Archive

Tag Archives: Federal Reserve Board

By George P. Brockway, originally published April 30, 1990

1990-4-30 Bunk About Junk Title

A RECENT EDITORIAL in the New York Times opened with these words: “Michael Milken is a convicted felon. But he is also a financial genius who transformed high-risk bonds junk bonds into a lifeline of credit for hundreds of emerging companies. Snubbed by the banks, these businesses would otherwise have shriveled …There is no condoning Mr. Milken’s criminality. But if overzealous government regulators overreact by dismantling his junk-bond legacy, they will wind up crushing the most dynamic parts of the economy.”

1990-4-30 Bunk About Junk Michael Milken

This reminded me of a story about Henry J. Raymond, the Times’ founding editor and a member of Congress. One day he was prowling the House floor, trying to arrange a pair on an important upcoming vote, so he could return to New York on business. Old Thad Stevens (one of my heroes) asked, “Why doesn’t the gentleman pair with himself? He’s been on both sides of the question already.” Raymond’s successors seem to be straining to be on both sides of the junk-bond question.

For my part, I’m ready to grant that Milken is (or was) a crackerjack salesman and a mighty cute operator. But a financial genius he was not. Certainly he was not the first investment banker (what an impressive-sounding job description!) to sell carloads of not-of-investment-grade securities (see “Junk Bonds and Watered Stock,” NL, March 24, 1986). Nor is the New York Times the first journal to discover virtue in such super salesmanship. Nor, I daresay, is this the first time the Times itself has made such a discovery. Junk bonds are a slight variation on a very old theme, played at least as early as the Mississippi Bubble and the South Sea Bubble, both of which burst in 1720.

I’m also ready to grant that a lot of emerging companies have been snubbed by banks, yet I rather wonder why. Having paid casual attention to some banks’ advertising campaigns, I was under the impression that nothing was more likely to make a banker’s day than an opportunity to lend a helping hand to a bright but inexperienced young woman with a new idea for a flower shop, or to a similarly energetic young man eager to play a part in the great drama of American business. If the banks weren’t seizing these opportunities, what were they doing with the money they persuaded us to deposit with them?

Well, one thing they did was make Milken’s junk-bond business possible. They were no big buyers of junk bonds themselves (although the savings and loans snapped up about a tenth of those issued). Instead, they supplied bridge loans. When Robert Campeau made his deals to buy the Allied and Federated department store chains, he did not put up much cash. He counted on selling junk bonds, and he knew that would take a little while, especially since it was important to wait for the moment when the market was right. The banks loaned him the money to bridge that gap. After the bonds were sold, the banks would be paid off, handsomely.

The trouble was, it turned out that the junk couldn’t be sold, at least not at the necessary price; so the banks involved couldn’t be paid off. They were stuck with nonperforming loans, and Campeau’s stores took refuge in bankruptcy. There are recurring rumors that one of the banks is on the verge of bankruptcy, too. Junk bonds aren’t doing a job the banks are falling down on; the banks are in fact doing the job indirectly by making all those bridge loans. The banks are essential players in the junk-bond game.

Not surprisingly, the Federal Reserve Board (which is responsible for the availability of credit) doesn’t see a problem here, anyhow. The Board has just reported: “There is little evidence that a ‘credit crunch’ is developing; the majority of businesses say they have not seen any change in credit terms and have had no trouble getting credit.  Where credit tightening by banks and thrift institutions has been noted, however, it has mainly affected newer small businesses and the real estate industry.” A medical researcher would scorn that diagnosis as anecdotal. It doesn’t mean much to say a “majority” of businesses have no trouble with credit; 49 per cent could be having a lot of trouble.

Whatever the situation, we can be sure that the “newer small businesses” turned away by the commercial banks are also unable to find an investment banker ready to float junk bonds for them. The junk bond market being thin and precarious, a $3 million issue is about the smallest anyone will undertake. This assumes a company with upwards of $15 million or $20 million in annual sales. It is not the sort of stuff that made Milken notorious, but it is considerably more than can be expected from most newer small businesses.

A new small business has always had a tough time and always will, for the reason suggested by John Maynard Keynes. “If human nature felt no temptation to take a chance,” he wrote, “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.” Every new enterprise faces a high probability of failure.

