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Originally published December 24, 1984

 

 

 

 

 

 

 

 

 

 

 

 

IN A RECENT issue of the Wall Street JournalPeter F. Drucker, the most prolific authority on the modern corporation, made an impassioned case against unfriendly takeovers, suggested some ways of inhibiting them, and concluded that “none of the policies we are likely to adopt will solve the basic problem, the one created by the shift in voting power from ‘owners’ to ‘fiduciaries.‘” Drucker has worried about this problem for some time. In so doing, he pursues, perhaps unwittingly, an attack on the way much, perhaps most, business has been done in this country since the invention of the limited liability corporation.

The fiduciaries troubling Drucker are the trustees of pension funds and (though he does not mention them) of charitable endowments, churches, foundations, universities, and private trust funds generally. He estimates that pension funds alone control between one third and one half of the stock of our great corporations. And these trustees have, as he says, “a legal duty to accept whatever gives their beneficiaries the highest immediate return.”

The courts, it must be sadly recognized, will always look with favor on accepting the highest immediate return, because this is in accordance with the antediluvian economic notions they are possessed by. At least since Adam Smith, the actors in the economic drama have been supposed to seek their own gain and to be led as by an invisible hand to achieve the social end of a wealthy nation. In fact, the managers of mutual funds, whose obvious interest is to maximize their gains, are acknowledged by Drucker to vote for takeovers exactly as do the trustees of pension funds. On the takeover question, legal theory and business practice are congruent.

Nevertheless, Drucker sees in “the takeover wave that is engulfing American industry” a threat not only to the companies being raided but also to the companies used as vehicles of the raids. Nor is this all. The ever-present danger of a raid forces managements to concentrate their attention on the next quarter’s bottom line, even though long-range development is thus sacrificed to short term profits. This tunnel vision, Drucker holds, is a leading cause of the decline of America’s competitive strength. In addition, it results in the demoralization of companies’ employees, “from senior middle managers down to the rank and file in the office or [on the] factory floor.” Conservatively managed companies, which have prudently written down their assets to the lowest reasonable figure, are especially attractive takeover targets.

If things are as bad as Drucker says (and they are), something should be done about it. He suggests that the Comptroller of the Currency might forbid banks to lend money for unfriendly takeovers. For my part, in the general interest of inhibiting speculation I would forbid lending money to facilitate the purchase of any securities, I would have the Federal Reserve Board close down margin accounts, and I would try to persuade the Congress to end the special tax treatment of capital gains.

But these measures, desirable though they are, do not meet Drucker’s fundamental concern: the erosion of the idea of property. He would deal with that by reviving the ancient Roman understanding of property. The Romans, he says, held that ownership entailed a responsibility to the thing owned. A farmer must not mistreat his land. A workman must not mistreat his tools. Even a slave master must not mistreat his slaves.

In their turn, it may be added, the Church Fathers were throughout careful to balance rights with duties, and that evenhandedness is intellectually very appealing. Similarly, the standard picture of the entrepreneur of the early Industrial Revolution is emotionally very appealing. He was celebrated by Joseph A. Schumpeter as the man who gets things done. Even John Maynard Keynes noted that” if human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.”

The classical entrepreneur defined himself through his enterprise. He was a textile manufacturer, a dry goods merchant, a railroad man. But to be a conglomerate person or a holder of a diversified portfolio is to be nobody in particular, with no commitment to anything except the bottom line – the bottom line being, indeed, the real reason for the conglomerate or the portfolio.

Today the typical corporation is itself the entrepreneur. Regardless of the occasional brilliance and frequent flamboyance of its managers, it is a public corporation. The profits (or losses) go to the stockholders, who own it. They, moreover, and they alone, have the right to sell the corporation or any part of it and to take for themselves the entire net proceeds of the sale. Yet as everyone knows, in reality the stockholders have nothing to do with the corporation beyond endorsing dividend checks and occasionally signing proxies, and this indifference is particularly true of the individual stockholders, whom Drucker in the end mistakenly celebrates. In contrast, fiduciaries and mutual-fund managers are likely at the minimum to have studied the quarterly statements and annual reports.

Not only do the stockholders have practically nothing to do with the corporation, most of them never wanted to have anything to do with it. They merely had some money and were eager to place it where it would be reasonably liquid and have a chance of returning something more than bank interest. The 19th-century invention of the limited liability company was a blessing for such people, and the blessing was magnified by the development of efficient securities markets. Since, with negligible exceptions, shares are” fully paid and nonassessable,” those who hold them do not have to worry about the company’s debts or legal involvements, or fear the loss of more than they paid for the stock. Because they can sell out at any time, they need not fuss either about providing alternatives to company policies they find dangerous or unsatisfactory.

The owners of a limited liability corporation accept no responsibility. They would not have become involved if responsibility had been expected of them. How could they have known that the gasoline tank of the Pinto was unsafely designed? How could they have known that DES might cause cancer? How could they have known that exposure to asbestos could lead to leukemia 20 years later? Assuming there was some way knowledge of this kind could be made available to stockholders, it still would be impossible for individuals holding a few shares or even thousands of shares to participate effectively in the daily operations of Ford or Lilly or Johns Manville. On the other side, the managements of those companies would claim they could not operate with participatory ownership. Apart from the confusion that would result, they could not then protect trade secrets (whatever these may be).

HAVING no responsibility other than to the thickness of their pocketbooks, individual stockholders will do what is necessary to get the highest immediate return precisely as fiduciaries and mutual- fund managers do. Thus they will put pressure on brokers to find them companies (new or old) that will bring quick returns; brokers will put pressure on investment bankers to float the issues of such companies; investment bankers will put pressure on commercial bankers to give priority to the needs of such companies; and all pressure will be brought to bear on the management of every public company to do whatever it can to increase the bottom line.

