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By George P. Brockway, originally published August 10, 1998

1998-8-10 A Fortunate Experiment titleONE OF THE mysteries of life in the United States today is why we are not in the midst of a raging inflation, a depressing recession, or both. The answer, though, is staring us in the face.

For the past 30 years, hard-nosed devotion to the theory of a natural rate of unemployment (a frequent target in this space) has been a prerequisite for appointment to the economics faculties of our major colleges and universities. Hence the doctrine has not only been taught at those institutions, it has been accepted respectfully in editorial rooms and enthusiastically in board rooms across the land.

The theory, of course, claims that if too few people are unemployed, inflation will accelerate rapidly, and the only way to slow it down is to raise and keep raising the interest rate. Chairman Alan Greenspan of the Federal Reserve says he does not altogether agree with the theory. He keeps talking, however, about raising the interest rate on some unspecified occasion in the future.

Yet today unemployment is lower than it has been for decades, while inflation (especially if you figure it as the Boskin Commission did a couple of years ago) has been practically invisible for at least four years. Moreover, during the same period the interest rate has been relatively stable. If mainstream economic theory were sound, the world would not move in this way.

Nevertheless, the world does move in this way and, I make bold to predict, will continue to do so until the Baby Boomers start retiring in substantial numbers, at which point the present stock market boom will come to an end. I hasten to explain that I agree with Mr. Greenspan that the market is overenthusiastic, overpriced and in danger of collapsing. But I also think that as long as the Baby Boomers keep pouring their savings into it, and as long as the interest rate does not go up, the market will continue to rise in a classic example of the “law” of supply and demand.

The situation is beautifully ironic. The market is all the bad and dangerous things Mr. Greenspan says, and he could stop them by jumping the interest rate-as the Reserve did in 1978 (not to mention 1929). But the Federal Reserve Board does not dare to act. Every three months the Reserve Board meets and the bankers anguish over their belief that inflation must be around the comer. Their terror, though, is that if they raise the interest rate to stop the inflation no one else can see, they will be remembered for having precipitated one of the great economic crashes of all time[1].

So the booming stock market that concerns Mr. Greenspan has incidentally forced the Reserve into an unnoticed experiment that lays bare the fallacies of conventional interest rate policy. If the economics profession can bring itself to pay attention to what is happening in this accidental experiment, we may be spared further exposure to the barbarous theory of a natural rate of unemployment.

Even without the experiment, the Reserve should have learned a few of the effects of raising the interest rate-at least five bad effects and one claimed to be good. The first thing it does is cause a drop in investment. By investment I don’t mean speculating in mutual stock funds and derivatives; I mean helping to finance the organization, continuation or expansion of companies that will produce goods and services to be sold in the marketplace and enjoyed by everyone. In the capitalist system, almost all investment depends directly or indirectly on credit, that is to say, borrowing.

Let’s look at the record. In the early 1960s, when the Federal funds rate averaged about 2.7 per cent, annual investment ran over 21 per cent of the gross domestic product. Today the Federal funds rate is at 5.5 per cent, and investment is only 16 per cent of GDP in an economy that, according to Mr. Greenspan’s recent Congressional testimony, is one of the best he has seen.

Second, an increase in the interest rate favors established and big businesses over small and start-up businesses. Since the latter provide most of the new jobs, any impediment to new business is an additional handicap for the poor, as well as for middle-class would-be entrepreneurs. Indeed, the percentage of American families living below the poverty line is higher in this economy that is one of the best Mr. Greenspan has seen than it was 25 years ago.

The third thing raising the interest rate does is raise the unemployment rate. According to conventional theory this cruel absurdity is a good thing and the way things are supposed to be. Howsoever that may be, the unemployment rate today is 4.5 per cent, or lower than it has been since 1969. In the quarter century before 1969, though, there were no fewer than 12 years with a lower rate of unemployment than the 4.5 per cent of this economy that is one of the best Mr. Greenspan has seen.

Fourth, raising the interest rate raises Federal, state, local, and school taxes, as the recent hoo-ha over the deficit has taught us all.

Fifth, raising the interest rate is a principal way for the rich to become richer. Mr. Greenspan has more than once cited the widening gap between the rich and the poor as dangerous to our democracy. He has protested that it is a problem for Congress, not for him. But every interest payment is a transfer to the haves from the have-nots. To be sure, not everyone who borrows is down and out. Still, as a general rule, people who lend money are richer than those who borrow[2].