Real estate, though, is a key industry. New Building Permits Issued is one of the “leading indicators” of the economy. No prosperity lasts long if real estate does not prosper. Moreover, we have great need of it. Not only do we have uncounted millions of homeless and ill housed; we are unable, in this supposedly family-oriented society, to provide enough affordable housing for young couples, employed and upwardly mobile though both partners may be.

Still, as everyone knows, real estate loans are prominent among the troubles of savings and loans and of commercial banks like the one pushed to the brink by the Campeau fiasco. Why do the loans go bad? Not because the housing is not wanted or not needed, and only partly because prices are too high. It is the high carrying charges that are to blame. Real estate loans go bad for the same reason junk bonds go bad. The interest rates are usurious. The usury affects real estate developers (another impressive job description) and contractors as well as potential buyers, and commercial construction as well as residential. High interest rates are a main factor of high real estate prices – and of high furniture and food and clothing prices, too.

Interest charges paid by the nonfinancial sectors of the economy are now in excess of 20 per cent annually. They were only 4.9 per cent of the GNP in 1950, rising to 7.2 per cent in 1960, to 10.1 per cent in 1970, and to 15.0 percent in 1980. These great leaps forward, culminating in today’s 20 per cent, didn’t just happen. They were carefully fine-tuned by the Federal Reserve Board.

Why did the Board members do it? They have certainly told us enough times. They’ve been fighting inflation. Unfortunately, the fight has not been remarkably successful. You can see that from the fact that the Consumer Price Index, which stood at 24.1 in 1950, reached 126.1 by last December-an increase of 523 per cent in the 40 years in question. (As I’ve remarked before, this figure seems to me too low; the food, clothing, shelter, transportation, education, medicine and entertainment I buy have all increased much more than that. But let that pass.)

1990-4-30 Bunk About Junk ChartHIGH INTEREST becomes a self-fulfilling prophecy. What is prophesied is the probable failure of the borrowers. The probability is a risk the lenders must protect themselves from. They protect themselves by charging even higher interest. That, naturally, increases the risk of failure.

Abstractly there is no end to the escalation of interest rates, for there is no end to the escalation of risk. Indeed, in a sort of Malthusian progression, risk increases geometrically while rates increase arithmetically. Actually, of course, the escalation does have an end, because potential borrowers are driven off. That may be prudence, but foreclosing production (or consumption) does not make for prosperity.

It all comes back to the nation’s monetary policy – its rates and rules and regulations. Deregulation, combined with tightened credit, results in escalation of rates. Escalation of rates discourages production and encourages speculation. Junk bonds are just one of the forms speculation takes. Junk bonds are the creation of the nation and of the Federal Reserve Board (which is, absurdly, an independent power), not of the genius of a super salesperson.

There is another issue here. The Times thinks that junk bonds are good because they force companies to become more efficient (and hence more “competitive”) in order to payoff the high interest charges. If this tale isn’t false, I wish somebody would cite a few shining examples.

There are certainly examples on the other side, Allied and Federated department stores being first among them. Both chains were long established. I know, because in the days of my youth I spent many gold-bricking hours waiting in their sample rooms to see buyers. They were also successful. They’re not successful now.

Furthermore, the usual test of efficiency is a fat bottom line, and the quickest way to fatten the bottom line is to fire some people and put a leash on the rest. But as John Kenneth Galbraith argued years ago in The Affluent Society, an economy that makes life unpleasant for people is something we don’t need. If the virtue of junk bonds is that they are a sort of handicap inspiring efficiency, why not try a different handicap by giving all the working stiffs a raise? It used to be said that management’s first test was meeting the payroll. Why wouldn’t meeting a bigger payroll be a better test than paying higher interest?

 The New Leader

By George P. Brockway, originally published June 12, 1989

1989-6-12 The Reserve's Silly New Equation Title

IN HIS EXCELLENT and comprehensive book about the Federal Reserve Board, Secrets of the Temple, William Greider properly fastens on the first word of his title, the Board being at least the third most secretive arm of the United States government. The rationale for the secrecy is that billions of dollars can be made by uncovering what, if anything, the Reserve is going to do next . Greider suspects, as I do, that the secrecy is useful mainly for instilling awe in us poor mortals.

