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By George P. Brockway, originally published July/August 2000

2000-7-8-a-new-new-theory-titleTWO YEARS AGO, the hope was expressed here that the Federal Reserve Board was on the verge of learning how a modem capitalist economy-call it “the New Economy” if you wish-actually works, or could work (“A Fortunate Experiment,” NL, August 10-24, 1998). But it has become clear that the Reserve was merely adopting another new theory of how a quasi-mercantilist economy functions at least the fifth in Chairman Alan Greenspan‘s incumbency.

The previous new theory of the old economy went like this: Exuberant stock markets are giving rise to a “wealth effect,” whereby wildly successful speculators are using their inflated capital gains as collateral for loans to buy second (or first) homes and automobiles and a variety of other items, some necessary and some simply nice to have. As a result, the economy is in danger of “overheating.”

Now here comes what they call in Silicon Valley the new new thing: The secret cause of our trouble is that our productivity is growing too fast (the year before last it was supposed to be growing too slowly); consequently, the wealth effect is higher than ever. Indeed, it is so great that people’s income from borrowing on their capital gains exceeds their income from working at productive jobs. This situation is said to be unbalanced and unsustainable. We are borrowing on the future,” “living beyond our means,” and violating other 18th century copybook maxims.

Yet that is exactly the virtue of modern capitalism. It is how the company I worked for could expand to give me a better job, how my wife and I could buy a decent home in which to raise our children, how the city could build schools to educate them, and not least, how World War II could be won.

It is also argued that the wealth effect will cause too much money to chase after too few goods, a.k.a. inflation. A moderately rational person might consider encouraging the production of more goods wiser in such circumstances than reducing the amount of available money. The answer to this suggestion is that to produce more goods we would have to hire more people; and since we pride ourselves on having practically full employment (so why not say it’s really full?), we can’t hire more people without starting a wage-price spiral. To be sure, we have some 20 million fellow citizens who are either unemployed, underemployed, uninterested in employment at the going wage, or turned off.

Because of (not in spite of) the Federal Reserve Board’s threat to resume increasing the Federal funds rate, the United States economy is on the launching pad for an interest-price spiral (not a wage-price spiral) that could start spinning tightly upward before the 2000 election and then, before the election of 2004, could collapse in the ninth recession since the end of World War II.

In It Can’t Happen Here Sinclair Lewis’ hero opined that we Americans might one day have fascism but would call it antifascism. True to this heritage, the Federal Reserve Board has adopted an inflationary policy but tells us (and itself) that it is fighting an inflation invisible to ordinary folk like us because it is around the curve.

PERHAPS not altogether coincidentally, the Reserve acted in the same way almost a third of a century ago, in 1969, the last year we had a budget surplus before the current one. It was also the final year of what is now the economy’s second longest expansion. During the following 14 years we had four recessions, the highest unemployment rates since the Great Depression, a series of sensational bankruptcies, and a record breaking 271.4 per cent surge in the Consumer Price Index. The Reserve was serious about inflation the whole time.

Of course, there was a war on in Vietnam then and (as at present) trouble with the Organization of Petroleum Exporting Countries, but raising the interest rate did not stop the war and in truth started the trouble with OPEC. Meanwhile, the costs of living and doing business went higher, and the budget surplus was wiped out.

Money has power-several powers, in fact, as we shall see. The most familiar is its purchasing power. The Federal Reserve Board, in its diurnal struggle with inflation, has long concentrated on restraining money’s buying power. It does this by increasing the interest rate in order to reduce the number of consumers able to buy interest-sensitive commodities (especially cars and houses). This, in turn, reduces the number of workers employed in supplying those commodities, keeping them from buying other commodities they want or need. All of that is supposed to prevent the economy from overheating.

When we return from a shopping (or web-surfing) expedition and say the dollar doesn’t go as far as it used to, we mean its purchasing power is reduced. That is the same as a rise in the general price level, which is the same-as inflation.

THERE ARE two other probable, but presumably unintended, consequences of the Reserve’s actions. The first is a recession. To rephrase “Engine Charlie” Wilson, what is bad for General Motors is bad for the economy. We can’t slow down on the building trades and the automobile industry and their many auxiliaries (steel, lumber, oil, glass, rubber, major appliances, and on and on) without slowing down the whole show. Second, although the Reserve may have only restraint of purchasing power in mind, raising the interest rate simultaneously reduces the borrowing and investing power of money.

A fall in the investing power of money is, of course, the same as a decline in the amount of investing that is done-in other words, stagnation. Assuming that a projected investment is attractive and that the credit of the company wanting to make it is sound, the interest rate determines the limit of investing the company can finance with a given sum.

The range of impacts on investing power is vast, as four historical examples will show. Before the 1951 “Accord” that “freed” the Federal Reserve Board from its World War II commitment to help the Treasury maintain the market prices (and, of course, the interest rates) of government securities (not an unreasonable chore for a central bank in time of war or peace), the prime rate was 1.5 per cent. In December 1980 and January 1981 the prime topped off at 21.5 percent. In June 1999, at the start of the Reserve’s present program, it stood at 7.75 percent. Now it has reached 9.5 per cent (not so long ago, anything over 6 per cent was illegal usury). A corporation that could afford an annual interest expense of $150,000 and borrow at prime, could therefore have borrowed and invested $10 million in the first example, but only $697,674 in the second example, $1,935,484 a year ago, and $1,598,947 today.

Moreover, the effects of a rise (or fall) in the interest rate multiply throughout the economy. When the prime hit 21.5 per cent around Christmastime 1980 and our company’s investment was limited to $697,674, the purchasing power of every dollar of that amount likewise fell 12 per cent. So the firm could actually purchase only $613,953 worth of goods and services for its investment.

The Reserve’s present program (ironically assisted by OPEC) will increase the cost of doing business and will soon prompt or excuse enough price increases to embolden the many inflation hawks on its Board of Governors to push harder for really pre-emptive strikes, whereupon further price increases will begin appearing on the visible part of the curve, and the interest-price spiral will be well launched.

The increasing prices will harden the inflation hawks’ belief that they “must” (as the business press puts it) raise the interest rate to hold prices down. But a capitalist economy is based on borrowing, and the causation runs from the cost of borrowing (the interest rate) to price, rather than the other way[1]. Every firm, before it starts work on a new project, or orders a new production run of an old one, must know its costs to set prices.