There you have the triumph of finance over enterprise. In these circumstances, loyalty is, as Drucker observes, comprehensively destroyed. No one is or can afford to be loyal to the enterprise – not the owners, not the fiduciaries, not the financiers, not the management, not the work force. Nor are owners, fiduciaries, financiers, managers, or workers encouraged to be loyal to each other. This atomization of concern is doubtless a major cause of the widely deplored decline in standards of workmanship and service. It is certainly a major cause of increased speculation on Wall Street.

The public consequences of atomization are matched by private consequences, whose severity cannot be overemphasized. Loyalty is one of the fundamental virtues; Josiah Royce held it to be the fundamental virtue. Deprive men and women of the opportunity for loyalty, and you shrivel their souls. Encourage them to be disloyal, and you corrupt them.  Cynicism cannot cure itself; it must be surprised – happily by joy, unhappily by catastrophe. The damned are those who are not surprised.

We find ourselves in danger of this damnation because of the success of the limited liability corporation and the efficiency of today’s security markets. Drucker would cure our cynicism by barring pension funds – another successful idea with unexpected consequences – from owning shares in corporations. But what is true in law of the trustees of pension funds is equally true of the trustees of eleemosynary institutions. And it is true in practice of practically each individual stockholder as well as of the managers of mutual funds. All of these people are – in business practice and legal theory – interested only in their own gain. None – in fact or in theory – has a responsibility to the corporation that happens to be, for the moment, their property.

Who, then, is left? Who in the modern public corporation is willing and able to accept duties to balance the rights of ownership? No one. The stockholders assert the rights of ownership but accept no duties. The workers, including the managers, have no ownership rights and reasonably shirk the duties that might balance those rights. Financiers, fiduciaries, brokers, bankers, and speculators are totally irresponsible. What is to be done? I will address that question in my next column.

The New Leader

Originally published November 26, 1984

I SUPPOSE I should say something about Secretary of the Treasury Donald T. Regan‘s recent Federal tax simplification proposals. As it happened, I was vacationing in Florida when they were announced and for a couple of weeks thereafter, so my initial information was limited to the local newspaper’s reports and the charismatic pronouncements of NBC’s Tom Brokaw.

The story filtering through to me and my neighbors was sufficiently vague on the interest-expense question to allow me to hope that one of my private ideas had a chance of becoming public law. It seemed that interest expense (with the exception of that on a primary-residence mortgage) would no longer be deductible. This certainly exercised the Sunbelt real estate operatives. It seemed, too, that the change would cover the interest expenses of businesses as well as of individuals. The latter, I have since discovered, is not the case. But I was briefly delighted for the following reasons, which I now offer in the event anyone asks you how the law should be revised.

Contrary to general opinion, the interest-expense deduction works mostly for the benefit of people with money to lend. It does nothing much for those with the need to borrow – especially not for those in the lower tax brackets. The first fact to bear in mind is that the interest rate is in one respect like other prices: It can’t go higher than the market will bear. You can’t get blood from a stone. If lenders attempt to set the rates too high, they will be left with idle money on their hands. If they do nothing with that money, they will be like the unfaithful servant in the Parable of the Talents. To get their cash out and working, they must lower the rates to levels that businesses and individuals are able and willing to pay.

Although borrowers are subject to euphoria, businessmen are restrained by the necessity to make a profit, or at the minimum to make ends meet. For some months now, despite the well -advertised recovery, profit rates have been falling. And so have interest rates. The connection between the two is indirect, not direct. Interest rates have been coming down partly because the Federal Reserve Board has slightly relaxed its control of the money supply, but mainly because there has been a declining demand for loans. Many businesses have not been pursuing loans for the simple reason that business isn’t good enough for them to afford the rates asked.

The second fact is that the corporate tax deduction for interest expense cuts the cost of business borrowing roughly in half, at least for the bigger borrowers. In other words, at the present time some businesses are able and willing to borrow money effectively costing them, say, 6 per cent, not the 10.75 per cent (or a point or two more) they pay their friendly bankers before taxes. It is consequently reasonable to foresee that, if the interest-expense deduction were abolished, the demand for loans at 10.75 per cent would truly plummet, callable bonds would be called, refinanceable loans would be refinanced, lenders would be drowning in money to lend, and the interest rate would have to drop until solid ground was reached again. For various reasons (including, we may be sure, inappropriate reactions of the Federal Reserve Board), the rate would probably not fall quite to the present effective rate of 6 per cent. Nevertheless, observe the outcome: Abolition of the interest-expense deduction would leave borrowers about where they were, while the take of lenders would be cut almost in half. To repeat for emphasis, the interest-expense deduction mainly subsidizes those with money to lend, not those eager to put it to work[1].

Obviously, introduction of the change in a hurry would hurt many individuals, businesses and banks. The suffering of most individuals and businesses would be assuaged by the promised reductions in the tax rates, but the crisis in banking might be acute. Don’t get me wrong.  If it were not for possible damage to the economy (and this could be mitigated by phasing in the change-over two or three years), I could regard a pit full of squirming bankers with a fair show of equanimity. My point has nothing to do with my feelings for bankers, some of whom are my best friends (though not always when I need them). My point is that the interest-expense deduction makes usurious rates seem tolerable. It is a prop holding up those rates for the enrichment of money lenders. I therefore thought Regan was absolutely right in trying (as I mistakenly understood it) to knock out this deduction.

Of course, I feared there wasn’t a prayer that he would prevail, despite the fact that everyone -everyone in the whole wide world (except for big lenders) – is longing for interest rates to come down. Last year, even with a more docile Congress and strong support from a not-yet-lame-duck President, the Secretary couldn’t get the banks to withhold taxes on interest – a measure that would have hurt only cheaters and the people who encourage cheating.

ALSO DOOMED (I thought, and still think) is Regan’s proposal to get a rein on the charity deduction. The churches and the colleges, the foundations and the funds, the museums and the libraries, the clinics and the think tanks – all the eleemosynary institutions in the land – are up in arms about this one. It is very sad and disillusioning. Many undoubtedly worthy, dedicated and, yes, necessary citizens have been tricked by the issue into making fools or hypocrites of themselves. Two pitiable examples turned up in the Florida paper I read.