1989-6-12 The Reserve's Silly New Equation Greenspan

Whatever the case, in contrast with its usual practice, the Reserve has recently gone to considerable trouble to call attention to a new equation that is supposed to predict inflation levels two years or so in advance. We are told that Chairman Alan Greenspan set a team of three economists to work on the problem when he took over in the spring of 1987, and that there is now light at the end of the tunnel. Remembering a New Yorker cartoon of a couple of years ago, I expect the apparent light will turn out to be New Jersey.

As constant readers know, I am, like Adam Smith, skeptical of all alleged mathematical solution to basic economic problems. Happily, the present formula is very elementary mathematics; something that kids probably do today in kindergarten, and that you used to toss off in fifth or sixth grade. So don’t panic.

First, a bit of background. Culminating a century of deep thinking by deep economists, Irving Fisher of Yale promulgated , 80-odd years ago, an equation sometimes said to be the essence of monetarism. Milton Friedman, in The New Palgrave (a four -volume economics encyclopedia I wish I could afford), assures us that monetarism is something else, and he’s entitled to his opinion; but it is Fisher’s formula the Reserve starts with.

 

Friedman also tells us, “There is no unique way to express either the nominal or the real quantity of money.” Nevertheless, some number is chosen and fed into an equation that says the quantity of money, multiplied by the velocity of its circulation, is equal to the general price level, multiplied by the goods produced. The equation, written all in capitals, looks formidable (MV = PQ) but expresses a simple, even a simplistic idea.

 

The money supply (M) is not the only term beset with difficulties. It turns out that the velocity (V) cannot be determined except by means of this equation. Fanciers of the theory contend that over the past many years V has been reasonably constant; MV is practically a single term.

 

The right-hand side of the equation presents different difficulties. Q stands for the total of the goods and services produced – that is, the “real” (stated in things), as opposed to the “nominal” (stated in money), gross national product. I have from time to time averred that the GNP, whether real or nominal, is less than it is cracked up to be, yet for the moment let’s accept it at its face value. We are immediately struck by the fact that its face value is expressed in money. Moreover, it cannot be expressed otherwise, for money is the sole relevant unit of measurement that applies to apples and oranges and tons of steel and all the rest. The paradoxical truth is that the “real” GNP can only be quantified “nominally.”

 

What, then, is the price level (P)? It is the sort of index I often grumble about, derived by combining the prices of a great variety of goods and services, each one weighted to allow its supposedly proper importance in the economy. But the prices of goods and services are already and necessarily included in the GNP. Many have therefore dropped P from the equation, effectively reducing it to M=Q. Translating it back into English, we learn that the total money spent for goods and services equals the total prices charged for those goods and services. Not much to learn from two centuries of study.

 

This is the reed the Federal Reserve leans on. It starts again with MV = PQ. Dividing both sides of the equation by Q. it gets P= MV/Q. Mainly because M2 yields a relatively constant value for V, which the Reserve wants, M2 is selected as the quantity of money. (M2 consists-you don’t have to pay attention here-of  currency, traveler’s checks, checking deposits, savings and ordinary time deposits, money market funds, and overnight Eurodollar deposits, but excludes time deposits of $100,000 or more.)

 

Next, the Reserve pretties up the equation with some asterisks or stars, like this: P* = M2 x V*/Q*. P* (or “P-star,” as insiders say) stands for the price level a couple of years down the road. V*is the determined constant, now with a suspiciously precise value of 1.6527. Q* is the future “real” GNP, assuming a steady growth of 2.5 per cent a year.

 

That last assumption is of course the secret of the game. The inflation-fighting Reserve wants the fraction to the right of the equal sign to be as small as possible, since it is equal to P*, or the future price level. As you remember from the fifth grade, you can reduce the value of a fraction either by reducing the numerator (1/3 is less than 2/3) or by increasing the denominator (1/3 is also less than 1/2). So taking the Reserve’s equation at face value, we could hold the price level (P*) down either by decreasing the money supply (M2) or by increasing production (Q*).