The cost of borrowing is established by the Federal Reserve Board when it determines the Federal funds rate. To be sure, that rate is the one banks charge each other for very short-term loans (usually overnight) to allow the borrowing bank to meet an emergency or to take advantage of an exceptional opportunity, but it also sets the floor under the cost of all borrowing.

Today the nation’s business enterprises routinely quote many millions of prices, change some, and establish thousands of new ones. Scores of millions of consumers agree to some of the prices, and sales are made; a few haggle for lower ones, with occasional success. All of these prices are based in part on what the Reserve did at its last meeting. But there is no way on earth that what the Reserve did at its last meeting could have been based on the prices sellers and buyers actually agree to afterward.

This is not a chickenandegg question. Actual prices are based on actual costs, never the other way around. Businesses do not set the floor under interest rates, the Federal Reserve does[2].

In sum, as the Federal Reserve Board continues to raise the interest rate, it will cause stagnation (a decline in investment), stimulate inflation (a rise in the price level), and achieve its perverse intentions (a decrease in demand and an increase in unemployment). It will prick the stock exchanges’ irrational bubbles with consequences that will confirm the wisdom of Marcel Proust, somewhere in whose expansive universe is the observation that our wishes may be fulfilled, on the condition that we not find in them the satisfactions we expected.

IT IS POSSIBLE that the Reserve is already too far in to back out, for to cut rates now would announce to all the Fed watchers that the threat of inflation was past. The bull market would roar ahead, speculators confident that the Reserve would protect them. (Economists call this phenomenon by the odd name of “moral hazard.”)

Yet at the very least stagnation would be avoided if the Reserve did the unimaginable and lowered rates. At the best, new ways might be found to expand the economy and to reverse the fatal trend toward continually widening the chasm between the haves and the have-nots of our society.

Given the Reserve’s blind tradition of “staying the course,” the summer’s growing inflation and stagnation may continue and prove enough to defeat Vice President Gore (as former Reserve Chairman

Paul A. Volcker‘s recession defeated Jimmy Carter 20 years ago). Similarly, 2004’s recession[3] may prove enough to defeat then-President Bush (as Chairman Greenspan’s recession defeated his father eight years ago).

The New Leader

[1] Ed:  my emPHAsis

[2] Ibid

[3] Ed:  Well, it happened in 2007

By George P. Brockway, originally published May 7, 1999

5-7-99-why-nairu-is-nonesense-title

MANY YEARS AGO, when I was a college undergraduate, there was some talk on campus about The Fountainhead[1], a massive novel by Ayn Rand. I was aware of it because one of my close friends told me a bit about it, and the older brother of a classmate had edited it, but I never read the book nor did I see the movie. Perhaps it was too huge for me (I was reading Ernest Hemingway‘s stories and Gertrude Stein‘s scribblings). Perhaps I was sufficiently law-abiding to be put off by the novel’s intensely self-centered architect hero[2], whose action at the end was the principal topic of what I heard (he destroyed an allegedly supremely beautiful building he had built because the owner wanted some changes).

I never read Atlas Shrugged either, or any of the other works by Ayn Rand, and I was not aware that she was a self- invented economist until I became one myself. Even then I was-and still am-put off by the name she gave to her philosophy (“objectivism“). But despite my ignorance of what she has written, I am prepared to claim that she has had a great and salutary effect on the present and possible prosperity of the United States of America. Maybe of the world.

One of Ayn Rand’s disciples was Alan Greenspan, who grew up to be Chairman of the Federal Reserve Board. So far as I know, Greenspan has never made a public reference to her, and so far as I am aware, only three of her doctrines may have slipped into the proceedings of the august body he heads. He has spoken some odd words on the movement of the price of gold as an indicator of the future course of the price level. His aversion to regulation of the rogue multitrillion-dollar derivatives market may be linked in his mind with the behavior of the hero of The Fountainhead. And almost alone among the public men of our time, he doesn’t believe in the barbarous theory of a natural rate of unemployment.

In any case, I suspect that her influence has been both more profound and more beneficial than her ideas. As a result of his association with her, Greenspan learned how to be at once the consummate insider and the consummate outsider.

Because he is a consummate insider, he got to where he is. Because he is a consummate outsider, he has not been overawed by the high-powered bankers and economists with whom he does business. Because he is not overawed by these worthies, we have not had a boost in the interest rate since March 1994, and in fact had three quarter-of-a -point cuts last summer and fall.

These 60-odd months without a rate increase constitute the longest, indeed the only, period of tranquility the Federal Reserve Board has allowed the American economy in the 30 years since the Reserve launched its all-out war against inflation-which propelled the Consumer Price Index from 36.7 in 1969 to 99.6 in 1984, a record-breaking and stupefying leap of 272 per cent in 14 years. It is for the present period of tranquility (and for its continuance, if he can bring it off) that Greenspan is renowned today and will be forever famous in the annals of economics and of political economy.

There is no doubt that if Greenspan had polled the economics profession and the banking profession he would have had them almost solidly against him. On July 19, 1995, Greenspan said in Congressional testimony, “I don’t believe that any particular unemployment rate-that 5 per cent or 5.5 per cent or whatever numbers we’re dealing with-is something desirable in and of itself. I don’t believe that.”

Neither the New York Times nor the Wall Street Journal reported this testimony (but THE NEW LEADER did, and I have the videotape). As I said at the time, this was earthshaking testimony. It directly contradicted what then was the first or second most sacred economic law, namely the natural rate of unemployment, a.k.a. the nonaccelerating inflation rate of unemployment, a.k.a. NAIRU. It is possible, but not certain, that the ancient “law” of supply and demand had a tighter grip than NAIRU on the hearts and minds of economists and those who pretended to an interest in economics. Yet Greenspan contradicted this barbarous doctrine, and got away with it.

As it happened, the economy jogged along pretty well. The stock market boomed, because the Baby Boomers were worried about saving for retirement and didn’t know where else to put their money. As the market soared, more and more of them made nice killings and began to spend some of their capital gains. Retail sales, especially of automobiles and other big-ticket items, picked up. Unemployment began to fall, and so, to almost everyone’s surprise, did inflation.