An official of the local United Way observed that the median income thereabouts is $17,000, and he worried that the vast majority of its contributors would not be able to continue their generosity if the law were changed. The United Way does its supporters an injustice. For it is surely true that practically all taxpayers with a gross income of $17,000 take the standard deduction and make most of their contributions because they want to, not because it is a way of diddling the tax collector.

A local parson had a clearer under-standing of finance – and of his parishioners. He argued that Secretary Regan’s proposal to cut the top tax rate from 50 to 35 per cent would greatly reduce the value of the charity deduction to those in the top bracket. He is certainly right. Rich people are in (if the parson will forgive me) a hell of a fix. We’ve been told since New Deal days that high taxes sap their incentive to work and save. Now we discover that low taxes sap their incentive to be charitable. Of such is the Kingdom of Heaven.

The local Salvation Army made a more responsible observation. It noted that the talked – about budget cuts (a.k.a. “freeze”) in welfare programs would increase the calls on private charity, while the tax changes would reduce contributions. Indeed, one wonders (to introduce a little of the spice of argumentum ad hominem into the discussion) what the President himself might be expected to do in these circumstances. You will remember that the Treasury proposes to count only contributions in excess of 2 per cent of adjusted gross income. You will also remember that the President’s tax returns have rarely (if ever) shown contributions up to or much beyond that level. Add to this the fact that he promises to cut his own pay, and I am led to suspect that his favorite charities won’t be able to count on him (and on many like him) as they have in the past.

There is no doubt that the charity deduction is grossly abused (mostly in ways I haven’t discussed). There is little doubt that Secretary Regan’s modest proposals for its reform will fail. Then we have the matter of no longer allowing the Federal deduction for state and local taxes. Here I think the Secretary has his best chance of succeeding.

The proposal has drawn fire from New York’s Governor, Mario Cuomo, as well as from both of its Senators, Democrat Daniel P. Moynihan and Republican Alfonse D’ Amato, and it is easy to rally the rest of the country in opposition to the Empire State. I’m opposed to this part of Regan’s plan, too, however. As I have argued in this space (“Eliminating Frictional Unemployment,” NL, March 7, 1983), the most rational approach would make state and local taxes a 100 per cent offset against Federal taxes. In brief, that would put an end to the game of beggar my neighbor states now play as they try to lure corporations away from each other with inadequate taxes. No chance.

Perhaps the most important single change advanced by the Treasury would eliminate most of the corporation investment credits and rapid-depreciation dodges. These allow companies like General Electric to have profits in the billions and pay no income tax at all, but instead receive rebates of a hundred million or more. The change was not deemed worth mentioning by my Florida paper. Maybe the editor foresaw that lobbyists would not have much trouble explaining to the President that his major campaign contributors would hardly be amused.

THE FOREGOING are only the principal ways the Secretary of the Treasury has gotten people mad at him. An indicator of the wrath he has incurred is that as staunch an Administration ideologue as William F. Buckley Jr. finds the program a disaster. This being the case, why did Regan make his irritating tax proposals?

In answer, I’ll venture the guess that he is playing the game perfectly straight, yet that the result will neutralize the Democrats. For the Regan plan is very close to (actually more liberal than) the one put together by Senator Bill Bradley of New Jersey and Representative Richard Gephardt of Missouri (see “A Cautionary Tale of Tax Reform,” NL, January 23), which has wide verbal support, especially among neoliberals. It would thus seem that with a substantial majority of Republicans and a scattering of Democrats, a melding of the plans – including the somewhat similar scheme of Republican Representative Jack Kemp of New York – might have a good chance of sailing through.

If it does, the new law will certainly have the nice low rates that have been proposed. You should not be surprised, though, if the lobbyists manage to keep most of the loopholes open. For my part, I’d not be surprised if Republicans and Democrats started bidding against each other, as they did in 1981, to see who could give the lobbyists more of what they want. The not impossible result could be both lower taxes and wider loopholes.

What then?

The first consequence would be, as in 1981, an upward surge of the deficit. The second consequence would be, as in 1982, a move (over the obviously sincere opposition of President Reagan) to increase Social Security taxes (although they have no bearing on the budget deficit) and reduce Social Security and Medicare benefits. The third consequence would be, as in 1983, the realization that controlling the deficit requires some brave new taxes. It would be explained that the campaign pledges of no tax increase have after all been honored, since the income tax rates actually were lowered. But something had to be done.

What would it be?

Few fortunes have been made by people acting on my prophecies. Still, if I were a betting man, I’d wager that we would start hearing a lot more about the value added tax – how widely it is used in Europe, how invisible it is in comparison with the sales tax, how comparatively easy it is to collect, how it taxes consumption rather than production (a fallacy I have discussed more than once).

I know the smart money says that former Democratic Representative AI Ullman of Oregon was defeated in 1980 because he supported a value added tax; that references to it in the last campaign drew a strongly negative response; and now even the Treasury has come out against it. Nonetheless, with the income tax rates down and the loopholes wide open the pressure to act would be very great. On other occasions Secretary Regan has argued for a tax on consumption, and so have people as far to his left as Senator Gary Hart of Colorado. The American Enterprise Institute and the Brookings Institution similarly want to tax consumption.

My prophecy stands. What we get won’t be called a value added tax, but what’s in a name?

The New Leader


[1] Editor’s emphasis

Originally published October 29, 1984

NOW, about that deficit: Ronald Reagan was quite correct, during the first Presidential debate, in insisting that there is no connection between the deficit and the interest rate. If he had been more precise, he would have said that there is no invariant connection between the two. Walter Mondale, too, was quite correct in insisting that the deficit presents a threat to the economy, to the nation and to the peace of the world, although again there is no invariant connection.