 

Faced with such an alternative, anyone who had not altogether taken leave of his (or her) senses would opt for increasing production, because after all that makes possible our standard of living. The Reserve, I’m sorry to say, opts for decreasing the money supply. It would unfair to imply that the Reserve doesn’t have a reason for its unnatural decision; the trouble is, the “reason” is erroneous. The Reserve, in fact, is not unlike one of my favorite characters in all literature, “The King of Korea I [who] was gay and harmonious: / he had one idea I and that was erroneous.”

 

The Reserve’s one idea is to control the money supply. For reasons that have taken me the better part of a book (to be published by Cornelia and Michael Bessie for Harper&Row about a year from now -advt.) to elucidate, the Reserve can very readily reduce the money supply -but it can’t be sure of increasing it. By “money supply” I don’t mean the gabble-gabble of items that make up M2; I mean the money actually at work in the economy. And in the capitalist economy everyone agrees we have, that is credit, the flip side of which is debit, or borrowing.

 

The textbooks say, I know, that bankers create money by lending it, yet actually they produce nothing except some useful services. Although bankers are often hyperactive in thinking up new financial “products” (index trading, etc.), they are passive partners in the work of the world. The active partners in the creation of money, and the uses it can be put to, are the borrowers. If no entrepreneur plans to produce a better mousetrap, if no consumers long for anything beyond their means, if no speculator schemes for a big killing, the banker sits idle. He can refuse to support plans, longings and schemes, but the first and essential step in creating money is taken by borrowers.

 

THE FEDERAL RESERVE –  the banker par excellence – can make it hard for ordinary banks to lend money, and hence hard for productive people to borrow money. Even if it makes borrowing easy, however, it can’t make people borrow. In other words, it can surely reduce the money supply, but can’t be sure of increasing it.

 

On the other hand, the Reserve can affect the interest rate, and that makes a difference the new equation does not take into account. By raising or lowering the Federal funds rate (the interest banks pay on temporary loans from each other, or from the Reserve itself) or the discount rate (the interest Federal Reserve banks charge commercial banks for short-term loans), the Reserve directly raises or lowers the interest banks have to pay, and consequently the interest they have to set. Naturally, too, by making it difficult for people and businesses to borrow money, the Reserve can indirectly raise the interest they have to pay.

 

Given that interest is a cost of doing business and a cost of living, raising the rate (whether directly or indirectly) ups those costs, thus certainly inhibiting or reducing output (Q*). But we remember that reducing Q* increases the value of the Reserve’s equation by increasing P* (the price level). So we find the Federal

 

Reserve deliberately reducing our standard of living and at the same time raising the price level. True to its one idea, the Reserve next solemnly goes about further reducing M2 (which might be the money supply if ours were a mercantilist system instead of a capitalist system).  In the process, it manages both to restrict the national output and to keep the inflation fires burning.

 

That is indeed the record the Federal Reserve Board has compiled since 1951, when it succeeded in abrogating its wartime agreement with the Treasury that kept the prime rate down to 1.5 per cent from 1939 to 1947. The abrogation was necessary, the Reserve argued, so it could be free to control the money supply (then said to be M1), as it dearly wanted to do.

 

Let’s go to the computer tape. Since the fateful year of 1951, the price level has increased 436.9 per cent. (That’s what the Bureau of Labor Statistics says; if food, shelter, clothing, and transportation have anything to do with the cost of living, I’ll say it has gone up a lot more than that.) More to the point, look at the figures that are left out of the Reserve’s equation: (l)interest paid as a percentage of GNP: up from 4.59 per cent in 1951 to 19.19 per cent in 1987; (2)pretax profits: down from 11.82 per cent of GNP to 6.92 per cent; (3) after tax profits (despite the best efforts of Ronald Reagan): down from 5.19 per cent of GNP to 3.94 per cent; (4)unemployment: up from 3.2 per cent to 6.1 percent; (5)Federal budget: from a surplus of 6.1 per cent of GNP to a deficit of 3.35 per cent; (6)foreign trade balance on current account, from positive $884 million to negative $153,964 million.