The shift from 4 per cent (or lower) FHA and VA mortgages of 50 years ago to today’s “low” rate of 7 or 7.5 per cent has been a gift of billions (if not trillions) of dollars to mortgagees and a corresponding drain on mortgagers. No wonder the rate of home ownership has fallen in this economy that is one of the best Mr. Greenspan has seen.

Now, I am not saying that the interest rate is solely responsible for the rich becoming richer and the poor poorer, and I am emphatically not against borrowing and lending and the charging of interest. I am saying that interest always has the immediate effect of taking from the poor and giving to the rich; that therefore the rich are richer and the poor poorer; that increasing the interest rate increases this effect; that the present rate does not improve matters (except in relation to the rates Mr. Greenspan’s predecessors gloried in); and that an unnecessary uncertainty is introduced into the economy by Mr. Greenspan’s unwillingness to specify conditions that would prompt him to raise the rates further.

THAT’S the bad news-or some of it-about raising the interest rate. The good news-or what’s supposed to be good-is that raising the interest rate stops inflation. Well, no one can say it quite does that, because since World War II the Consumer Price Index has gone up in every year except 1955 (and that year the prime interest rate was lower than in any subsequent year) [3].

But there have been 10 surges of the economy since World War II, and except for the present surge, every one of them was seen by economists as threatening to spiral into inflation and snubbed down by the Federal Reserve Board. In short, its raising the interest rate reduced the investment rate, increased the bankruptcy rate of businesses, increased the poverty rate, increased the cost of living, raised taxes, made the rich richer, caused nine recessions-and thus slowed the rate of inflation.

Those consequences were not unpredictable. They are inherent in the nature of money, something conventional economics has archaic ideas about. Money has no price (there is no point in paying a dollar for a dollar bill). What money has is power-purchasing power and borrowing power. The piece of greenbacked paper you have in your pocket has no practical use as paper. It is an IOU of the state, was issued by the government in payment for some goods or services, and will be accepted by the government in payment of some tax or fee. It is accepted in private transactions because there are always, somewhere in the economy, citizens who need government IOUs to pay taxes or government fees.

You may borrow the use of someone else’s money by paying a fee (interest), which is a cost to you and has the effect of diminishing the amount you can borrow. The relation of money to the fee for its use is similar to the relation of the price of a government bond (also an IOU) to the rate of interest. In both cases, the higher the interest rate, the lower the purchasing power (the effect on borrowing power, essential for investment, is even more severe).

When one speaks of low purchasing power, it is the same as speaking of a high general price level. By upping the interest rate, the Federal Reserve Board reduces everyone’s purchasing power and thus increases the general price level.

Raising the interest rate does not cure inflation; it causes it. (This, you may remember, is Brockway’s Law Number Two, first proclaimed here in the issue of January 9, 1989.) Raising the interest rate gives the appearance of stopping inflation because, on the supply side, it increases the costs of operating a business, discourages expansion and leads to downsizing, which, in turn, reduces wages and thereby contracts the demand side. In other words, raising the interest rate tends to bring about a recession.

That is the way all threats of inflation have been contained since World War II -with a single exception, the present one. This time the Federal Reserve Board has refrained from raising the interest rate, as its governors would normally be inclined to.

The current stock market boom has accidentally forced upon us an economic experiment of world shaking possibilities. We are finding that holding the interest rate steady does not cause inflation, even when the unemployment rate steadily falls[4]. All the dismal prophecies of a natural rate of unemployment have proved false. Also proved false is the immoral claim that a decent minimum wage causes unemployment.

With such empirical results in hand, we may be emboldened to take the next step and discover that lowering the interest rate can lower the price level, increase productive enterprise, and start the long task of healing the suppurating wound in our society that gapes between the rich and the poor.

Do we dare?

The New Leader

[1] Ed –  this experiment has been repeated during the Obama administration when the Fed under Bernanke and now Yellen kept interest rates low whilst talking on end about raising them

[2] Ed – on this fifth factor, despite low interest rates in the Obama years the separation continues.  Just speculatin’, but the current economy is fully “globalized” and has no Glass-Steagall.

[3] Ed – current tables add only one other year, 2009, the deepest year of the Great Recession

[4] Ed – as has happened during the Obama Administration

By George P. Brockway, originally published May 4, 1998

1998-5-4 Learning From Japan titleTHE ECONOMICS profession and the military are similar in many ways, but they differ in one important respect. Generals are notorious for planning and training for the last war, while economists, who do not believe in history, have only one basic prescription for whatever problem may befall.