There are, in fact, few (if any) invariant connections in economics, but it would be lèse majesté[1] to expect Mr. Reagan or Mr. Mondale to understand that, especially since most economists don’t either. There are few (if any) invariant connections in economics, because every economics question has to do with money. As I said in this space last time (” ‘Trust Funds,”’ NL, October 15), without money you have physiology and engineering and so on (all necessary parts of our life), but you don’t have economics (also a part of life, like it or not). And as I said here two and a half years ago (“Let’s Put Indexing on the Index,” NL, April 5, 1982), there is no invariant connection between any good or service and money. The mere fact of inflation is enough to settle that question, even if there were not sound metaphysical considerations (which you may not take so seriously as I do) on the same side.

So we seem to have a dilemma. Reagan and Mondale are both right, and they’re both wrong. At the root of the dilemma is money – well known to be at the bottom of much else. At the root of money is the banking system, and in the United States the Federal Reserve Board is at the root of the banking system. Since neither Reagan nor Mondale dared or cared to mention the Federal Reserve Board, there was an air of irrelevance to their debate.

Before digging to the root of the matter, let’s consider the causes for and the effects of the exponential surge in the deficit. The principal causes are not in dispute: a tremendous increase in military spending, the vast and varied tax cuts of 1981 and the high interest rates. Of these, the military spending had a positive effect on the business recovery, the tax cuts were neutral and the interest rates were negative.

The economic virtue of military spending is that there is no end to it. In a famous example of his irony, Keynes writes: “Ancient Egypt was doubly fortunate … in that it possessed two activities, namely, pyramid building as well as the search for precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as good as one, but not so two railways from London to York.”

Military hardware likewise does not “serve the needs of many by being consumed,” so it can be added to forever. And like pyramid building it increases aggregate demand. Demand is what stimulates business activity. Businesses produce things if they foresee a demand for them. Any expenditure is stimulative, yet government expenditure, being both large and highly visible, is especially stimulative. As Keynes suggests, building housing would be as stimulative as building pyramids or armaments. Or as John Ruskin (a better economist than you may have realized) exclaims, “What an absurd idea it seems, put fairly in words, that the wealth of the capitalists of civilized nations should ever come to support literature instead of war!” It would, in short, not be difficult to conjure up better uses for our money, and hence better ways of stimulating the economy; nonetheless, the military build-up-foolishness, highmindedness, viciousness, waste, and all – has in fact been the motive power behind the recent business recovery.

The tax cuts were, as I say, essentially neutral. If you wisely keep a file of THE NEW LEADER, you will find the reasons set forth in the issue of March 8, 1982 (“Why Deficits Matter”). For those who can’t lay their hands on back issues, I’ll summarize the reasons briefly. The tax cuts were, you will remember, intended to stimulate the supply side, on the theory that saving is the cause of investment. The theory is fallacious. Not even Representative Jack Kemp (R.- N. Y.) can imagine that the industrial half of President Eisenhower’s Military – Industrial Complex would build a factory to produce cruise missiles before the military half placed an order.

The supply-side theory turned out to be fallacious in still another way. In accordance with its logic, the 1981 personal income tax favored the rich, and the corporate tax favored the prosperous, the hope being that those who didn’t need the money would save it. This hope was disappointed, and for a simple reason. Since the Federal budget was already in deficit, the tax cuts necessarily increased that deficit. The increased deficit had to be funded; that is, bonds to cover it had to be sold. To whom were they sold? To those who had money to pay for them, of course, and they were, in general, the people who had benefited from the tax cuts. The upshot was that the rich and prosperous were given money to buy government bonds. In effect, they were given the bonds. The maneuver accomplished as extraordinary a transfer of wealth – albeit to the wealthy – as America has seen.

But if this transfer had any effect on the Gross National Product, it was merely a distortion of priorities. The disadvantaged were somewhat less able to buy food and housing, and the fall-off was balanced by a surge in the sale of Cadillacs and Lincolns. Aggregate demand, and hence aggregate production, were not substantially affected one way or the other. (Do you wonder why I’m disrespectful of the GNP?)

The third factor in the deficit, the high interest rates, was of course a drag on the business recovery. Mind-boggling though the fact is, this was intended to be a drag. The idiocy of the intention is not, however, what interests me at the moment. It is the effectiveness of the intention that gets to the root of the matter, for the policies of the Federal Reserve Board are thus demonstrated to be not irrelevant.

Empirically, Reagan was perfectly right. In 1980 the deficit was much lower than today’s, but the interest rate was much higher. How, then, can one claim that the deficit is the cause of high interest rates? But Mondale was perfectly right, too. The present deficit is indeed the cause of the present high interest rates, and these in turn contribute to continuing high unemployment, the strength of the dollar, the decline in exports, and the increasing trade gap.

The reason why the deficit is the cause of high interest rates is very simple: The Federal Reserve Board says it is. On this subject Board Chairman Paul A. Volcker is a cracked record, going around and around, saying the same thing endlessly.

To be sure, it is not literally what the Federal Reserve Board says that is of consequence. Persuasive though he is, Volcker does not run the rates up or down simply by jawboning. His speeches have an impact on the rates only to the extent that they are taken as hints of what the Board will do. It is what the Board does that matters. For the Board controls the rates, partly by setting the rediscount rate, partly by determining margin requirements, and mainly by controlling the money supply. Money earns interest in rough proportion to its scarcity, and for a third of a century now the Federal Reserve has been making money scarcer and scarcer. It has been doing this under the misapprehension that it was thereby containing inflation. It obviously wasn’t. The record is clear here, but that is another story.

WHETHER THE deficit causes the high interest rates directly by scaring Wall Street or indirectly by scaring the Federal Reserve Board, there is no doubt that the high rates increase the deficit. The bonds that were sold to finance the 1981 tax cuts and are now sold to finance the deficit offer a fantastic return -12 to 14 per cent or more. I have some that will pay me 14 per cent yearly until November 15, 2011. I should live so long.

The interest payable on the Federal debt is an incubus of daunting weight that will smother the economy for generations to come. Even now, as Senator Daniel P. Moynihan (D.-N.Y.) has shown, the annual interest payments are approximately equal to the annual deficit, and the compounding of that interest will more than offset any savings that might be made elsewhere in the budget. The compounding, moreover, is not of the ordinary sort. Thirty-year bonds that were sold in 1954, paying an average rate of 2.4 per cent, must be paid off today with money raised by selling bonds paying more than five times the old rate. Look at this another way: If the old rates were still in force, the deficit would be less than one fifth of what it is.