 

That is one sorry record. Monetarists say it is the consequence of failing to restrain M2 even further; but they know in their hearts that if the Reserve had in fact restrained it any further, the interest rate would have gone God knows how high, and we would have spent the subsequent years in a rapidly deepening depression that would have made 1932 seem idyllic.

 

How long must we allow ourselves to be deluded by silly equations?

 

The New Leader

 

Originally published July 1, 1985

INTHE PREFACE to their best seller Free to Choose, Milton and Rose Friedman write, “We are still free as a people to choose whether we shall continue speeding down the ‘road to serfdom,’ as Friedrich Hayek entitled his profound and influential book …. ” Since Hayek’s book was published 40 years ago, it would seem that we have been “speeding” down that road at a remarkably sedate pace. I must confess that praise like the Friedmans’ put me off reading The Road to Serfdom until now.

That was a mistake. Hayek is well worth reading, both for what he says and for what he doesn’t say. Looking first at the latter, we find that he is far from advocating the sort of libertarian – that is, practically nonexistent state the Friedmans envisage. The Friedmans share with Marx a longing for the state to wither away, but Hayek is having none of that; he merely wants the state to act responsibly.

He is, for example, willing to consider “restricting the allowed methods of production, so long as these restrictions affect all potential producers equally and are not used as an indirect way of controlling prices and quantities …. ” He also believes that “To prohibit the use of certain poisonous substances or to require special precautions in their use, to limit working hours or to require certain sanitary arrangements, is fully compatible with the preservation of competition.” Hayek would thus not be sympathetic with the notion, advanced by both neoliberals and neoconservatives, that factories should be allowed to pollute as they please, so long as they pay a fee for the privilege.

Nor would he approve of the merger movement and the consequent concentration of power in sprawling conglomerates. He disputes, without naming him, his fellow countryman Joseph A. Schumpeter (who is at present being touted by neoconservatives as a foil to Keynes), rejecting “the myth … that … competition is spontaneously eliminated by technological changes.” In addition, Hayek quotes with favor from the New Deal report of the Temporary National Economic Committee: “‘The superior efficiency of large establishments has not been demonstrated … monopoly is frequently the product of factors other than the lower costs of greater size. It is attained by collusive agreement and promoted by public policies. When these agreements are invalidated and when these policies are reversed, competitive conditions can be restored.'”

In another place Hayek says, “It is only because the control of the means of production is divided among many people acting independently that nobody has complete power over us.” He is against monopoly as well as against the “monster state,” and in his last chapter, he writes (anticipating E.F. Schumacher), “It is no accident that on the whole there was more beauty and decency to be found in the life of the small peoples.”

Though Hayek’s main thesis is objection to a comprehensively planned economy, he recognizes that “the case for the state’s helping to organize a comprehensive system of social insurance is very strong.” He holds, too, that the state should be concerned in “the extremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them.” And strong as he is in his insistence on private property, he thinks that the case for inheritance may not be supported with “the same necessity.”

I have quoted Hayek extensively because his reputation is that of an extreme, devil-may-care, laissez-faire conservative. His book was actually greeted with qualified praise by Keynes, as Robert Heilbroner tells us in The Worldly Philosophers; but endorsements like the Friedmans’ have established his reactionary” image.” Much of Hayek’s later work, however (e.g., his attack on John Kenneth Galbraith; see” Rereading Galbraith,” NL, June 13,1983), does exhibit a hardening conservatism.

This is not, I think, an instance of the notorious syndrome whereby flaming youths turn into reactionary elders (“When old age came over them / With all its aches and qualms, / King Solomon wrote the Proverbs / And King David wrote the Psalms”[1]). Rather, it is an instance of a common, albeit little noticed, progression whereby a great leader becomes misled by his followers. The change is not always in a conservative direction. Marx became more violent and conspiratorial at least in part because his most vocal supporters were conspiratorial. John Dewey, whose Human Nature and Conduct showed strong elements of philosophical idealism, became famous for the contrary theory of instrumentalism that appealed to his admirers.

I have also seen such changes occur at less rarefied levels. One of the most delightful books I ever published was Little Britches (I was never good at titles) by Ralph Moody. It was the first of several memoirs of family life. No one reading the series would guess Little Britches was begun as a polemic against the Social Security system. But Ralph’s readers – starting with those in an extension writing course in Berkeley-praised him for the warmth of his characterizations, and he became more interested in people and less in abstract theory.