After a while the media began looking for someone to give the credit to. President Clinton was willing, but no matter what he claimed, and no matter what photo ops were arranged, people kept saying that he was too preoccupied with impeachment to run the country. Perhaps they were right, and, obviously the Republicans were too preoccupied, for the same reason.

Greenspan was available, and an interview with him was almost as good copy as the stories quoting Casey Stengel used to be. He talked about the free market, so he became the leader of the free world.

Of course, I wasn’t there, but I have a clear picture of what happened next. At meeting after meeting, the Federal Reserve Board staffers brought in sheaves of disturbing figures showing that Wendy’s in Sandusky was having trouble holding dishwashers and hiring cashiers; that Kmart in New Jersey had constant openings for stock clerks; that Boeing in Seattle was looking for riveters. Everywhere, in other words, the unemployment rate was falling-falling steadily below the rate at which all the bankers in the country knew, and all the mainline economists in the country absolutely knew, that inflation definitely had to break out again. The financial press talked nervously of the importance of being ahead of the curve, and Greenspan himself spoke of making a pre-emptive strike against inflation.

Nevertheless, Greenspan has not acted. He tried jawboning the stock market-and quickly learned that his reputation as economic wise man of the Western World was in jeopardy because practically no one was in favor of repeating the 1987 market crash.

Lately he has made a series of speeches suggesting that an increase in the productivity index explains our “miraculous” combination of falling unemployment and falling inflation. Since the productivity index is a fraction (output divided by hours worked), its value rises when the denominator falls. Greater productivity, therefore, is hardly an explanation of increasing employment.

WELL, maybe Greenspan can pull it off, but it would help if he could make clear why NAIRU has not performed as advertised. Since the business and financial press has not been able to do that either, the professional belief in NAIRU has been muted but not stilled. The true believers are prepared to stay the course, because they have been given no reason not to.

We shall continue to live in fear that our tranquil days of steadily expanding prosperity will soon be over unless somebody sets them straight. So, it might as well be me, here and now.

It isn’t enough to remind the believers that not so long ago they insisted the telltale rate of unemployment was 7.0 per cent, then 6.5 per cent, then 6.0 per cent, then 5.5 per cent, then 5.0 per cent, then 4.5 per cent, and now it must be 4.0 per cent or lower. They shrug off this embarrassment with the complaint that the available statistics are imperfect or that, as Humphrey Bogart said when told there were no waters in Casablanca, they were misinformed.

It also is not enough to show them that every one of the nine recessions since World War II has been preceded by boosts in the interest rate. The boosts were said to be necessary to nip inflation in the bud. But in fact inflation accelerated more rapidly after the boosts than before them. Another fact: In all the years since World War II, no matter what the Federal Reserve Board has tried, the price level has fallen only once, and in that year (1955) the interest rate fell too. Again, of course, the statistics are imperfect. And without a coherent theory everything is anecdotal, the diehards argue, as the doctors did when Linus Pauling tried to tell them about Vitamin C.

Yet the reason NAIRU is nonsense is not far to seek. To begin with, the interest rate and the unemployment rate are both percentages, just as apples and oranges are both fruits. Interest is a direct cost or an opportunity cost on both sides of every economic transaction. Labor costs are similarly universal. But interest costs are closely uniform for comparable risks throughout the economy; labor costs vary widely from industry to industry, job to job, locality to locality, and (shamefully) from ethnic group to ethnic group as well as from gender to gender.

The two percentages are so radically different in composition that NAIRU theorists themselves never had a theory of their interaction. All they had were some empirical observations that occasionally made pretty graphs, like the Phillips curve. As with all empirical observations, though, theirs were liable to falsification by events.

The serious recessions of 1974-75 and 1980-82 were certainly falsification enough. But those events were disregarded, perhaps because practitioners of this dismal science tend to believe that dismal outcomes must be true, while relatively happy outcomes (like the present situation) must nurture some occult seeds of their own distraction.

Moreover, a 1 point fall in the unemployment rate causes little more than a 1 point rise in the national wage bill (which itself is only three-fifths of the costs of production), whereas a 1 point rise in the basic interest rate (now 4.75 per cent) eventually results in a drop of about 20 per cent in the purchasing power of money (which is, of course, equivalent to a 20 per cent rise of the price level, or a pretty stiff dose of inflation).

Far more important, the interest hike would produce a 16.7 per cent decline in the borrowing power of money, resulting, as we shall see, in a 33 per cent drop in the value of investments that must be made to keep the capitalist system going. If the interest rate is 5 per cent, $500 will get you a year’s use of $10,000. You can invest that $10,000 in an enterprise of your choice, and, unless you are unwise or unlucky, you will earn back your $500 interest plus a profit to boot and be ready to do more of the same.

But if the rate rises to 6 per cent, you will be able to borrow only $8,333 with your $500. Worse yet, the purchasing power of the $8,333 you borrow will have been reduced 20 per cent; so in the end you will have only $6,667 worth of goods to invest in, compared with the $10,000 worth you would have had before the interest hike.

Any way you look at it, the “punishment” of a 1 per cent increase in the interest rate does not fit the “crime” of a 1 per cent decrease in the unemployment rate.

Federal Reserve Bulletin please copy.

The New Leader

[1] Ed: Not likely as an undergraduate.  The author graduated college in 1936.  The Fountainhead was published in 1943

[2] Ed: Howard Roark is no more self-centered, say, than Donald Trump…

By George P. Brockway, originally published March 3, 1999

3-8-99-the-love-song-of-homo-economicius-title

T.S. ELIOT sang of “Songs[1] that follow like a tedious argument! Of insidious intent! To lead you to an overwhelming question …. ” Economics

sometimes seems like that-tedious as well as dismal. Economics is also very like the next line of The Love Song of J. Alfred Prufrock”: “Oh, do not ask, ‘What is it?”’

For the characteristic economics essay or book lays out-“Like a patient etherized upon a table”-an account of the economy, or some part of it, demonstrating how it works, or doesn’t work. Often the putative truths contained therein are unpleasant, like the iron law of wages in the 19th century or the natural rate of unemployment in the 20th. Nonprofessionals are frequently prompted to ask, not “What is it?” but the truly overwhelming question, “What should we do about it?” Professional economists have tended to brush that question aside. They are, they say, scientists, not humanists; and science concerns what is, not what ought to be.

But there is another reason for the posture of most economists, and that is the problem posed by the first sentence of the last chapter of John Maynard KeynesGeneral Theory of Employment, Interest and Money: “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 income.” One would have to be extraordinarily deficient in empathy for one’s fellow human beings not to recognize the justice and urgency of Keynes’ dictum. One would also have to be exceptionally ignorant of the ways of the world to imagine that the problem will simply solve itself. Indeed, anyone with empathy and knowledge must find it acutely uncomfortable to deny that confronting those “faults” is the special responsibility of economists.

Yet starting with Adam Smith in 1776, the history of modem economics has instead been the story of a search for an automatic polity, a mechanism that, whether it makes all well or not, at least makes everything inexorable. With Smith, of course, it was the invisible hand. With Jeremy Bentham it was the felicific calculus, supposed to operate like Newton’s laws of motion. With Jean-Baptiste Say it was production creating its own demand. With John Stuart Mill it was supply and demand. With Karl Marx it was dialectical materialism. With William S. Jevons, Leon Walras and Carl Menger it was marginal utility. Among our contemporaries, equilibrium is the chosen control-metaphorical with John Hicks, mathematical with Gerard Debreu and Paul Samuelson, quasi-psychological with Frank Hahn and Edmund S. Phelps.

All those I have named are honorable men, as I believe almost every economist to be. I am sure none would dispute the truth of Keynes’ pronouncement. Faced with the enormity of the problem, though, all, with the possible exception of Marx, have found in pseudoscience an excuse for denying the need or ability to do anything substantial, and hence for refusing their responsibility.

The first thing to note about the problem is that originally it was a double pronged affair, but by now the prongs have joined together. In the ancient world, the feudal world and the mercantilist world, you could have full employment along with unconscionable disparities of wealth and income. Perhaps even in Keynes’ day, over half a century ago, it was possible to consider the two great failures of the economy separately. Today, however, we shall not be able to solve unemployment without at the same time solving maldistribution.

An explanation for the intertwining of the two problems was suggested by Joseph A. Schumpeter in an observation of the sort he made so casually and so tellingly. “The capitalist achievement,” he wrote, “does not typically consist in providing more silk stockings for queens but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort.” The modem economy, unfortunately, may not be quite so good to factory girls as Schumpeter suggests.

The reason lies with the opportunities the wealthy have to dispose of their income. In most cases, their money derives from mass production, but they do not spend much of it on the products of the assembly line. This is not merely a matter of taste. It would be flatly impossible to do so. You can buy a top-of-the-line Mercedes, the archetypal expensive, mass-produced commodity, for about $145,000. If you were a senior officer of a Fortune 500 corporation, or a partner in a major financial house, you could pay cash for a brand-new Mercedes the first of every month, junk it at the end of the month, and still have more money than you and your family could conveniently spend.

Traditionally the wealthy have invested their surplus, a practice generally considered to return it to the producing economy it came from. And, like Prufrock’s Yankee contemporary, Miniver Cheevy, they think they “have reasons” to believe they are doing something good. Theoretically, for example, their investment would make more silk stockings available at lower prices by increasing productivity. But in common with the romantic notions Cheevy holds so dear, the idea is largely spurious.

This is because, regardless of what distinguished economists say, the producing economy is, in general, overcapitalized. As things stand, it could very easily, without investment in another machine or machine tool, increase its output by 15 or 20 per cent. It has that capacity right now. More investment will not lead to greater productivity.

Increased demand would. But Chairman Greenspan still hopes to restrain the “exuberance” of the stock market-in which case its upper middle class “wealth effect” will disappear. And far from trying to stimulate consumption, credit card companies can’t wait to put fear of a new bankruptcy law into their lower-middleclass clients.

These actions reduce the nonwealthy to relying on what they earn by working, and what they earn necessarily falls short of being able to buy what industry produces: Schumpeter’s silk stockings (or their millennial equivalent) become less affordable. The shortfall is equal to the earnings and other withdrawals of the wealthy. Its correction must also come from that source.

LEFT TO THEIR own devices, how do the wealthy spend their money? After buying several Andy Warhols and subscribing to tables at a couple of dozen charity balls, it is all too easy to become frustrated by the attempt to consume one’s income and turn to speculation. So the money the wealthy take out of mass production industry stays out, and the money devoted to speculation becomes a flood.

A “moderate” session of the New York Stock Exchange today sees half again as many shares traded as were thrown on the market in the frenzy of the crash of October 1987. And still there is not enough to meet the demand. Besides the NASDAQ and the Amex and the mercantile exchanges and exchanges abroad (including way stations all over the new global village), there are $85 trillion worth of derivative “products” invented by clever bankers and brokers to facilitate betting on almost anything you can think of. In comparison, numbers running is child’s play.

Also in comparison, trying to make money by operating an enterprise that turns out actual goods and services is a mug’s game. As fortunes are made in speculation, the opportunity cost of productive enterprise rises. To keep those who have invested in industry from selling out, they have to be promised increased profits; and the fashionable way of doing that is for lean and mean companies to become leaner and meaner, thereby narrowing the already narrow market. Where once there was a spreading wage-price spiral, heading upward, the economy has slipped into a constricting lean-mean spiral, heading downward.

3-8-99-the-love-song-of-homo-economicius-ts-elliotThe wealthy are not the only ones contributing to this trend. The middle class is the beneficial owner, through what are called “institutions” (especially mutual funds and pension funds and insurance policies), of between one-third and one half of all the shares on the current exchanges. By being funded rather than treated as current expenses, these institutions soak up purchasing power and weaken aggregate demand. The funds’ speculating deprives the producing economy of efficient financing. The resulting shrinkage of the producing economy raises the rate of unemployment, accelerating the erosion of the middle class the institutions were created to protect, and exacerbating the polarization of society.

That is how we are approaching the turn of another century: The nonwealthy are unable to buy the products their industry can produce; industry consequently has fewer opportunities for expansion; the wealthy consequently have fewer opportunities for productive investment; the nonwealthy consequently have fewer job opportunities and more of them become unemployed (“naturally”).

It is easy to convince yourself that looking to the government to fix the situation is hopeless. President Franklin D. Roosevelt couldn’t get a cap on stay-at home incomes even in the midst of World War II, when millions of young men and women (and middle-aged ones, too) were risking their lives for their country. President Richard M. Nixon, despite being re-elected by the second largest percentage of the popular vote yet recorded, couldn’t enlist a Congressional majority for a negative income tax. The current tax law, whose top rate is less than half the top rate of 25 years ago, does not assess even the present top rate against capital gains. And who can imagine the Federal Reserve Board maintaining an interest rate that is either low or steady, let alone both?

Some (if not all) of these things should be done to mitigate the polarization of our society. If they can’t be done in the current political climate, what can economists be expected to do about it? Well, if economists can’t suggest answers, the least they can do is get out of the way. Certainly no solution will succeed if no one has the will to work for it, and certainly those most responsible are the people claiming professional status.

In the meantime, the outstanding “faults” of our economic society, albeit forged into one, are substantially identical with those of Keynes’ day. But the degradation, despair, and (in the words of the late Erik Erikson) negative identity are worse. Will human voices wake us before we drown?

 

The New Leader

[1] Ed. Well, I’ll be damned.  The author, uncharacteristically, has the quote wrong.  Eliot wrote of “streets”, not “songs” that follow like a tedious argument ….

By George P. Brockway, originally published January 11, 1999

1-11-1999 Interest Rates I have Known titleFRIENDS have been congratulating me on bringing the Federal Reserve Board around to my way of thinking about the interest rate. It is, to be sure, true that over the years I have scolded Chairman Alan Greenspan many more times than once about his interest rate policy, and that I scolded his predecessor, Paul A. Volcker, even more harshly (because his notions were indeed worse). Well, I am still at it: I don’t think the Federal Reserve Board has gone far enough.

Greenspan himself had the Federal Funds rate lower than it is at present from November 1991 through November 1994, and he kept it hovering around 3 per cent from mid-1992 through early 1994. Somehow it seems impossible for most people, especially financial reporters and bankers’ advertising agents, to remember what happened that long ago. Every day we read in the business pages that truck and minivan sales are responding vigorously to the current “low” interest rates, and that the real estate market is strong thanks to “low” mortgage rates. Commercials running on television have been touting mortgages at 6.5 per cent as “the lowest they’ve ever been!”

My own memory goes back somewhat farther. In 1940, like millions of our fellow citizens, my wife and I had an FHA mortgage at 4 per cent. In 1947, we refinanced it with a GI mortgage that started at 4 per cent and ultimately dropped to 3.5 per cent. At that time, anything above 6 per cent was condemned as usury by state law.

In 1947, too, I became a junior officer of a small firm and quickly learned the importance of a low interest rate to any company whose business is at all seasonal (you borrow money in one half of the year and pay it back in the next). The prime rate (what the majority of banks charge their most reliable customers) was then 1.5 per cent (it is now 7.75 per cent).

Two years later the prime was up to 1.75 per cent. I remember especially the concern with which our legal counsel telephoned us a few months later to tell us that he had just seen on the ticker that the prime had jumped to 2 per cent. He strongly recommended that we raise prices and go slow with some of the projects we were working on.

The point I’m trying to make is that, contrary to what you read in the newspapers or hear on the radio or TV, interest rates in this country are high by historical standards. They are higher than they have been in most of the years since the end of World War II, higher than in most of the years since the creation of the Federal Reserve Board in 1913, higher than of the Constitution.

In fact, they are so high that it will take a good long time to get them down to where they ought to be. How long is a good long time? Well, Milton Friedman says his empirical work convinces him that it takes at least two years for monetary policy to have a substantial effect in the world of action. Given the $15 trillion of mortgages, bonds and other long term indebtedness now outstanding, and given the number of leases and other long-term contracts with settled prices, I expect it will take nearer five years, and perhaps 10, to squeeze an appreciable amount of the inflation out of the system.

AS I HAVE SAID many times before, our capitalist system runs on borrowing, and borrowing is paid for by interest. Interest is a direct or indirect cost of every business and every farm in the land. The direct cost is what you pay to whoever lends you money. The indirect cost (technically termed “opportunity cost”) is what you pay yourself for using your own money in your own business, instead of taking the opportunity of lending it to another firm and making an effortless profit from the interest you would receive. Your business has to earn its opportunity cost, or it is not worth doing, except for fun; and it has to earn the direct cost, or it goes bankrupt. I’m all for having fun running a business (or a farm, though that seems more like hard labor to me)-after all, it is how you spend most of your waking hours-but you have to pay for it directly or indirectly or both.

Direct and indirect interest costs are therefore factors in the prices you charge. They are not the only factors, but they are unavoidable factors. You can’t escape them. If the interest rate falls, competition is likely to persuade you to lower your prices. If the interest rate goes up, the prices you charge have to go up too, or your profits go down.

In all this, you are not alone. That’s the way our economy works, and it works better than any other yet invented. But, to paraphrase President Calvin Coolidge, as I like to do, when many people raise prices, inflation results.

Last year, and for at least the past half century, the total indebtedness of the nonfinancial sectors of the economy ran fairly close to double the Gross Domestic Product. On this basis, a shift of one percentage point in the interest rate should cause a shift of almost two percentage points in the price level. Like most economic calculations, this one is far from precise. There are too many gaps and lags and crosscurrents and arguable assumptions and downright errors in the statistics.

We don’t need precision in this case, however. We merely need a direction, because the desired end is an interest rate barely high enough to cover transaction costs (which will, I hasten to say, include loan officers and clearinghouses and deposit insurance and much of the other paraphernalia of modern banking). The record here is so clear that it does not overstate the matter to say that a rise of one percentage point in the interest rate will cause a rise of at least one percentage point in the price level, and that a fall of one percentage point in the interest rate will cause a roughly corresponding fall in the price level. (Constant readers will recognize that the foregoing is a restatement of what appeared in this space 10 years ago as “Brockway’s Law No.2: Raising the interest rate doesn’t cure inflation; it causes it.”)