Continuing the observation, we see that the world according to Volcker is upside down. He says it would be fine to have low interest rates, if only the deficit could be reduced to manageable size. But the deficit would have been manageable if the Federal Reserve Board had kept interest rates low. The interest rates have no life of their own, any more than the deficit has. Even on Volcker’s theory, it would appear that high interest rates swelled the deficit, and not the other way around.

As things are, the only way to reduce the deficit-the Federal Reserve Board’s price for lowering the interest rates is to raise taxes. That is what Mondale promised to do. But Reagan (good Keynesian malgré lui[2]) said raising taxes threatens to send the economy into a new depression, because increased taxes mean a reduction in aggregate demand, and a reduction in demand is followed by a depression as surely as an increase in demand is followed by a boom.

This dilemma could have been avoided if the tax cuts had gone to those who would spend them. It could have been avoided if the Treasury and the Federal Reserve Board had cooperated in holding down the interest rates, as they did during World War II. As it happened, both fiscal and monetary policies were fatefully misdirected. If the President does not look good in the history books, the reason may be that he did not have the wit – and we did not give him the power – to beat some sense into the Federal Reserve Board.

The New Leader


[1]  a : a crime (as treason) committed against a sovereign power b : an offense violating the dignity of a ruler as the representative of a sovereign power

[2] despite himself <extraordinary talents, which somehow always crop out to show him at his best malgré lui —Saturday Rev.>

Originally published October 29, 1984

Big Bad Business

 

George P. Brockway believes that he knows the lesson of Continental Illinois, Financial Corporation of America, Lockheed, and Chrysler. According to him, it is that “great size, in and of itself, is an economic evil” (“Big Is Ugly,” NL, September 3).

Brockway’s point is that big companies need big bailouts when they fail. True enough. But there are other, perhaps more important, economic evils. We ought to explore the proposition that corporate expansionism can have beneficial consequences, and examine all the effects of the corporate Balkanization he favors.

Consider the electronics industry. Japan competes against us through its handful of giant concerns. The United States, of course, has two that are even larger, IBM and AT&T. We also have a fair number of middling companies and a multitude of small ones. IBM is in fine shape. The telephone company certainly is not, though its difficulties result from its emasculation, rather than from its size.

Many of our other firms are in trouble, too. The basic reason is that in the competitive and mercurial high-tech marketplace, businesses must spend fortunes to create popular new products, yet have to replace them almost immediately with still newer ones. In a situation of this kind it is very difficult indeed to make money.

Of the American companies, only IBM and AT&T clearly have the resources to finance and carry out the kind of research and development that will be needed in future. Japan’s monoliths are smaller, but it has more of them. To compete, we may or may not have to concentrate our economy to the extent that Japan has. But our romantic preference for small, independent businesses is likely to be compromised; at the very least, we will have to permit cooperative R&D, financing and production.

Houston                                                                                                           TEDDY GONZALES

Rich Man’s Bluff

George P. Brockway may be a careful reader, but his amended rich man’s dodge of borrowing money, deducting the interest expense from income tax, and investing the principal in tax-exempt bonds (“Between Issues,” NL, September 17) is still wrong. Unfortunately for Brockway’s analysis, and fortunately for the American taxpayer, the Internal Revenue Service has ruled that if one borrows money to purchase tax-exempt securities, the interest on the borrowed funds is not tax deductible. This makes Brockway’s revised scheme either unprofitable or illegal.

Edwardsville, III.

JERRY HOLLENHORST

Economics Department,

School of Business
Southern Illinois University

George P. Brockway replies:

Not exactly. As I said in the original piece, you’ve got to have some money to begin with. Let’s say you have $100,000 in loose cash and a hankering for a vintage model Rolls Royce. You buy some tax-exempts with your own money, and sometime later you borrow $100,000 to pay for the jalopy.

The New Leader

Originally published October 15, 1984

I SEE by the papers that the New York State Education Department is preparing a new social studies curriculum that will include a year’s course in economics in the 12th grade. They did not have anything like that when I was in high school, so my initial reaction to the news is that it can’t be a very good idea. On second thought, I will allow that it might be all right if they ran the course my way (which they probably won’t, I reflect sourly). And that thought leads me to wonder how I would go about it if I had my druthers.

I should perhaps say at the outset that I come by my sourness in the line of duty. I once had to edit a text on educational psychology, and it almost turned my brain to oatmeal. Somewhat later I wasted several years attempting to put together a series of secondary-school literary anthologies. I’d had some experience with college-level anthologies; but professional educators, it developed, were unanimously of the opinion that what succeeded with 18-year-olds was quite different from what 17-year olds could or should be interested in. I didn’t believe it then, and I still don’t. That there is a difference, I recognize. That it is as great as pretended by those who call themselves educationists, I doubt. In any event, I think it should be an objective of an educational program to narrow the difference.

In the year boys and girls are graduated from high school, they become young men and women old enough to vote.  Not old enough to drink (who is?), but old enough to vote and bear arms.  About half of them will go to work at on now embroil myself in the question of whether some familiarity with our literary heritage would make them better citizens leading fuller lives.  Certainly, however, it does seem altogether fitting that some effort should be made to teach them how the world of work works.

The difficulty, of course, is that we grownups don’t agree on how the world of work works.  There is scant chance of satisfying both the Democracy Project and the American Enterprise Institute.  What pleases the AFL-CIO doesn’t always please the Business Roundtable.  It is happily no longer fashionable for us to call each other Communists (I was astonished to learn the other day that the John Birch Society still exists[1]), but we nevertheless generate a good many British Thermal Units in charging each other with operating a front for special interests.

On the record, the schools are entitled to anticipate a lot of trouble when they start to teach economics.  It will not be surprising if they try to avoid this by reducing the whole enterprise to the lowest common denominator of their students’ capabilities and fancies.  Such solutions are not unheard of.  Yet in the case of economics the lowest common denominator is likely to be that of our grownup prejudices, and the resulting pablum[2] is liable to be not merely non-nourishing but positively poisonous.  The world of work is not an uncomplicated, noncontroversial place, and it is dangerous for citizens to think that it is.

The first problem in any course is to decide what the emphasis is to be.  As it happens, I can lay my hands on the opening sentence of a book I’ve been writing, which goes like this:  “We will define economics as the study of the principles whereby people exchange money for goods and services.”  Although I go on to say that “people” is the most important word in the definition, I think that with 12th-graders I would choose to concentrate on another word: “money.”

No one should object to talking about money in a class on economics, and that’s what I would focus on.  Money is, in fact, an ideal subject to talk about with kids.  It is something everyone deals with every day; people discuss it all the time; and it provokes the most extraordinary notions.  In sum, it is both familiar and full of surprises.

Money is, moreover, the absolutely essential idea in economics.  Try to avoid it and all the other aspects of the course fall away of disappear.  What can you say about prices without mentioning money?  Obviously nothing, because prices must be stated in terms of some monetary unit.  Without money, what becomes of production or supply?  It reduces to agriculture or engineering.  Without money, what becomes of consumption or demand?  It reduces to physiology and psychology.  If you don’t have money, you don’t have economics.  You have all those other disciplines that are good in their own right, and are often confused with economics, but are not economics.

My first units (that’s educationese for chapters) would be on what happens when you go to work. You do what the job requires for a day or a week or (if it’s a classy job) a month, and then you get paid for what you’ve done. Nothing mysterious about that. But you have in effect lent your employer your earnings for the period. In the rare cases when you get paid in advance, your employer lends money to you. There is no way you can get paid instantaneously for the work you do each instant; so you and your employer have to trust each other.

Now, the interesting thing is that this mutual trust is creative. By working you have increased the goods in the economy, and by lending your employer your earnings you have increased the capital in the economy. This could not have happened unless your employer made the job possible; and if you had to be paid in advance, your employer would have less money to spend on machinery and materials.

There is a further role for trust. Not only do you and your employer have to trust each other, but you both have to have faith in the economy and in the nation that sponsors it. Your employer would not hire you unless he (or she) was confident (fides = faith) that there was a market that would pay good money for what the two of you are producing together; and you wouldn’t work unless you were confident the economy would let you enjoy the money you earn. The money you receive has no worth except as you are able to credit it as worthy of your trust.

In the other direction, money is what makes it possible for you and your employer to agree. You will do so much work for so much money. Without money, your relationship would at best be sharecropping and at worst slavery.

The stress in the initial part of the course would therefore be that money is faith, trust, credit. It is not paper or silver or gold. And the moral of the first part might be stated by paraphrasing Baron Heyst of Victory: “Woe to the [nation] that has not learned to hope, to love – and to put its trust in life.”

This moral, I am afraid, would be the hardest point to get across. I took my World War II basic training with a lot of kids from the Lower East Side of New York and from South Philadelphia (whites had of course been separated from blacks at the reception centers), and I was bewildered by the difficulty many of them had in even imagining the possibility of a disinterested action. They possessed what has since come to be called street smarts, and they suspected an angle to everything. Intellectuals, too, find trust a difficult idea, for intellectual smarts are a facility in uncovering unconscious motivations and special interests. And conservative smarts are a passion for gold that bespeaks a sentimental longing for something more trustworthy than the national economy and our fellow citizens.

So establishing the nature and need of trustworthiness would take time, especially since street, intellectual and conservative smarts are sadly often right in clinging to their suspicions in specific situations. For the sake of the economy, and for the sake of the individuals who participate in the economy, however, it is more important to do right than to be right.

By now we would probably be well into January or possibly February, and the next group of units would take some time, too. The subject would be fractional reserve banking and how it works. This is comparatively simple, though I doubt that even two of the next 20 people you meet could explain it to you. With time running out, the last group would be on private debt and public debt, and how they’re alike and unalike, plus maybe a hint or two about their connection with inflation and employment. This could be highly controversial, but mercifully the school year would be almost over.

Do you think it would be next to impossible to get these ideas over to 17-year-olds? I do, too. Yet I also think that if the next generation doesn’t understand money any better than the present generation, it won’t matter too much what else they learn about the economy. They’d be much better off reading those anthologies I never published.

The New Leader


[1] One wonders, reading such observations in 2012 what was considered, at least by the author, settled in 1984, what he would say were he here…

[2] Since Microsoft Word didn’t recognize the word a link seemed appropriate

Originally published September 17, 1984

Between Issues

PRAISING Anthony Burgess’ A Clockwork Orange in THE NEW LEADER of January 7, 1963, Stanley Edgar Hyman declared: “Perhaps the most fascinating thing about the book is its language. Alex [the protagonist] thinks and talks in the ‘nasdat’ (teenage) vocabulary of the future, a remarkable invention by Burgess …. It has a wonderful sound, particularly in abuse, when ‘grahzny bratchny’ sounds infinitely better than ‘dirty bastard.”

Before the issue had been out a week, the phones were humming and the letters were pouring in: Didn’t Hyman know that the “amazing vocabulary” he was so taken with consisted largely of adaptations from Russian? At the NL, readers rarely write to praise; they seem to feel (rightly, in our view) that good or even excellent pieces should be the norm. But a goof will soon bring guffaws. And among those who could not resist at least a smile was Burgess’ publisher, George P. Brockway of W. W. Norton-who nonetheless thought so highly of Hyman’s essay that an emended version became the Introduction to the paperback edition of Clockwork.

We were reminded of all this when the phones began ringing and the letters started arriving about a blooper by Brockway- now an NL columnist-in “Big is Ugly,” his cover piece for our September 3 issue. One representative letter, from Lloyd McAulay Esq., will suffice to illustrate: “George Brockway’s original comments on the economic scene are interesting to read, for they certainly make one think. However, one would like to believe that he presents his proposals with some care. His example of financial alchemy in the 50 per cent tax bracket is amiss. He suggests that borrowing $100,000 from Bank Aat 15 per cent interest, and investing it in Bank B at 13.6 per cent interest, will provide an annual after tax net of$ 3,050. That is just not careful arithmetic. True, the $15,000 interest on the loan from Bank A will only cost the borrower $7,500 after taxes. But the $13,600 interest on the Bank B deposit is taxable income. At the 50 per cent bracket’ this will mean net earnings of $6,800. Since the loan cost $7,500, the taxpayer would have a net loss of $700.”

Apparently Brockway remains a careful reader, because we had not yet had a chance to get in touch with him when he sent along the following:

“Oops! I of course slipped in my column of September 3 when I parenthetically outlined a rich man’s scheme for borrowing money and buying CDs. For the dodge to work, you have to buy tax-exempt bonds and take your chances on the market. In other words, you have to do a little laundering, but it’s so simple that you don’t even have to go to Miami for the purpose. Sorry.”·

Readers may reasonably wonder why the editors were not more careful readers. To that we can only reply, rather lamely, that the games the rich play are Russian to us.

OUR COVER drawing of Israel’s Prime Minister Shimon Peres is by Claudia Fouse.

The New Leader

Originally published September 3, 1984

THE Continental Illinois and the Financial Corporation of America bailouts, although different in nature, have one glaringly obvious lesson that everyone sees and even talks about endlessly yet refuses to think about. The lesson is that this bank and this thrift institution were too big to be allowed to fail, just as Chrysler and Lockheed were before them.

Everyone knows and says that. Everyone has enough mathematics to know as well that if Financial Corporation of America, the nation’s 12th-largest organization of its kind (counting both commercial banks and thrifts) is too big to be allowed to go under, there must be at the very least 11 others in the same category. Clearly, Citibank and Chase and the rest did what they did in South and Central America because they were confident that no matter what happened, they would not be allowed to fail, and in the meantime they could make a lot of very big loans at very high interest. Still, only a few people – like William Wolman, editor of Business Week – dare to say that in the end many, if not most, of these loans will be repudiated, and that Uncle Sam will, in one way or another, pick up the tab.

This may not be so bad in the event as it looms in contemplation. You have probably been struck by the fact that an awful lot of money is involved, and that no one seems to be certain exactly how much; yet whatever the amount, it is not overwhelming in relation to our national debt or even to our annual Reaganomic deficit. When Uncle Sam picks up the tab, we won’t be bankrupted. Indeed, we may be sure that the whole operation will be handled in such a discreetly indirect way that we will not notice it. There is a time for flamboyance and a time for discretion, and bankers are very good at telling which is which. Have you heard anything about the Polish loans lately?

More than money is at issue here. There has been talk about having someone – the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, or some private insurance company – look more closely over the bankers’ shoulders. New laws are being proposed, and complaints are being made that old ones are not being enforced. The bankers are not much concerned, though, because they know that not much can come of it.

As long as the big banks are substantially free of regulation on the interest they can pay, they will be free of significant regulation elsewhere. Walter Wriston, the recently retired chairman of Citibank, who may be said to have initiated the current state of affairs with the dictum that countries don’t go bankrupt, now says that bankers are too proud to conduct their business in the expectation that the government will rescue them from their mistakes. He is undoubtedly as reliable one time as the other.

Early last month, the New York banks had a little war to see who could pay the highest interest on certificates of deposit. The war was apparently started by Manufacturers Hanover as a macho gesture, to show that current rumors of its weakness were false. An ad for Citibank, and several others, at one stage quoted an effective annual rate of 13.6 percent on one-year CDs. That sounded dandy (and was) for those with the cash to take advantage of it.

You may wonder how, with a prime rate that was then 13 per cent, Citibank could pay 13.6 per cent for its money. Mr. Micawber would have said: “Annual income thirteen per cent, annual expenditure thirteen and six-tenths, result misery.” It’s pretty hard to fault Mr. Micawber’s reasoning. Are bankers alchemists after all?

AT LEAST three things are going on behind the scenes. The first is that the bankers are practicing alchemy-up to a point. When they increase their reserves by selling you a CD for $1,000, they are able, very conservatively, to increase their lending by $5,000. A prime rate of 13 per cent on $5,000 earns them $650; so they can easily afford to pay you $136 for your money and are happy to spend a lot on television and newspaper ads to lure you into their shops.

(Incidentally, should similar battles flare up among the banks where you live, you might want to keep in mind that you can be an alchemist, too – assuming you are in the 50 per cent bracket and have some security to offer. It’s easy: You borrow $100,000 from Bank A, paying perhaps 15 per cent interest. You use this money to buy a $100,000 CD from Bank B that will earn $13,600. Since your tax will be reduced by $7,500 because of interest paid, you will have a profit of $6,100. After taxes you will be left with $3,050 net-all for simply signing your name a few times, and having a lot of money to begin with. And if you run part of this through your IRA, your gain will be greater.)

Can the banks continue doing that forever? Well, it isn’t quite like a chain letter, but it can be kept up as long as there are people and businesses clamoring to borrow money. (The private dodge I have outlined for you can be pursued as long as Congress allows a deduction for interest paid.) Should the demand for loans collapse, or should the loans turn “nonperforming,” the party would be over. For this reason, one may presume that a modest shuffling of the feet is also going on behind the scenes as the banks get ready to raise the prime rate again, probably not until after the election.

And why not? It’s as plain as day that their little CD wars will result in a higher cost of funds for all of them. Finally, a playlet is being prepared behind the scenes that will go like this:

Enter Stern Bank Examiner, who says (sternly): “Hey, you’ve got to stop making those crazy loans to Third World countries and oil wildcatters and speculators in California real estate. Even though the United States has figured out how to have what we say is a recovery with eight or 10 million unemployed, the rest of the world is still depressed, and the demand for oil is going down, and there really is a limit to what anyone in his right mind will pay for a piece of the San Andreas Fault.”