THERE ARE other interesting themes in The Road to Serfdom.  One of these appears in his analysis of the failure of the Social Democrats to stop Hitler. We have heard much of the trahison[2] of the Communists; but Hayek argues that the socialist emphasis on comprehensive planning predisposed the German electorate in favor of grandiose schemes like Hitler’s. If he is right, this fact should give pause to our Atari Democrats, who want to set up a committee to decide which industries we should foster and which we should abandon and in general to plan how to use our resources. As Robert Lekachman has pointed out, such committees are more likely to be run by big business than by idealistic planners.

The Social Democrats were further weakened, Hayek says, by a split that appeared in the labor movement. For various reasons, certain unions and certain categories of workers were able to achieve remarkable economic gains, while others were left far behind. The laggers were understandably disillusioned about the Social Democrats and became ready to acquiesce in, if not support, the National Socialist program.

“To them,” Hayek writes, “and not without some justification, the more prosperous sections of the labor movement seemed to belong to the exploiting rather than to the exploited class.”

This is a problem that American labor leaders have yet to solve. The split in our labor movement was opened, as I suggested last year (“Voodoo on the Primary Trail,” NL, April 30, 1984) by the Vietnam War. But it has been astutely widened by apologists for big business and by the just- folks demeanor of President Reagan, and deepened by the misguided anti-labor Presidential campaign of Gary Hart.

It is said, by the way, that Hart appealed especially to the so-called Yuppies- young, upwardly mobile professionals. I venture to think that Hayek’s analysis of what happened in Germany is closer to what is happening here. He writes that “no single economic factor has contributed more to help [the Nazis] than the envy of the unsuccessful professional man, the university-trained engineer or lawyer, and of the ‘white-collar proletariat’ in general for the … members of the strongest trade unions whose income was many times theirs.” I suggest that the “white-collar proletariat,” hitherto most visible in countries like India, will become a growing and destabilizing factor in our public life as computerization and conglomeration steadily reduce the need for “middle management.”

Another theme of current interest in Hayek’s book is his concern over the tendency of legislatures to turn hard questions over to independent public authorities. I suppose he would therefore welcome a good deal of the current deregulation, but he would appear not to have been a knee-jerk deregulator. Hayek’s concern is also a central topic in Theodore J. Lowi‘s widely read The End of Liberalism. Both men describe the irresponsibility that results from the delegation of undefined powers. Hayek emphasizes the dictatorial arrogance that ensues; Lowi notes (as does Lekachman in the comment cited above) that ill defined regulatory commissions tend to be co-opted by the industries they regulate. A different example of irresponsible delegation is the willingness of Congress to give the President power to commit military forces to action, and indeed to launch a nuclear strike, without carefully defining limits to that power.

In the same way, control over our money, and hence over our economy as a whole, has been surrendered to the Federal Reserve Board. I regret to have to admit that three Democratic Presidents played crucial roles in the surrender: Woodrow Wilson, who admitted he knew nothing about banking, signed the Federal Reserve Act. Harry Truman allowed his Secretary of the Treasury to dissolve the agreement with the Federal Reserve that had held the prime interest rate down to 1.5 per cent during the War. Jimmy Carter appointed Paul Volcker chairman of the Fed.

How all this came about is told in fascinating and chilling detail by F.W. Maisel in a little book entitled Great American Ripoff (Condido Press, Box27551,San Diego 92128). Maisel may upset the sensitive by his espousal of a conspiracy theory of American banking; nevertheless, it’s hard to fault his facts, and I’m not even prepared to say he’s wrong about the conspiracy.

Should you feel that the bankers running the Federal Reserve, far from being conspirators, are idealistic public servants who have, in Hayek’s phrase, “devoted their lives to a single task,” there is still reason to be wary of them, for “From the saintly and single-minded idealist to the fanatic is often but a step.” Single-minded conservatives please copy.

The New Leader


[1] A poem by James Ball Naylor http://www.jamesballnaylor.com/

[2] French for “betrayal” or “treason.”

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.>

%d bloggers like this: