access to easy, cheap credit. Low interest rate loans on easy terms can turn run of the mill asset bubbles into dangerous leveraged ones by decreasing the total cost of assets. To borrow $10,000 for a year to buy a car at 10% simple interest will cost $1,000, raising the total cost of the car to $11,000. At 1%, the same loan will cost only $100, making the car’s total cost, excluding taxes and so forth, only $10,100. Lower total cost, in turn, raises the quantity demanded.
Interest rates affect the total cost of some assets more than others. They have very little direct effect on toothpaste, food, and other inexpensive items but they deeply influence the total cost of more expensive goods, things that people typically borrow to purchase. They have an especially powerful effect on real estate, which is relatively fixed in supply. Low interest rates bring down the total cost of owning land, increasing demand, but the supply does not change appreciably. That means prices can only go in one direction, up. The same analysis applies to real estate improvements, like houses and strip malls, although their supply will eventually increase as new construction projects are completed. Of course if interest rates increase the process reverses and real estate prices sag, all else constant.
If investors believe that interest rates will remain low for an extended period, or if they think that some new technology or change in market conditions will make an asset permanently more valuable, they begin to get very excited. They will start to borrow money to buy the asset with the sole intention of reselling it soon afterward at a profit. In other words, they increase leverage to engage in speculation. Some people call this greed but it is really just business, trying to buy low and sell high, or in the case of bubbles to buy high and sell yet higher.
What makes speculation dangerous is the leverage or borrowing part. Playing with leverage is like playing with fire. If all goes well, fire is a great friend that helps us to stay warm, cook our food, and frighten away dangerous critters. If it gets out of control, however, it can burn both speculators and their lenders and, it seems, the entire economic forest.
Speculators employ leverage to increase their returns by risking other people’s money. That is fantastic on the way up but when asset prices begin to slide, as they always eventually do, lenders get nervous and begin to ask for their money back and limit further lending. Most borrowers can repay only by selling the asset they borrowed to buy. They desperately try to unload but buyers are few because prices are no longer soaring and easy loans are no longer to be had. That realization causes a panic, a moment when everybody must sell and few can or want to buy. Prices then plummet, triggering additional calls, and yet more selling. Speculators cannot sell assets quickly enough, or for a high enough price, to repay their loans so banks and other lenders begin to suffer defaults. In turn their lenders -- other banks, depositors, holders of commercial paper -- begin to wonder if financial institutions are still creditworthy and call or restrict their lending. That is what brought down Bear Stearns, Lehman Brothers, AIG and other seemingly invincible financial giants.
Some financial economists, of the rational expectations/efficient markets ilk, argue that asset bubbles are impossible. In their models, which is to say in their minds, they are correct: speculators do not overpay for assets on the expectation of selling out to a bigger sucker and sophisticated financial institutions do not make loans to such speculators. But in the real world, bubbles clearly do occur. Another group of financial economists, the behavioralists, attribute bubbles to human irrationality. People tend to launch themselves over cliffs like legendary lemmings and to make decisions based on emotions instead of cold, hard logic. It is difficult to dispute the existence of excitable morons, even -- or should I say especially? -- on Wall Street. The efficient markets proponents counter that the presence of irrational traders does not mean that markets, which aggregate the individual decisions of many participants, will be irrational. In the limit, one rational trader will ensure proper prices.
The sanguine expectations of the efficient markets crowd, however, meet a difficult reception in many real world markets. Key to their belief that one smart uber-trader can drive prices to their rational value is the ability to “short” the asset or, in other words, to profit at the expense of investors who pay too much for it. In many markets regularly troubled by bubbles, including agricultural, real estate, and mortgage markets, shorting is impossible or at least very expensive. Proponents of efficient markets also fail to see that what is rational for corporations’ stockholders and what is rational for their hired managers can be very different things.
Regardless of their position on bubbles, most economists agree that the economy is in quite a pickle at present. The largest financial institutions lost most of their capital making bad loans of various types. That put the economy into recession, which made it difficult for the banks to recapitalize and also pressured marginal industries, like automobile manufacturing, consumer electronics retailing, and others. Unable to obtain private sector loans, companies in those industries have been going bankrupt. Additional bad loans hurt already crippled financial institutions and layoffs decrease consumption, further deepening the recession.
That is the same sort of nasty downward spiral that helped to make the Depression so depressing, culminating in Rose of Sharon Joad’s suckling of a starving man. (That, by the way, refers to the final scene in Steinbeck’s book The Grapes of Wrath, not the Henry Fonda movie version.) Thankfully for us, we have thus far avoided the worst part of the Depression, a bout of serious sustained deflation. When the prices of everything decrease month after month, quarter after quarter, and year after year, businesses find it difficult to make long term investments. Nobody wants to buy high and sell low.
Currently, prices are holding pretty steady and the economy is clearly trying to reverse course. Leading economic indicators, including initial jobless claims, new manufacturing orders, building permits, consumer sentiment, the spread between 10-year Treasuries and the federal funds rate, and the growth of the money supply have improved in recent months, in the sense of being less bad, but they are still giving signals that are far from unequivocal. Moreover, an unexpected economic shock like the resurgence of the swine flu or the failure of a major depository institution could quickly nip any tentative recovery in the bud.
If we’re lucky and no shocks strike, the rapid expansion of the Fed’s balance sheet to over $2.2 trillion will eventually stimulate economic activity. As Milton Friedman once famously pointed out, however, monetary policy works only with “long and variable lags.” In other words, nobody knows when more money will lead to more output and, again, any number of unexpected shocks could further delay recovery.
Even more disturbing, the recovery, when it comes, might be short-lived. America has suffered through at least five double-dip recessions, in 1837-39, 1890-93, 1910-13, 1929-37, and 1980-81. All stemmed from the same basic cause, government meddling. Our time, my voice, and your patience preclude a detailed examination of each of those episodes but I would like to take a few minutes to describe how the federal government snuffed the life out of the recovery that began in April 1933. By April 1937, the economy was almost back to its 1929 highs but a balanced federal budget and several unexpected increases in the reserves that the Federal Reserve required banks to hold sent it spiraling back into recession. It recovered in just 13 months this time, over a year before Hitler invaded Poland I might add, but later conflation of the two recessions in the American psyche extended the Great Depression over the entire 1930s and created the pernicious myth that Hitler and Tojo saved capitalism.
Truth is, the government’s policies not only caused the Roosevelt Recession of 1937-38, they postponed the recovery and diminished its vigor. Myths that Herbert Hoover believed in laissez faire to the contrary notwithstanding, the government actively interfered with market mechanisms in the early 1930s, prompting FDR of all people to claim that Hoover was “leading the country down the path to socialism.”
The first Hoover bailout attempt was called the Smoot-Hawley Tariff Act. Enacted in June 1930, the act imposed the highest tariffs, or taxes on imported goods, in U.S. history. It was named after the two jokers, who happened to be U.S. legislators, who concocted it. Republican Willis Hawley hailed from Oregon’s 1st Congressional District, which he had served in the House of Representatives since 1907. Ironically, before turning to politics Hawley had taught history and economics at Willamette for about 16 years. Apparently, he knew little of either subject. Ridiculously persistent legends to the contrary notwithstanding, America’s industrial revolution began late in the eighteenth century, not after the Civil War, and owed little to tariff protection. Reed Smoot was a Republican from Utah and, judging from the photographs I’ve seen of him, a total nerd. By the 1930s, however, he was a powerful nerd, having served in the Senate since 1903. He almost wasn’t allowed his seat because he was a Mormon, and an apostle of the Latter Day Saints at that. He was eventually allowed in, however, because he had only one wife and purportedly did not take the Mormon “oath of vengeance” against the U.S. government, which had treated Mormons rather roughly in the 1840s and 1850s. Whether he took the oath or not, the tariff he co-sponsored did take a terrible toll on America. Not that he was solely responsible for the economic carnage that followed. It was the entire government’s call, and it made the wrong one.
Reed Smoot and Willis Hawley got their just desserts in 1932, when they both lost re-election bids. Although many Americans thought the act would be beneficial, 1,028 economists had opposed it, as had Henry Ford, who called it “an economic stupidity,” GM director Graeme Howard, who predicted it would cause the “most severe depression ever experienced,” and investment banker Thomas W. Lamott, who termed it, and I quote: “asinine.”
In 1932, Hoover attempted yet another major bailout, this time of distressed banks, by creating the Reconstruction Finance Corporation or RFC. Unlike the tariff hike, the RFC was not outright destructive and after a rocky start may have marginally helped the recovery by speeding up the resolution of failed banks. Nevertheless, it did not stem the waves of bank failures that repeatedly shocked the economy and further decreased the all-important money supply.
Opinions regarding subsequent bailouts, generally termed “the New Deal,” were also mixed. Some economists and businesses opposed all or most of them but others, followers of John Maynard Keynes and kindred spirits, supported them. The basic notion was that the government could increase output almost at will by borrowing and spending. Government spending, proponents hoped, would stop the cycle of unemployment, default, and bank failure plaguing the economy.
Did the rash of government spending programs cooked up by the Roosevelt administration pull the economy out of recession? The timing is right: Roosevelt took office in late March 1933 and in his first 100 days he induced Congress to pass numerous spending measures. Even more spending came in subsequent years. Government deficit spending, however, was simply too small to have had much effect. The economy recovered because the money supply grew after Roosevelt devalued the dollar. That decreased real wages and real interest rates, which increased investment by making some businesses profitable again.
Some economists argue that increasing government spending cannot really help the economy, Keynes and his many minions to the contrary notwithstanding. Remember the tax rebate checks the government sent you in 2001 and 2008? What did they do for the economy, as opposed to your wallet? Exactly zero. Oh, I was happy to cash both checks and spend the manna, as I am sure you were too. And businesses were happy to serve us meals, sell us televisions, and so forth. Knowing that the windfall was temporary, however, none of them invested in new facilities or hired new employees. And most people realized that government borrowing today means higher taxes tomorrow, which of course mutes the effects of the stimulus. The rebate checks were therefore little more than a fart in a bottle. They didn’t last very long or smell very good.
So Little Orphan Annie was right: the New Deal was more political bunk than economic funk. Rather than depicting the New Deal as the economy’s savior in the mid-1930s, it’s more accurate to say that the economy managed to bounce back despite the bungling interference of the Roosevelt and Hoover administrations. That is not to say, of course, that the New Deal’s relief programs should not have been implemented. If anything, they should have been extended. Relief redistributes resources rather than increasing the size of the economy but it is the right thing to do during systemic downturns, when people are laid low through no fault of their own. Too bad the government botched many of its relief efforts by waging turf and ideology wars against state and private relief organizations like the Fraternal Order of Eagles and the nation’s schools of philanthropy.
New Deal programs that created public goods also should be immune from imputation. Public goods are things of value that the government must produce if society is to enjoy them because no individual or business would have an incentive to create them. Technically, pure public goods are non-excludable and non-rivalrous, meaning that no one can be excluded from using the good and consumption of the good by one person does not reduce its availability for others. National defense is the classic example, as is protection of life, liberty, and property more generally.
Most New Deal programs, however, did not supply public goods. Worse, they hurt the economy by unwisely allocating resources. Some of the New Deal dollars that did not merely redistribute wealth, in other words, may have actually destroyed wealth by using real resources to create goods that nobody at the time wanted for what they cost to create. To the extent that the programs used resources that would have been wasted due to the uncertain business climate, they were better than nothing. Of course the government itself helped to create, perpetuate, and even amplify the uncertainty that plagued the business environment.
The Federal Deposit Insurance Corporation or FDIC, which insured the retail deposits of solvent banks beginning in 1934, was a great boon even before it began operations because its mere announcement induced depositors to stop running on their banks. That helped to keep the money supply from disintegrating and hence was crucial to the recovery that began in April 1933. Ever since, the FDIC has effectively prevented classic bank runs, like that in It’s a Wonderful Life. It has not, however, stemmed the tide of so-called silent bank runs, where creditors simply refuse to roll over short term loans to banks. It also lulls depositors to sleep, which allows bankers to take on additional risks without fearing the wrath of depositors. The FDIC’s twin, the Federal Savings and Loan Insurance Corporation (FSLIC), was one of the key causes of the Savings and Loan crisis of the 1980s for precisely that reason. Most economists agree that aside from its initial success in stabilizing the banking system in the 1930s, the FDIC’s net contribution to the economy has been approximately zero. Due to the existence of the insurance, bank runs are less likely but bank risk taking is higher.
Given the initial effectiveness of the FDIC, it is ironic that the Roosevelt administration opposed its creation. Its intransigence led to a great compromise of dubious merit. The advocates of deposit insurance, led by Henry B. Steagall, a Democratic congressman from Alabama, joined forces with advocates of the separation of commercial from investment banking, led by Virginia Democratic Senator Carter Glass. The compromise, officially known as the Banking Act of 1933, created the FDIC and also, in a section colloquially known as Glass-Steagall, forbade banks from engaging in both investment banking activities, like issuing securities, and commercial banking activities such as accepting deposits and making loans. The major fear was that risky investment banking activities endangered the safety of deposits and hence the solvency of the insurance fund. Of course that potential problem would have been mitigated if the FDIC had charged risk-based premiums, to wit if it charged riskier banks proportionally more to insure their deposits. It would later do so but not effectively, likely because the intricacies involved boggled its staff. For a variety of reasons, government regulators have been slow to use market based signals of financial institution risk-taking.
The Gramm-Leach-Bliley Act of 1999 officially repealed the Glass-Steagall prohibition, about a decade after the Federal Reserve had rendered it a dead letter by allowing bank holding companies to acquire investment bank subsidiaries and about four decades after financial innovations and regulatory arbitrage had greatly weakened the “Chinese Wall” separating the two types of banking activity. The law never made much sense because commercial bankers who want to take big risks can do so in numerous ways regardless of their ability or inability to underwrite securities. Glass-Steagall was thus akin to trying to reduce the murder rate by banning baseball bats but allowing an open trade in assault rifles. Tellingly, few other countries adopted similar prohibitions and many actually encouraged the development of so-called universal banks that engaged in securities underwriting, loan making, and deposit taking. Some commentators blamed the Panic of 2008 on the repeal of Glass-Steagall but when pressed most admitted that they invoked the law merely as an example of the need for re-regulation. In other words, they did not know what they were talking about.
The new Securities and Exchange Commission or SEC also had a dubious impact on the U.S. financial system and economy, one that I will spare you today. Suffice it to say that someone had to take the fall for the Depression and the government was not about to blame itself or its creature, the Federal Reserve. Securities market participants were the best scapegoats because few people understood what they did but most maintained deep prejudices against them. Americans, nay all human beings, innately distrust and envy great wealth. Likely a residue of life in poor, zero sum economies, where the rich truly became so at the expense of their neighbors, our instinctive repulsion has largely been overcome by education in the rich, positive sum economies of North America, Western Europe, and East Asia. People in those places, in other words, realize that wealthy individuals and large corporations usually create new wealth, not steal existing property. In a crisis, however, people often revert to emotion or instinct and back politicians and policies that they wouldn’t under normal circumstances.
Thus emboldened, the Roosevelt administration forged ahead and created another federal bureaucracy that does little more than lull investors to sleep. Chronically short of funds, the SEC was a nearsighted and nearly toothless securities market policeman. Unfortunately, investors believed the SEC was bigger, stronger, and smarter than it actually was. So, much like the FDIC, the SEC’s biggest effect was to reduce private monitoring. Investors began to act like people who leave their doors unlocked when they vacation because they believe the town cop will watch their house and automobile as if they were his own. When they return home to all of their property, they attribute it to police vigilance rather than blind luck. If robbed, they are shocked and wonder how anything like that could ever happen.
Finally, some New Deal bailouts were simply wrongheaded, attacking the wrong problems in the right way, or methodologically flawed, attacking the right problems in the wrong way. One doesn’t kill zombies with a stake to the heart or sunlight – well, except I Am Legend zombies -- or destroy vamps with a bullet to the brain. But that didn’t stop the government from trying to support farm prices, which had dropped precipitously in the latter half of the 1920s, from $1.30 to $.44 per bushel of wheat and $113 to $29 per bale of cotton. Initially, the government’s policy was the height of economic and political folly, destroying crops in the field and six million young pigs fattening for market. The correct policy, of course, would have been for the government to buy the food with borrowed or new money and distribute it to the needy. In subsequent years, U.S. agricultural policy was made only slightly less destructive by paying farmers not to grow crops or raise livestock in the first place. Farmers gladly took animals and acres out of production, cashed their government checks, and increased yields per acre on the rest of their farms by investing more heavily in tractors, fertilizer, better seeds, and so forth. That kept output high and prices low, a fact that even cocksure Agricultural Adjustment Administration bureaucrats eventually conceded. Soon, farmers captured the AAA, turning their ostensible regulators into prisoners who did their bidding in Congress. Unsurprisingly, agricultural subsidies remain with us to this day.
Perhaps the worst of the New Deal’s bailouts was the National Industrial Recovery Act. In July 1933, Roosevelt announced the new program, noting that it was designed to increase hourly wages and keep prices up by means of the collusion of government-sanctioned cartels. To induce companies and consumers to join the effort, the administration created a Blue Eagle emblem, a spread winged raptor clutching an industrial cog in one claw and three lightening bolts in the other, over the phrase “We Do Our Part.” Roosevelt explained that “in war in the gloom of attack, soldiers wear a bright badge to be sure that comrades do not fire on comrades. Those who cooperate in this program must know each other at a glance. That bright badge is the Blue Eagle.” After the beloved president’s speech, the Blue Eagle emblem quickly gained notoriety. Hollywood hotties Martha Virginia “Toby” Wing and Frances Drake, for example, sunburned the emblem onto their backs, though of course not in blue.
Due to the government’s call for consumers to boycott firms that refused to join the NIRA, companies at first clamored to join to enjoy the right to put the eagle on their advertising and products and thus avoid their customers’ wrath. The government, however, announced the program before enough emblems were available so it had to outsource their printing to private companies. It also had to allow exempt companies, like sole proprietorships, to display the emblem so they would not be mistakenly boycotted. It allowed companies that were noncompliant to join and at first did not have a compliance division. Even after its establishment, the compliance division took only 564 cases to court out of the 155,102 complaints it received. Soon, the Lincoln, Nebraska compliance board quit in disgust. Only about a third of the businesses under its jurisdiction sporting the Blue Eagle faced complaints but it lacked the resources to force the businesses to comply or to give up their emblems. Soon after, most of the Lowell, Massachusetts board quit for the same reasons.
The NIRA’s laughable execution was surpassed only by the inanely insane economic theory underlying the program. The poor little eagle and the program it symbolized were doomed from the start. As noted previously, the biggest problem facing the economy was that wages were already too high. Driving them higher would simply create more unemployment, a far cry from Roosevelt’s claim that the Blue Eagle was a “badge of honor … in the great summer offensive against unemployment.” The government’s reasoning was backwards. It believed that high wages created prosperity but in reality, as banker Albert Wiggin noted, “it is not true that high wages make for prosperity. Instead, prosperity makes high wages.” Moreover, the price level was almost entirely a function of the money supply, not of market structure. Instead of supporting prices across the board, in other words, the NIRA’s cartels merely caused relative prices to change. They also injured consumers dull witted or patriotic enough to shop only where the Blue Eagle kept prices of specific goods artificially high.
Thankfully, most American consumers and businesses were not so daft. Especially given the program’s well known enforcement difficulties, the public soon felt justified ignoring emblems and seeking the best bargains. After the initial flurry of activity, the Blue Eagle died quickly and painlessly. The Supreme Court drove the final nails into its little coffin by declaring it unconstitutional.
Auto manufacturer Henry Ford was the first major public critic of the NIRA, refusing to sign the industry code in August although his company had long since far exceeded the guidelines. Ford was an advocate of efficiency wages, or paying workers extremely well but expecting much from them in return, so he already paid much more than the guideline minimum wage. Apparently, however, he disliked the code’s recognition of workers’ right to unionize. He called the eagle a “Roosevelt buzzard” and ignored a cartoon showing him cutting off his own nose with a pair of scissors labeled “non-participation.” Tellingly, the government continued to buy his company’s automobiles anyway. American citizens must have followed their Uncle Sam because Ford lost no market share during the Blue Eagle’s brief life. Smaller fry began to take heart and stand up to the big blue buzzard too. In Hagerstown, Maryland, for example, gasoline station owner Herman Mills publicly fought the NIRA, vowing to take his case all the way to the Supreme Court on the grounds that it eliminated legitimate competition.
The government was astute enough to sidestep Mr. Mills but soon fell afoul the Schechter Brothers, purveyors of kosher chickens in Brooklyn. They bought the birds wholesale, alive, and kept them alive until a customer picked one for dinner, at which point a shochtim would ritually slaughter it if he believed it fit for human consumption. The brothers were also fierce competitors, eager to hold their own against larger rivals by cutting prices when necessary. Those practices, however, ran contrary to the NIRA codes and unusually vigilant inspectors let the Schechters know it. Eventually, the NIRA dragged them into court. Fearful that their very Jewishness was on trial, the chicken men fought like the dickens. They made it to the Supreme Court and won by showing the codes were as un-American as they were unconstitutional.
The short of all this is that another major threat to recovery is the Obama administration and the Democratically-controlled Congress. An attempt to reform healthcare, Social Security, or the tax system could energize our nation’s latent entrepreneurial talents or it could turn into our generation’s NIRA. Regulatory reformation could be salutary but could also spark a “strike of capital” the likes of which have not been seen since the 1930s. Massive fiscal stimulus added to aggressive money supply growth may spur growth but could just as easily unleash inflationary pressures too intense for the Fed to combat.
The biggest threat of all, though, may be something much more prosaic, UNCERTAINTY. We don’t fear fear itself, we sweat what schemes our politicians might concoct to win the next election. The natural response to uncertainty is timidity. Better to hold onto what one already has than to aim for the stars, most people conclude. That’s exactly what makes uncertainty so economically dangerous. I’m going to counter that, however, and propose that small business owners in Sioux Falls do not have as much to worry about as they may think. Where ever governments adequately protect life, liberty, and property economies trend upward over time. America’s long-term prosperity rests on the solid foundation of relatively non-predatory government, a modern financial system, open access entrepreneurship, and capable corporate management. We still have property rights in this country, a judicial system that for all its faults will protect us from government encroachments, and arguably the best system of federalism in the world. You may not trust the politicos in Washington – I sure as heck don’t – but the men and women in “Peer” provide us with a buffer. Their power is limited but thankfully we’re not facing a Hitler, Stalin, or Pol Pot in Washington.
And we’re not facing the antichrist either, as some bloggers contend. Maybe I’m wrong about that but if I am then nothing matters anyway. So you might as well attend the conference today and formulate safe ways to improve or expand your business tomorrow, or next week, or next month. Don’t wait for the economy to improve … collectively, you ARE the economy. Instead, have faith in your country and its ability to rebound. Due to its roots in a leveraged asset bubble the current recession is a formidable foe. But we’ve been through worse before, far worse in fact.
So let’s get back to work!
This time I’m really done. Thank you.
By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College
I have good news, bad news, devastating news, and hopeful news. The good news is that the recession will end. The bad news is that I can’t predict when it will do so and I don’t think anyone else can either. The devastating news is that the economy may improve for a short time before plunging again into recession. The hopeful news is that the nation’s long-term economic outlook remains very good indeed.
Thank you!
Thank you!
Just kidding. That was my opening joke. I’m sure you’d like to know how I came to those conclusions. I know the recession will end eventually because they always do. According to the National Bureau of Economic Research or NBER, the United States since 1857 has suffered through 32 recessions including the one that began in December 2007. The longest to date lasted from October 1873 until March 1879, a total of 65 months. The Great Depression proper lasted a mere 43 months, from August 1929 until March 1933, but was quite deep. Since World War II the American economy has contracted 10 times and never for more than 16 months, as in the 1973-75 and 1981-82 downturns.
Well, until the current recession that is. Fact is, recessions differ considerably in ferocity and duration due to their underlying causes. Recessions caused by small, one-off shocks, temporary inventory gluts, and unleveraged asset bubbles tend to come and go quickly. Recessions stemming from leveraged asset bubbles, by contrast, tend to be long and nasty and until last year the United States hadn’t faced one since the early 1930s.
Bubbles originate in a soapy mixture of new technology and expected future demand of unprecedented proportions. Sometimes they are puffed up by the child’s breath of cheap credit, sometimes not. By their very nature they are unstable, sparkling and glistening as they magically float upward. Then they suddenly pop, leaving only toxins behind.
If a bubble is unleveraged, if in other words buyers of the inflated asset used their own money to speculate, the cleanup is relatively easy. In China’s Yunnan province a bubble in a special type of tea called Pu’er recently burst. The local farmers’ aspirations were shattered and their cash flows crimped but their balance sheets remained intact. They complain, for example, of owning fancy automobiles that they cannot afford to put gasoline into and having to shift production to corn and rice. Because they were largely free of debt, however, they still have their farms, much improved during the boom, and can sell their fuel-less cars for cash. By the way, I don’t mean to pick on the Chinese here; American farmers did not invent the agricultural bubble – and neither did the Dutch with their tulip mania – but they have concocted more than their fair share of them. I detail an early U.S. beet sugar bubble in my book One Nation Under Debt.
In any event, what saved the farmers was that they did not have access to easy, cheap credit. Low interest rate loans on easy terms can turn run of the mill asset bubbles into dangerous leveraged ones by decreasing the total cost of assets. To borrow $10,000 for a year to buy a car at 10% simple interest will cost $1,000, raising the total cost of the car to $11,000. At 1%, the same loan will cost only $100, making the car’s total cost, excluding taxes and so forth, only $10,100. Lower total cost, in turn, raises the quantity demanded.
Interest rates affect the total cost of some assets more than others. They have very little direct effect on toothpaste, food, and other inexpensive items but they deeply influence the total cost of more expensive goods, things that people typically borrow to purchase. They have an especially powerful effect on real estate, which is relatively fixed in supply. Low interest rates bring down the total cost of owning land, increasing demand, but the supply does not change appreciably. That means prices can only go in one direction, up. The same analysis applies to real estate improvements, like houses and strip malls, although their supply will eventually increase as new construction projects are completed. Of course if interest rates increase the process reverses and real estate prices sag, all else constant.
If investors believe that interest rates will remain low for an extended period, or if they think that some new technology or change in market conditions will make an asset permanently more valuable, they begin to get very excited. They will start to borrow money to buy the asset with the sole intention of reselling it soon afterward at a profit. In other words, they increase leverage to engage in speculation. Some people call this greed but it is really just business, trying to buy low and sell high, or in the case of bubbles to buy high and sell yet higher.
What makes speculation dangerous is the leverage or borrowing part. Playing with leverage is like playing with fire. If all goes well, fire is a great friend that helps us to stay warm, cook our food, and frighten away dangerous critters. If it gets out of control, however, it can burn both speculators and their lenders and, it seems, the entire economic forest.
Speculators employ leverage to increase their returns by risking other people’s money. That is fantastic on the way up but when asset prices begin to slide, as they always eventually do, lenders get nervous and begin to ask for their money back and limit further lending. Most borrowers can repay only by selling the asset they borrowed to buy. They desperately try to unload but buyers are few because prices are no longer soaring and easy loans are no longer to be had. That realization causes a panic, a moment when everybody must sell and few can or want to buy. Prices then plummet, triggering additional calls, and yet more selling. Speculators cannot sell assets quickly enough, or for a high enough price, to repay their loans so banks and other lenders begin to suffer defaults. In turn their lenders -- other banks, depositors, holders of commercial paper -- begin to wonder if financial institutions are still creditworthy and call or restrict their lending. That is what brought down Bear Stearns, Lehman Brothers, AIG and other seemingly invincible financial giants.
Some financial economists, of the rational expectations/efficient markets ilk, argue that asset bubbles are impossible. In their models, which is to say in their minds, they are correct: speculators do not overpay for assets on the expectation of selling out to a bigger sucker and sophisticated financial institutions do not make loans to such speculators. But in the real world, bubbles clearly do occur. Another group of financial economists, the behavioralists, attribute bubbles to human irrationality. People tend to launch themselves over cliffs like legendary lemmings and to make decisions based on emotions instead of cold, hard logic. It is difficult to dispute the existence of excitable morons, even -- or should I say especially? -- on Wall Street. The efficient markets proponents counter that the presence of irrational traders does not mean that markets, which aggregate the individual decisions of many participants, will be irrational. In the limit, one rational trader will ensure proper prices.
The sanguine expectations of the efficient markets crowd, however, meet a difficult reception in many real world markets. Key to their belief that one smart uber-trader can drive prices to their rational value is the ability to “short” the asset or, in other words, to profit at the expense of investors who pay too much for it. In many markets regularly troubled by bubbles, including agricultural, real estate, and mortgage markets, shorting is impossible or at least very expensive. Proponents of efficient markets also fail to see that what is rational for corporations’ stockholders and what is rational for their hired managers can be very different things.
Regardless of their position on bubbles, most economists agree that the economy is in quite a pickle at present. The largest financial institutions lost most of their capital making bad loans of various types. That put the economy into recession, which made it difficult for the banks to recapitalize and also pressured marginal industries, like automobile manufacturing, consumer electronics retailing, and others. Unable to obtain private sector loans, companies in those industries have been going bankrupt. Additional bad loans hurt already crippled financial institutions and layoffs decrease consumption, further deepening the recession.
That is the same sort of nasty downward spiral that helped to make the Depression so depressing, culminating in Rose of Sharon Joad’s suckling of a starving man. (That, by the way, refers to the final scene in Steinbeck’s book The Grapes of Wrath, not the Henry Fonda movie version.) Thankfully for us, we have thus far avoided the worst part of the Depression, a bout of serious sustained deflation. When the prices of everything decrease month after month, quarter after quarter, and year after year, businesses find it difficult to make long term investments. Nobody wants to buy high and sell low.
Currently, prices are holding pretty steady and the economy is clearly trying to reverse course. Leading economic indicators, including initial jobless claims, new manufacturing orders, building permits, consumer sentiment, the spread between 10-year Treasuries and the federal funds rate, and the growth of the money supply have improved in recent months, in the sense of being less bad, but they are still giving signals that are far from unequivocal. Moreover, an unexpected economic shock like the resurgence of the swine flu or the failure of a major depository institution could quickly nip any tentative recovery in the bud.
If we’re lucky and no shocks strike, the rapid expansion of the Fed’s balance sheet to over $2.2 trillion will eventually stimulate economic activity. As Milton Friedman once famously pointed out, however, monetary policy works only with “long and variable lags.” In other words, nobody knows when more money will lead to more output and, again, any number of unexpected shocks could further delay recovery.
Even more disturbing, the recovery, when it comes, might be short-lived. America has suffered through at least five double-dip recessions, in 1837-39, 1890-93, 1910-13, 1929-37, and 1980-81. All stemmed from the same basic cause, government meddling. Our time, my voice, and your patience preclude a detailed examination of each of those episodes but I would like to take a few minutes to describe how the federal government snuffed the life out of the recovery that began in April 1933. By April 1937, the economy was almost back to its 1929 highs but a balanced federal budget and several unexpected increases in the reserves that the Federal Reserve required banks to hold sent it spiraling back into recession. It recovered in just 13 months this time, over a year before Hitler invaded Poland I might add, but later conflation of the two recessions in the American psyche extended the Great Depression over the entire 1930s and created the pernicious myth that Hitler and Tojo saved capitalism.
Truth is, the government’s policies not only caused the Roosevelt Recession of 1937-38, they postponed the recovery and diminished its vigor. Myths that Herbert Hoover believed in laissez faire to the contrary notwithstanding, the government actively interfered with market mechanisms in the early 1930s, prompting FDR of all people to claim that Hoover was “leading the country down the path to socialism.”
The first Hoover bailout attempt was called the Smoot-Hawley Tariff Act. Enacted in June 1930, the act imposed the highest tariffs, or taxes on imported goods, in U.S. history. It was named after the two jokers, who happened to be U.S. legislators, who concocted it. Republican Willis Hawley hailed from Oregon’s 1st Congressional District, which he had served in the House of Representatives since 1907. Ironically, before turning to politics Hawley had taught history and economics at Willamette for about 16 years. Apparently, he knew little of either subject. Ridiculously persistent legends to the contrary notwithstanding, America’s industrial revolution began late in the eighteenth century, not after the Civil War, and owed little to tariff protection. Reed Smoot was a Republican from Utah and, judging from the photographs I’ve seen of him, a total nerd. By the 1930s, however, he was a powerful nerd, having served in the Senate since 1903. He almost wasn’t allowed his seat because he was a Mormon, and an apostle of the Latter Day Saints at that. He was eventually allowed in, however, because he had only one wife and purportedly did not take the Mormon “oath of vengeance” against the U.S. government, which had treated Mormons rather roughly in the 1840s and 1850s. Whether he took the oath or not, the tariff he co-sponsored did take a terrible toll on America. Not that he was solely responsible for the economic carnage that followed. It was the entire government’s call, and it made the wrong one.
Reed Smoot and Willis Hawley got their just desserts in 1932, when they both lost re-election bids. Although many Americans thought the act would be beneficial, 1,028 economists had opposed it, as had Henry Ford, who called it “an economic stupidity,” GM director Graeme Howard, who predicted it would cause the “most severe depression ever experienced,” and investment banker Thomas W. Lamott, who termed it, and I quote: “asinine.”
In 1932, Hoover attempted yet another major bailout, this time of distressed banks, by creating the Reconstruction Finance Corporation or RFC. Unlike the tariff hike, the RFC was not outright destructive and after a rocky start may have marginally helped the recovery by speeding up the resolution of failed banks. Nevertheless, it did not stem the waves of bank failures that repeatedly shocked the economy and further decreased the all-important money supply.
Opinions regarding subsequent bailouts, generally termed “the New Deal,” were also mixed. Some economists and businesses opposed all or most of them but others, followers of John Maynard Keynes and kindred spirits, supported them. The basic notion was that the government could increase output almost at will by borrowing and spending. Government spending, proponents hoped, would stop the cycle of unemployment, default, and bank failure plaguing the economy.
Did the rash of government spending programs cooked up by the Roosevelt administration pull the economy out of recession? The timing is right: Roosevelt took office in late March 1933 and in his first 100 days he induced Congress to pass numerous spending measures. Even more spending came in subsequent years. Government deficit spending, however, was simply too small to have had much effect. The economy recovered because the money supply grew after Roosevelt devalued the dollar. That decreased real wages and real interest rates, which increased investment by making some businesses profitable again.
Some economists argue that increasing government spending cannot really help the economy, Keynes and his many minions to the contrary notwithstanding. Remember the tax rebate checks the government sent you in 2001 and 2008? What did they do for the economy, as opposed to your wallet? Exactly zero. Oh, I was happy to cash both checks and spend the manna, as I am sure you were too. And businesses were happy to serve us meals, sell us televisions, and so forth. Knowing that the windfall was temporary, however, none of them invested in new facilities or hired new employees. And most people realized that government borrowing today means higher taxes tomorrow, which of course mutes the effects of the stimulus. The rebate checks were therefore little more than a fart in a bottle. They didn’t last very long or smell very good.
So Little Orphan Annie was right: the New Deal was more political bunk than economic funk. Rather than depicting the New Deal as the economy’s savior in the mid-1930s, it’s more accurate to say that the economy managed to bounce back despite the bungling interference of the Roosevelt and Hoover administrations. That is not to say, of course, that the New Deal’s relief programs should not have been implemented. If anything, they should have been extended. Relief redistributes resources rather than increasing the size of the economy but it is the right thing to do during systemic downturns, when people are laid low through no fault of their own. Too bad the government botched many of its relief efforts by waging turf and ideology wars against state and private relief organizations like the Fraternal Order of Eagles and the nation’s schools of philanthropy.
New Deal programs that created public goods also should be immune from imputation. Public goods are things of value that the government must produce if society is to enjoy them because no individual or business would have an incentive to create them. Technically, pure public goods are non-excludable and non-rivalrous, meaning that no one can be excluded from using the good and consumption of the good by one person does not reduce its availability for others. National defense is the classic example, as is protection of life, liberty, and property more generally.
Most New Deal programs, however, did not supply public goods. Worse, they hurt the economy by unwisely allocating resources. Some of the New Deal dollars that did not merely redistribute wealth, in other words, may have actually destroyed wealth by using real resources to create goods that nobody at the time wanted for what they cost to create. To the extent that the programs used resources that would have been wasted due to the uncertain business climate, they were better than nothing. Of course the government itself helped to create, perpetuate, and even amplify the uncertainty that plagued the business environment.
The Federal Deposit Insurance Corporation or FDIC, which insured the retail deposits of solvent banks beginning in 1934, was a great boon even before it began operations because its mere announcement induced depositors to stop running on their banks. That helped to keep the money supply from disintegrating and hence was crucial to the recovery that began in April 1933. Ever since, the FDIC has effectively prevented classic bank runs, like that in It’s a Wonderful Life. It has not, however, stemmed the tide of so-called silent bank runs, where creditors simply refuse to roll over short term loans to banks. It also lulls depositors to sleep, which allows bankers to take on additional risks without fearing the wrath of depositors. The FDIC’s twin, the Federal Savings and Loan Insurance Corporation (FSLIC), was one of the key causes of the Savings and Loan crisis of the 1980s for precisely that reason. Most economists agree that aside from its initial success in stabilizing the banking system in the 1930s, the FDIC’s net contribution to the economy has been approximately zero. Due to the existence of the insurance, bank runs are less likely but bank risk taking is higher.
Given the initial effectiveness of the FDIC, it is ironic that the Roosevelt administration opposed its creation. Its intransigence led to a great compromise of dubious merit. The advocates of deposit insurance, led by Henry B. Steagall, a Democratic congressman from Alabama, joined forces with advocates of the separation of commercial from investment banking, led by Virginia Democratic Senator Carter Glass. The compromise, officially known as the Banking Act of 1933, created the FDIC and also, in a section colloquially known as Glass-Steagall, forbade banks from engaging in both investment banking activities, like issuing securities, and commercial banking activities such as accepting deposits and making loans. The major fear was that risky investment banking activities endangered the safety of deposits and hence the solvency of the insurance fund. Of course that potential problem would have been mitigated if the FDIC had charged risk-based premiums, to wit if it charged riskier banks proportionally more to insure their deposits. It would later do so but not effectively, likely because the intricacies involved boggled its staff. For a variety of reasons, government regulators have been slow to use market based signals of financial institution risk-taking.
The Gramm-Leach-Bliley Act of 1999 officially repealed the Glass-Steagall prohibition, about a decade after the Federal Reserve had rendered it a dead letter by allowing bank holding companies to acquire investment bank subsidiaries and about four decades after financial innovations and regulatory arbitrage had greatly weakened the “Chinese Wall” separating the two types of banking activity. The law never made much sense because commercial bankers who want to take big risks can do so in numerous ways regardless of their ability or inability to underwrite securities. Glass-Steagall was thus akin to trying to reduce the murder rate by banning baseball bats but allowing an open trade in assault rifles. Tellingly, few other countries adopted similar prohibitions and many actually encouraged the development of so-called universal banks that engaged in securities underwriting, loan making, and deposit taking. Some commentators blamed the Panic of 2008 on the repeal of Glass-Steagall but when pressed most admitted that they invoked the law merely as an example of the need for re-regulation. In other words, they did not know what they were talking about.
The new Securities and Exchange Commission or SEC also had a dubious impact on the U.S. financial system and economy, one that I will spare you today. Suffice it to say that someone had to take the fall for the Depression and the government was not about to blame itself or its creature, the Federal Reserve. Securities market participants were the best scapegoats because few people understood what they did but most maintained deep prejudices against them. Americans, nay all human beings, innately distrust and envy great wealth. Likely a residue of life in poor, zero sum economies, where the rich truly became so at the expense of their neighbors, our instinctive repulsion has largely been overcome by education in the rich, positive sum economies of North America, Western Europe, and East Asia. People in those places, in other words, realize that wealthy individuals and large corporations usually create new wealth, not steal existing property. In a crisis, however, people often revert to emotion or instinct and back politicians and policies that they wouldn’t under normal circumstances.
Thus emboldened, the Roosevelt administration forged ahead and created another federal bureaucracy that does little more than lull investors to sleep. Chronically short of funds, the SEC was a nearsighted and nearly toothless securities market policeman. Unfortunately, investors believed the SEC was bigger, stronger, and smarter than it actually was. So, much like the FDIC, the SEC’s biggest effect was to reduce private monitoring. Investors began to act like people who leave their doors unlocked when they vacation because they believe the town cop will watch their house and automobile as if they were his own. When they return home to all of their property, they attribute it to police vigilance rather than blind luck. If robbed, they are shocked and wonder how anything like that could ever happen.
Finally, some New Deal bailouts were simply wrongheaded, attacking the wrong problems in the right way, or methodologically flawed, attacking the right problems in the wrong way. One doesn’t kill zombies with a stake to the heart or sunlight – well, except I Am Legend zombies -- or destroy vamps with a bullet to the brain. But that didn’t stop the government from trying to support farm prices, which had dropped precipitously in the latter half of the 1920s, from $1.30 to $.44 per bushel of wheat and $113 to $29 per bale of cotton. Initially, the government’s policy was the height of economic and political folly, destroying crops in the field and six million young pigs fattening for market. The correct policy, of course, would have been for the government to buy the food with borrowed or new money and distribute it to the needy. In subsequent years, U.S. agricultural policy was made only slightly less destructive by paying farmers not to grow crops or raise livestock in the first place. Farmers gladly took animals and acres out of production, cashed their government checks, and increased yields per acre on the rest of their farms by investing more heavily in tractors, fertilizer, better seeds, and so forth. That kept output high and prices low, a fact that even cocksure Agricultural Adjustment Administration bureaucrats eventually conceded. Soon, farmers captured the AAA, turning their ostensible regulators into prisoners who did their bidding in Congress. Unsurprisingly, agricultural subsidies remain with us to this day.
Perhaps the worst of the New Deal’s bailouts was the National Industrial Recovery Act. In July 1933, Roosevelt announced the new program, noting that it was designed to increase hourly wages and keep prices up by means of the collusion of government-sanctioned cartels. To induce companies and consumers to join the effort, the administration created a Blue Eagle emblem, a spread winged raptor clutching an industrial cog in one claw and three lightening bolts in the other, over the phrase “We Do Our Part.” Roosevelt explained that “in war in the gloom of attack, soldiers wear a bright badge to be sure that comrades do not fire on comrades. Those who cooperate in this program must know each other at a glance. That bright badge is the Blue Eagle.” After the beloved president’s speech, the Blue Eagle emblem quickly gained notoriety. Hollywood hotties Martha Virginia “Toby” Wing and Frances Drake, for example, sunburned the emblem onto their backs, though of course not in blue.
Due to the government’s call for consumers to boycott firms that refused to join the NIRA, companies at first clamored to join to enjoy the right to put the eagle on their advertising and products and thus avoid their customers’ wrath. The government, however, announced the program before enough emblems were available so it had to outsource their printing to private companies. It also had to allow exempt companies, like sole proprietorships, to display the emblem so they would not be mistakenly boycotted. It allowed companies that were noncompliant to join and at first did not have a compliance division. Even after its establishment, the compliance division took only 564 cases to court out of the 155,102 complaints it received. Soon, the Lincoln, Nebraska compliance board quit in disgust. Only about a third of the businesses under its jurisdiction sporting the Blue Eagle faced complaints but it lacked the resources to force the businesses to comply or to give up their emblems. Soon after, most of the Lowell, Massachusetts board quit for the same reasons.
The NIRA’s laughable execution was surpassed only by the inanely insane economic theory underlying the program. The poor little eagle and the program it symbolized were doomed from the start. As noted previously, the biggest problem facing the economy was that wages were already too high. Driving them higher would simply create more unemployment, a far cry from Roosevelt’s claim that the Blue Eagle was a “badge of honor … in the great summer offensive against unemployment.” The government’s reasoning was backwards. It believed that high wages created prosperity but in reality, as banker Albert Wiggin noted, “it is not true that high wages make for prosperity. Instead, prosperity makes high wages.” Moreover, the price level was almost entirely a function of the money supply, not of market structure. Instead of supporting prices across the board, in other words, the NIRA’s cartels merely caused relative prices to change. They also injured consumers dull witted or patriotic enough to shop only where the Blue Eagle kept prices of specific goods artificially high.
Thankfully, most American consumers and businesses were not so daft. Especially given the program’s well known enforcement difficulties, the public soon felt justified ignoring emblems and seeking the best bargains. After the initial flurry of activity, the Blue Eagle died quickly and painlessly. The Supreme Court drove the final nails into its little coffin by declaring it unconstitutional.
Auto manufacturer Henry Ford was the first major public critic of the NIRA, refusing to sign the industry code in August although his company had long since far exceeded the guidelines. Ford was an advocate of efficiency wages, or paying workers extremely well but expecting much from them in return, so he already paid much more than the guideline minimum wage. Apparently, however, he disliked the code’s recognition of workers’ right to unionize. He called the eagle a “Roosevelt buzzard” and ignored a cartoon showing him cutting off his own nose with a pair of scissors labeled “non-participation.” Tellingly, the government continued to buy his company’s automobiles anyway. American citizens must have followed their Uncle Sam because Ford lost no market share during the Blue Eagle’s brief life. Smaller fry began to take heart and stand up to the big blue buzzard too. In Hagerstown, Maryland, for example, gasoline station owner Herman Mills publicly fought the NIRA, vowing to take his case all the way to the Supreme Court on the grounds that it eliminated legitimate competition.
The government was astute enough to sidestep Mr. Mills but soon fell afoul the Schechter Brothers, purveyors of kosher chickens in Brooklyn. They bought the birds wholesale, alive, and kept them alive until a customer picked one for dinner, at which point a shochtim would ritually slaughter it if he believed it fit for human consumption. The brothers were also fierce competitors, eager to hold their own against larger rivals by cutting prices when necessary. Those practices, however, ran contrary to the NIRA codes and unusually vigilant inspectors let the Schechters know it. Eventually, the NIRA dragged them into court. Fearful that their very Jewishness was on trial, the chicken men fought like the dickens. They made it to the Supreme Court and won by showing the codes were as un-American as they were unconstitutional.
The short of all this is that another major threat to recovery is the Obama administration and the Democratically-controlled Congress. An attempt to reform healthcare, Social Security, or the tax system could energize our nation’s latent entrepreneurial talents or it could turn into our generation’s NIRA. Regulatory reformation could be salutary but could also spark a “strike of capital” the likes of which have not been seen since the 1930s. Massive fiscal stimulus added to aggressive money supply growth may spur growth but could just as easily unleash inflationary pressures too intense for the Fed to combat.
The biggest threat of all, though, may be something much more prosaic, UNCERTAINTY. We don’t fear fear itself, we sweat what schemes our politicians might concoct to win the next election. The natural response to uncertainty is timidity. Better to hold onto what one already has than to aim for the stars, most people conclude. That’s exactly what makes uncertainty so economically dangerous. I’m going to counter that, however, and propose that small business owners in Sioux Falls do not have as much to worry about as they may think. Where ever governments adequately protect life, liberty, and property economies trend upward over time. America’s long-term prosperity rests on the solid foundation of relatively non-predatory government, a modern financial system, open access entrepreneurship, and capable corporate management. We still have property rights in this country, a judicial system that for all its faults will protect us from government encroachments, and arguably the best system of federalism in the world. You may not trust the politicos in Washington – I sure as heck don’t – but the men and women in “Peer” provide us with a buffer. Their power is limited but thankfully we’re not facing a Hitler, Stalin, or Pol Pot in Washington.
And we’re not facing the antichrist either, as some bloggers contend. Maybe I’m wrong about that but if I am then nothing matters anyway. So you might as well attend the conference today and formulate safe ways to improve or expand your business tomorrow, or next week, or next month. Don’t wait for the economy to improve … collectively, you ARE the economy. Instead, have faith in your country and its ability to rebound. Due to its roots in a leveraged asset bubble the current recession is a formidable foe. But we’ve been through worse before, far worse in fact.
So let’s get back to work!
This time I’m really done. Thank you.
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