I don’t mean economists deny that Caesar crossed the Rubicon, or that Columbus sailed the ocean blue, or that Paul Revere went for a ride. What they deny is that economics was any different in those years from what it is today or will be tomorrow. They recognize, to be sure, that people in prior eras had different ideas concerning the economy, but they regard these ideas as wrong or irrelevant and not worth bothering about. They note that the laws of physics and chemistry and other such proper sciences are understood to have worked in the days of Aristotle whether he knew it or not, and assert that the same is true for the laws of economics- which, they claim, were not properly formulated until a half century ago, or after the death of John Maynard Keynes.

As a consequence, Japan is now having a rough time. We are likely to have a rough time, too, if we don’t watch out.

At the end of the Good War, General MacArthur explained to the chastened Japanese that it was not polite to steal things from other countries, and that in the future they would have to make or buy whatever they wanted. Economists pointed out to them that in order to buy things from foreign countries they would have to sell things to foreigners. So they set to work to export textiles (the United States had sent warships under Commodore Matthew Perry in search of silk back in 1854), but soon decided to put what they had learned in the Good War to good use.

One important lesson they had learned was how to organize themselves. Everyone was prepared to make sacrifices. Since their land was not rich in resources (it especially lacked oil), they did not waste time and energy on producing items for local consumption and pleasure. Even their captains of industry led relatively modest lives-far more modest than those of their conquerors. As the country gradually recovered, everyone continued to live unpretentiously, and to save famously. Japanese saving became proverbial, the envy of Wall Street and MIT economists.

In fewer than 20 years they supplanted the West Germans as the wonder workers of the postwar world. Japanese radios and television sets took over the American market. Then came a great stroke of luck. The OPEC inflation and oil embargo of the 1970s hit the United States just as the Japanese were trying their compact and subcompact cars on the American market. Ford and General Motors and Chrysler relied on earlier market research indicating a strong American preference for long, heavy, powerful, chrome-encrusted gas-guzzlers. Recent experience has shown the market research was basically not far wrong[1], but the tiny Japanese cars were immediate hits, and their agile manufacturers have not lost their share of the American market.

For another 20 years Japan’s foreign trade balance grew, and still the country maintained its-parsimonious domestic life. To some extent the parsimony was cultural, but in any event, it was enforced.

We are so imbued with Ben Franklin’s ethics of a penny saved equaling a penny earned that we may mistakenly imagine Japan is the second coming of Tocqueville’s America. Indeed, it is not. Bribery of government officials and extortion by government officials are commonplace. Ordinary business is lubricated by expense accounts that put American extravagances to shame. Furthermore, the class distinctions are so strong that there is little protest when the cost of living (not to be confused with the rate of inflation) puts many conveniences and amenities beyond the reach of ordinary citizens. Japanese cameras are notoriously more expensive in Tokyo than in New York[2].

Those who read this column in the issue of June 14, 1982 (16 years ago, I ask you to remark), learned then that Japan was far from the ideal society being described by the Western business press. In particular, the “lifetime employment” the press continues to talk about covers only workers in the largest companies (less than 30 per cent of the total employment in the automobile business) and “runs only to age 55, whereupon the worker is either demoted, farmed out to a supplier of the giant firm, or turned loose with a couple of years’ severance pay. In each case he faces old age without a pension.” Although women were 36 per cent of the Japanese work force, they had none of the foregoing perks.

I went on to explain that “the Japanese economy is hierarchical in an idiosyncratic way.” Operations that in the U.S. would be performed by divisions of a company are performed in Japan by satellite companies that are technically independent but actually at the mercy of the giant firms. As a result, the employees of the satellite firms are paid low wages and are subject to sudden layoff and dismissal.

The vaunted “productivity” of Japanese automobile companies came from dividing the value of the finished cars by the number of employees of the major companies, excluding those of the parts suppliers[3]. “In spite of all of Japan’s ‘sunrise’ industries in steel and shipbuilding and textiles and electronics and optics as well as in automobiles, the Japanese GNP per capita is still well below ours.”

I also noted: “As Gus Tyler has shown (in ‘The Politics of Productivity,’ NL, March 22,1982), the notion that the Japanese are ‘catching up’ is a statistical flim-flam.”

In short, some Japanese may live abstemiously because of their upbringing; some may live abstemiously because they have to; and some may live abstemiously because consumption is discouraged in other ways. Jean-Baptiste Say, who wrote, “It is the aim of good government to encourage production and of bad government to encourage consumption,” would have loved modern Japan.

The trouble with good government as defined by Say is that you soon have more money than you know what to do with. The citizens have their little nest eggs, and the big businesses have their big profits, and the government has an enormous “favorable” balance of trade. Modern economists nod their heads approvingly because exports are a positive factor in the Gross National Product, while imports are a negative factor. Nevertheless, this is not an unmixed blessing.

Japan became (and remains) very rich by almost any definition; yet despite its riches, the economy began to go sour with the worldwide recession that set in after the Gulf War. In fact, Japan’s success in exporting all over the world led to its present weakness. Building its economy completely on the world market, Japan necessarily faltered when the world market faltered.

At this point, a feature of the Japanese economy that has captured the admiration of American observers came into play. Japanese banks, which are not restricted and regulated the way American banking is, naturally became the depository of industry’s enormous profits. Lists of the 10 or 20 largest financial institutions in the world were therefore dominated by Japanese banks. American bankers were (and are) envious of how intertwined giant industries and giant banks were. Banks owned and speculated in common stocks and real estate, and thus owned industrial corporations. The latter owned bank stocks and speculated in them. From time to time the central bank joined in the fun.

As world trade languished, and as Japanese forays in foreign investment from Radio City in New York to the Pebble Beach Golf Course[4] in California proved disappointing, bankers and indeed the whole of the Japanese economy devoted all available wit and energy and money to speculating in domestic securities and real estate. The stock market shot up faster and farther than Wall Street has ever managed, and the newspapers were filled with stories of lots 10 feet square in central Tokyo selling for a million dollars. Memberships in fashionable golf clubs also were said to cost a million dollars. Besides playing the markets for their own account, bankers lent vast sums to other high rollers. Speculation spilled over to Korea and bubbled around the Pacific rim.

THE HOME BUBBLES burst first, years before the current debacle in Southeast Asia. Japan’s economy has been essentially flat for most of the present decade.

Economists know what to do in such situations: increase saving, control consumption, raise the interest rate, cut taxes, balance the budget, and deregulate. As we have seen, however, Japan was already very much the sort of state advocated by Jean-Baptiste Say.

At the same time there were puzzling differences in details. Unemployment remained well under 3 per cent, yet inflation was close to zero (a situation similar to the one in the United States that is currently bewildering the Federal Reserve Board). The interest rate was below 2 per cent-as it had been in America in the decade ending in 1951-yet there was so much money around that raising the rate proved to be difficult. The regulations that the U.S. most objected to were those that made imports difficult and hence restrained consumption.

Well, it’s a long story and includes political plots and subplots and dark tales of gangsters (for some reason not known as the Japanese Mafia), but here I merely want to mention one detail. Evidently to appease sternly anti consumption economists, Japan introduced a national sales tax a couple of years ago. The latest “reform” package included extensive corporate and personal income tax cuts, but the sales tax was left intact.

There is, I think, very little chance that Japan will recover from its extended stagnation without a fundamental change of policy. Japan had a brilliant postwar run from destruction and demoralization to the second largest economy in the world. As we observed at the beginning, modern economics has a one-track mind, and Japan followed it. The economic advice that enabled the country to achieve riches is now hampering the recovery. It is as successful a supply-side economy as the modern world has seen, and as such its difficulties should be a warning to the United States.

A one-sided economy is unjust and, in the end, is inefficient. Adam Smith was a true citizen of the Enlightenment. He wrote, “Consumption is the sole end and purpose of all production, and the interest of the producer ought to be attended to only as far as it may be necessary for promoting that of the consumer.”

Keynes had a broader understanding of the needs and purposes of modern life. He wrote, “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” Japan came close to correcting the first fault, and we are nearer to it than we have been in modern times. But Japan has overlooked the second fault and is checkmated, and we are increasingly in danger of the same fate.

The New Leader

[1] Ed:  An example of what Steve Jobs, among others, hated about “market research” in that it echoed what people already knew about cars not what was possible about cars…

[2] Ed: “Yodobashi Camera is two blocks south of the Kamiyachō station on the Hibiya subway line.  Yodobashi Camera means BIG savings!”

[3] Ed:  Note that this is exactly paralleled in the US practice of using outsourcing to reduce headcount vs revenue thus presenting productivity gain by not counting the now, outsourced, jobs.

[4] Ed:  A great place to shoot 79 by playing the last 5 holes in one under par…

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