WELL, as you have no doubt guessed, I am in favor of the Federal Reserve Board continuing the policy of nibbling away at the interest rate started last summer. It might be risky to do this too fast, but it should be done steadily, and there is a recent example that should give the Board confidence. The Reserve brought the Federal Funds rate down from 9.21 per cent in 1989 to 3.02 per cent in 1993. That is a fall of about 67 per cent in four years. Such a fall, starting today, would give us in 2003 a Federal Funds rate of 1.5 per cent-just about what it should be.

Also in the years from 1989 to 1993, the annual change in the Consumer Price Index fell from 4.6 per cent to 2.7 per cent, a fall of about 60 per cent. This may be little more than a coincidence, rather than a consequence of the fall in the Federal Funds rate, but at least it’s a happy one and does not contradict our theory that the interest rate and the inflation rate tend to go up and down together, with the former causing the latter.

There are certainly occasional cases where a short supply, natural or man-devised, of a quasi-essential resource allows the ancient “law” of supply and demand to drive a particular price up, whereupon a one-time shock runs through the economy. In ordinary commerce today, though, price is the independent variable, usually set by the seller, while supply and demand are dependent upon it.

If the foregoing analysis is correct, the role of the Federal Reserve Board should be largely restricted to regulating banking (or some of it), to running a clearinghouse, and to maintaining a truly low and steady pattern of interest rates in order to stabilize the price level. Most of the other great desiderata of a good economy must necessarily be left to Congress and the President, provided they can get their minds off sex.

The New Leader

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 5, 1997

1997-5-5 Why I Want to Shake Alan Greenspan titleIN CONGRESSIONAL testimony, Chairman Alan P. Greenspan of the Federal Reserve Board has talked, in his gnomic way, about the rich getting richer and the poor getting poorer. Responding to a Congressman’s question, he testified: “There has been a regrettable dispersion of incomes that goes back to the later ’60s …. What’s the major threat to our society? I’d list this as a crucial issue. If it divides the society, I do not think that is good for any democracy of which I am aware.”

Sometimes you want to shake the man. He has done a bit to open up the Federal Reserve Board to public scrutiny, but often it seems he can’t make a straightforward declarative statement. There is no “if” about this proposition. Of course the “dispersion of incomes” divides the society. It does so by definition. We’ve known that since Aristotle. Whether or not there may be some democracies of which he is not aware, the dispersion is certainly not good for a democracy that was conceived in liberty and dedicated to the proposition that all men are created equal.

Later in his testimony Mr. Greenspan expressed regret that the Federal Reserve Board lacked the power to contribute to the solution of the problem. Whether it truly lacks that power is surely debatable.

What is beyond debate is that the Federal Reserve Board can make the problem worse. For they in fact did so as recently as March 25, 1997.

By raising the interest rate, the Reserve slowed the economy down-deliberately. A slowdown means that fewer goods and services will be sold than would have been sold otherwise-not necessarily fewer than are sold today, but certainly fewer than might have been sold tomorrow.

Since fewer goods and services will be sold, fewer will be supplied, and fewer people will be employed in supplying them. Since fewer people will be employed, fewer people will have money with which to “demand” goods and services. And since fewer people will be employed, those lucky enough to have jobs will hesitate to ask for raises and so also will have less money with which to demand goods and services. The expectation is that inflation will be contained or pre-emptively struck, depending on the metaphor you’re using this week, and that the rest of us will be free to choose among moderately priced commodities.

Now, it is obvious to everyone except (perhaps) the Federal Reserve Board that if raising the interest rate does in fact contain or pre-empt inflation, it does so at the expense of the workers and the would be workers of America. In other words, most of the poor will be poorer.

And will anyone be richer? That, too, should be obvious. When the interest rate is raised, someone benefits. Who else can that be but people with money to lend, that is, people with more money than they need for daily expenses of living? We may call these people rich. And most of them will be richer.

Nor will the middle class escape unscathed. For convenience, let’s say the middle class consists of all people who are constantly making mortgage payments or payments on their automobile or payments on educational loans or payments on their furniture or on their credit cards. They’re like the government: They pay their bills, and their credit is good, but they don’t balance their budgets.

These people will be hurt, some more than others, by the increase in interest rates, and the rich will be made richer at their expense. Since March 25, 1997, everyone with an outstanding variable rate loan and anyone taking out a new loan to buy a house, a car, a refrigerator, a loveseat, or a college education has been paying more-in some cases thousands of dollars more-than would have been required before March 25. Anyone lending after that date is correspondingly enriched. (Yes, most of the lending is done by banks and such, but these institutions are owned by people who are not poor.)

The rich will be distanced farther from everyone, from the middle class as well as from the poor. The rich have done nothing to deserve their increased incomes. They have not denied themselves more pleasures to finance the activities of the rest of us, and they will not be required, or even requested, to do anything. Their increased interest income is an outright gift from their fellow citizens, from the nation’s businesses, and from the Federal, state and local governments and school districts.

Nor has the middle class done anything to deserve having part of their wealth and income taken away from them. However large or small the part may be, it is, as the politicians say, their money-and it’s being given, not to the government for the presumed good of all, nor to some charity of their choice, but to the rich merely because they are rich.

As for the poor, they have done nothing to deserve the refusal of raises they might have had, or the denial of jobs that might have been created, or the downsizing from jobs they once had. Bernard Shaw’s Undeserving Poor are surely still with us, and some of them are doubtless unemployable, but the malign consequences- the intended malign consequences- of the increase in the interest rate will be visited on the poor whether they are otherwise deserving or not.

Some say that a quarter-point increase in the interest rate can’t hurt anyone very much. If that is so, why do it? The intention is to hurt. The alleged need is to hurt enough to force people to buy less, to consume less, to enjoy less.

Anyhow, the question before us is not whether it hurts, but whether it increases what Mr. Greenspan calls the dispersion of incomes. The answer to that question is clear. Because of the quarter-point increase in the interest rate, the total annual incomes of the richest 5 per cent of the population will be increased by several billion dollars, and the total annual incomes of the other 95 per cent will be decreased by several billion dollars. Moreover, since the rich are so few, they will, on average, grow richer almost 20 times as fast as their average fellow citizen becomes poorer. The income gap will continue to widen as long as the new rate is in effect, and it will widen even further if, as expected, the Reserve increases the rate again and again during the coming months.

The Federal Reserve Board has singlehandedly effected all these increased dispersions in income. Why did they do it? Surely they are not altogether oblivious of what happens to real people and real societies in the real world.

Well, we know why they did it. They’ve told us plenty of times. They were fighting inflation. They were fighting inflation when they caused recessions in 1954, 1958, 1961, 1970, 1975, 1980, 1982, and 1991. They’ve been fighting inflation, although they now say inflation never was as high as reported. They’ve been fighting inflation, although they’ve never made clear exactly what inflation is.

EVIDENTLY inflation is not all prices going up together, because they never have all gone up together; and since ordinary business requires making contracts at fixed prices, they never could all go up together. Evidently inflation is not an increase in the price of energy (a.k.a. oil) or an increase in the price of food, because economists have now concluded that these prices are controlled by foreigners or the weather or both. Evidently inflation is not an increase in the multimillion-dollar salaries of executives, entertainers and professional athletes, because such incentives are said to be needed to bring out the best in lethargic souls.

Evidently inflation is not an increase in profits, because profits are what it’s all about. Evidently inflation is not an increase in the cost of borrowing money, because raising the interest rate is the sole weapon the central bank uses in its perennial fight against inflation.

So what is left? Judging from press reports, it would appear that the chief signs of inflation are a fall in the unemployment rate, a fall in the number of new applications for unemployment insurance benefits, faint signs that some wages may be rising almost as fast as productivity, and improvement in the sales of discount stores.

As Pogo might have said, conventional economics has met the enemy and they is us. Inflation is some prices going up faster than others. In the conventional lexicon, the only really bad prices are the incomes of the middle class and the poor.

There is little doubt that an increase in these prices would eventually result in increases in some manufactured products, in some of what used to be called dry goods, and in some services. After all, the middle class and the poor do most of the work of the world, and wages are certainly a cost of doing business and thus a factor in prices.

But interest is also a cost of doing business and a factor in prices.  Increases in the interest rate thus push up prices. If Mr. Greenspan only grappled on to that simple and obvious fact, and if he took seriously his concerns about a divided society, he might launch a policy of slowly reducing the interest rate, striving to use his great power to achieve a new soft landing for all of us in a larger, more generous, more inclusive, more united, and more rewarding economy.

Conventional economists would of course scream that high interest rates are necessary to enforce a “natural rate of unemployment,” and that the Treasury couldn’t sell its bonds if the rate were reduced to what was common only 40 or 50 years ago (before the dispersion of incomes began). But everyone who is active in the economy wants lower interest rates-the automobile business and its ancillaries, the building industry and its suppliers from producers of carpet tacks to manufacturers of major appliances, all sorts of retail concerns and their customers, managers of mutual funds and their investors, most bankers, and governmental entities at all levels as they struggle to balance their budgets.

Did I say “most bankers”? Of course I did. The usurious rates of the ’70s and ’80s taught them a lesson. To attract and hold deposits they had to compete with Treasury bills paying as much as 16.3 per cent, while the Federal Reserve set a rate of up to 19.1 per cent on interbank loans. Borrowers resisted the rates that banks had to charge and cut their borrowing to the bone. Hundreds of S&Ls were wiped out (see “Who Killed the Savings and Loans?” NL, September 3, 1990), and many regular banks failed.

Mr. Greenspan himself, in answer to a question once posed about the natural rate of unemployment, said, “I don’t believe that any particular unemployment rate-that 5 per cent or 5.5 per cent or whatever numbers we’re dealing with is something desirable in and of itself. I don’t believe that.” Responding to a suggestion that interest rates had to be high to attract foreign bond buyers, he has also said, “I’m not aware that we’ve had very many difficulties selling the debt-the Federal debt at low interest rates.”

Conventional economists may sneer at Mr. Greenspan for voicing such unconventional ideas. A more valid complaint is that he doesn’t act on them.

The New Leader

By George P. Brockway, originally published February 24, 1997

1997-2-24 The 7-Up Solution Title

THE LAST TIME I saw Michael J. Boskin on the tube, he was Chairman of the President’s Council of Economic Advisers under George Bush, and he was arguing against extending jobless insurance as the 1991 recession dragged on. Doing this would, he explained, discourage the unemployed from rushing to grab new jobs-jobs that were, he neglected to point out, a lot worse and paid a lot less than those they’d lost.

Now Boskin is being presented as the fellow with a nonpolitical scientific story about the Consumer Price Index. In 1995 the Senate Finance Committee put him in charge of an independent commission appointed to look at the accuracy of the CPI as a measure of inflation; a few months ago the panel issued its report, and since then he has been very much with us. As I listen to him these days, I am reminded of Carl Jonas‘ comic novel The Sputnik Rapist, in which an old goat of an aging mountain man is sweet talking an Indian maiden, whispering in her ear about the great time they’re having. She replies, “Well, perhaps, but I think I’m being screwed.”

I’ve already given you my notion that the CPI is not, and never was meant to be, a COLA. It measures changes in the price level, and that is not the same as changes in the cost of living (see “What Does It Cost You To Live?” NL, June 3-17, 1996). I don’t propose to go into that again in detail, but I do have a couple of points to add.

Professor Boskin and other members of his commission all have a lot to say about how the CPI doesn’t adequately measure the improvement in products over time. Automobiles last longer than in the past, they point out, so no wonder a car costs more. Well, I don’t know about you, but I run my automobile longer than

I used to because the new ones cost too much. In fact, the last new car I bought was in 1982.

Besides, they contend, items that used to be extras are now standard equipment, and so should be reflected in the CPI; what is more, the equipment is better than it used to be. Perhaps it is, but I used to be able (it was a fight, but I could win it) to buy a car without a radio and a tape deck and CD player and quadrilateral sound and white sidewall tires.

Still, the Boskin commission thinks the CPI should be cut 0.6 percentage points for these reasons.

Another claim they make, exactly contrary to the previous one, is that lots of things-literature, for example-are cheaper than they used to be. Eight or 10 years ago, a best-selling novel was $12.95 in hardcover; now it might be $25, but you can get a paperback for $10.95, and so are better off. (paperbacks once were 25 cents, but let that pass.) Indeed, they say, you don’t have to spend even $10.95, you can go to the library for free.

I seem to remember that we could go to the library for free when we were children and the world was young; so the cost of reading shouldn’t be a factor in the CPI anyhow, even assuming that the CPI measures changes in the cost of living rather than changes in the price level. Speaking of-libraries, however, how do you factor in the fact that increased book and magazine prices, coupled with decreased budgets, have forced reductions in the number of books purchased and also in the hours libraries are open?

Anyway, the commission wants to trim 0.4 percentage points for cheaper substitutes.

Finally, they want to knock off 0.1 of a percentage point for the availability of less expensive places to shop, like warehouses. I don’t know of such a place in my neighborhood; and even if there were one, I can’t imagine how I’d get the stuff home or where I’d store it if I did get it home. I’d have to rent a larger place, which would surely cancel the savings from buying wholesale, not to mention the interest I’d have to pay on my investment in canned goods.

The grand total of all the deductions comes to 1.1 percentage points. While this doesn’t sound like much, it amounts to between three-tenths and a half of recent COLAS. Everything I’ve said, of course, is anecdotal, but so are the explanations we’ve been given about the presumed inaccuracy of the CPI.

There is another issue that is not anecdotal at all; it goes to the heart of the conservative passion for cutting the CPI. That is the effect of the CPI on the interest rate. It should be of particular concern to Chairman Alan Greenspan of the Federal Reserve Board. Although he was the first to make a public clamor about the CPI, he seems to be bashful or (maybe) blind to this issue.

Almost always when he’s talking about the interest rate, Mr. Greenspan is careful to make clear whether he’s referring to the money rate or the real rate. When in 1993 he gave up on his attempt to use M2 to forecast the future, moreover, he indicated that the real rate continued to be the object of Reserve policy. The real rate, of course, is the money rate (the rate banks actually charge and we actually pay) less the CPI.  Thus if the CPI is overstated by “at least” 1.1 per cent, the Federal Funds rate (the key rate the Reserve sets) is also overstated by at least 1.1 percentage points, as are all other rates.

This should give Mr. Greenspan and the Republican-New Democratic cabal furiously to think. Right now the outstanding debt of nonfinancial sectors of the economy is about $14 trillion. That $14 trillion includes everything from what you owe on your bank credit card through Treasury 30-year bonds. If the CPI is 1.1 per cent too high, the annual interest paid on that $14 trillion is 1.1 percentage points too high-or $154 billion, almost 50 per cent more than the current budget deficit.

Or look at it this way: During the past 10 years, while Alan Greenspan has been keeping the Federal Reserve’s eye trained on the “real” rate of interest, we-you, me, all the businesses of the land, and the city, state, and Federal governments-have paid over $1 trillion too much in interest. We will again pay $1 trillion too much in interest between 1997 and the mystic year of 2002.

Now, the most that any of the Boskin commission expects to gain by cutting the Social Security COLA, modifying the brackets of the income tax, and holding down government and service pensions and disability entitlements seems to be about $200 billion over the next six years. If the commission would just take Mr. Greenspan aside and explain to him how the CPI is overestimated, he could save five times what the commission wants to dock the elderly and disabled.

Not only that: Since he claims to have been aware for a long time of errors in the CPI, he could have made proportionate savings for us at any time in the last decade without bothering the elderly and disabled. The Federal Reserve Board is an independent agency with large staffs of well-paid economists, not only in Washington but also in the 12 district banks. It doesn’t have to base its policies on numbers crunched by the underfunded Bureau of Labor Statistics of the Department of Labor, which computes the CPI, or by the Boskin panel either.

If the Fed were to take a responsible approach to the CPI question, it would sooner or later (depending on how fast they can do simple arithmetic in their heads) come up with a solution that would render irrelevant the Boskin commission’s report and all the debate and talk shows and editorials it has inspired.

BEFORE GETTING DOWN to this solution, let’s make a minor adjustment in nomenclature. I used to talk about the “Bankers’ COLA,” but a friend has complained that the term made unfair fun of bankers; they, after all, are not the only ones to benefit from it. So suppose we now call it the “Fed’s COLA,” because it is the Federal Reserve Board that decides how big the interest rate’s cost-of-living adjustment is.

The simple arithmetic is this: The Federal Reserve Board decides on an estimate of the current rate of change in the CPI, and then adds that estimate-the Fed’s COLA-to the “real” interest rate (which is determined altogether separately) to set the “money” rate. Multiply the outstanding indebtedness of the nonfinancial sectors of the economy by the Fed’s COLA, and you get its cost to the economy.

Next, multiply the Gross Domestic Product by the same rate of change in the CPI (whatever it is). This will give you the cost of inflation to the economy, for that is what the Consumer Price Index is supposed to point to.

Lastly, compare these two costs. In today’s economy it will turn out, no matter what the rate of change in the CPI is, no matter how or by whom calculated or by whom approved, that the Fed’s COLA costs the economy almost twice what inflation costs. The plain and simple reason, as Tom Swift used to say in a marvelous old series of books for 10-yearolds, is that the outstanding indebtedness of the nonfinancial sectors of the economy is, and has been for many years, almost twice the Gross Domestic Product. So when you multiply them both by the same number, no matter what it is, you get figures that are different by nearly a factor of two.

It doesn’t take Tom Swift to see that if there were no change in the CPI, there would be no Fed’s COLA. Conventional economics, which is perhaps not so smart as Tom Swift, concludes that the thing to do is to get inflation down to zero, whereupon the interest rate could be lowered because the Fed’s COLA would be reduced to zero, too. In order to get inflation down to zero, though, the Federal Reserve Board (which is nothing if not conventional) raises interest rates to control inflation putting us right back where we started from.

Since interest rates are set before things are made, and hence before prices are set, one might rationally expect that the proper procedure would be to get rid of the Fed’s COLA, which (if the estimate of the CPI change is correct) would get rid of inflation as a consequence. And if we got rid of inflation, we could get rid of all the other COLAS. And nobody would be hurt, as people are being hurt today. For a variety of reasons, this could not happen overnight. I’ll name two: First, monetary policy seems to take about two years to have a substantial effect. Second, most existing indebtedness has many years to run. But it shouldn’t take Tom Swift to convince us that we ought not to do the wrong thing just because doing the right thing takes time.

The New Leader

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