To that, Deregulated Big Banker will reply (contritely): “Well, shucks, sir. Then this bank, which I remind you is bigger than you can possibly imagine, will have to go bankrupt, because our cost of funds is so high that we have to make these crazy loans at high rates, or we can’t pay our bills. If you say we have to go bankrupt, why of course, we’ll do as you say. But if we go, I humbly remind you, we’re so big that we’ll pull a whole lot – maybe everything-down with us, and we wouldn’t like to do that. ”

Whereupon Stern Bank Examiner will answer (sternly): “Well, all right. If you can’t be good, be careful.”

The consequences of such unavoidably permissive regulation will extend far beyond the cost of bailing out a superbank every now and then. Most immediately, the rest of the banking system will be strangulated. If the biggest banks are essentially free of regulation, the remaining banks (some of them bigger than I can imagine) will be at a competitive disadvantage unless they can sell out to a super bank or combine with others similarly situated and become superbanks themselves. The merger movement, already possessed of enough momentum to satisfy a sports announcer (including one formerly known as Dutch[1]), will proceed apace. Everybody will become too big to be allowed to fail.

That last sentence is twice as long as it should be. If we are truly to learn the lesson of Continental Illinois and Financial Corporation of America and Lockheed and Chrysler, the sentence should read, “Everybody will be too big.” Period. Put another way, the lesson we should learn is that great size, in and of itself, is an economic evil. For almost a century, since the passage of the Sherman Antitrust Act in 1890, we have said and repeated and contrived to believe that the issue is competition, not size. The Sherman Act has been amended and strengthened, most notably by the Clayton Antitrust Act of 1914 and the Robinson-Patman Act of 1936; the courts have been clogged with cases, some of which dragged on for decades without a decision; and always the effort has been to discover and enforce a judicial definition of competition.

The effort has not succeeded. The power of the “trusts” of 1890 was insignificant in comparison with that of the Fortune 500 or the Forbes 500 of today. Absurdities have multiplied. It is, for example, established antitrust law that a company can engage in what the law defines as unfair business practices when the company has to do so to meet competition. If you think that’s nutty, you’re right.

I’m not saying that we would be better off without Robinson-Patman and the rest. I’m merely saying that the expensive, time-consuming antitrust effort has failed to come close to its promise, and that its failure follows from the apotheosis of competition.

In this space a couple of months ago (“Unthinkable Thoughts on Competition,” NL, April 2), I presented some empirical evidence that competition doesn’t always work for the benefit of the consumer. For evidence that it doesn’t always work for the benefit of the producer or of society, I refer you to a 1921 essay entitled “The Ethics of Competition” by the late Professor Frank H. Knight of the University of Chicago. Knight demonstrates in careful detail what we know in our hearts, namely that the competitive race is seldom fair, and that the effort it stimulates is as likely to result in chicanery as in beneficial innovation. One of Knight’s favorite pupils was Milton Friedman, showing that, happily for mankind, personal relations are thicker than ideology.

If competition doesn’t work, what does? Not cooperation. That is merely the flip side of the coin. Milovan Djilas and a great many others are ready to tell you in convincing detail that cooperative societies, with the best will in the world, tend to degenerate into stultifying dictatorships. I propose that we look a bit more closely at the question of size.

SINCE THERE ARE unquestionably economies of scale, it would seem that we are stymied in that direction, too. As a matter of practical politics, we are undoubtedly stymied now and will be for a long time. But there does exist a workable solution. It is embodied in a 166-page book published in 1947. The title is The Limitist, and the author is Fred I. Raymond.

Raymond was a successful executive in a family business that was sold, against his advice, to Wall Street speculators. Then he was an inventor of successful heart-regulating devices that he had to sell to Minneapolis-Honeywell because he couldn’t get at the market for them. Then he pondered what had happened to him and wrote his book, which I am very proud to have published. It attracted attention from John Chamberlain of the Wall Street Journal on the Right and Senator Paul Douglas of Illinois on the Left, but of course was (and unfortunately still is) long before its time.

Observing the courts’ inability to define competition, Raymond put forward what he called a limitist law. The speed limit is such a law. If you go over 55 miles an hour you are in violation, no matter what arguments you can make about safety or efficiency or the behavior of others. Observing the way business works, Raymond concluded that seeming economies of scale are often (if not generally) results of the favored access great size can command to finance and to markets. The Chevrolet plant in Tarrytown, New York, for instance, achieves (or could achieve) all the engineering economies of scale available in automobile manufacturing. It is not made more efficient by the existence of similar Chevrolet plants elsewhere.

On the basis of these observations, Raymond proposed that a business organization could be as large and as spread out as it wanted to be, provided that it had only one place of shipment to its customers, whether other manufacturers, retailers or the public. If a business had more than one point of delivery, it would be limited to a certain number of employees. Raymond suggested 1,000 as the maximum. He drafted a “Business Limitation Act” that runs to not quite 2,000 words, including definitions of terms.

I doubt that you have heard of a more elegant, simple, effective, and far-reaching proposal. The book never sold many copies and has long been out of print, but I suppose you can find one in some library. If you do, you will be well repaid for the two or three hours it takes you to read it. It is, as Chamberlain said, “a practical way of dealing with the economic ‘sin’ of bigness that doesn’t require cumbersome bureaucratic supervision, insidious taxation of human energy, or incessant effort to prevent government corruption.”

We can, of course, simply give up and turn the country over to the Business Roundtable. Or we can keep muddling through the courts. Or we can make a start at diagnosing and treating our actual ailment. That is, we can face up to the problem of bigness.

The sad fact is that we had a limitist law in banking in the shape of Regulation Q, which limited the interest certain banks could pay. It was not altogether effective because it could not (given the patchwork control of our financial system) cover all it should have covered. In the circumstances it would have been rational to extend the coverage. But overawed by the wealth and wisdom of Walter Wriston and his ilk, we reduced it, instead. The more fools we.

The New Leader


[1] Reagan

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