A New New Theory

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

TWO 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 18^th 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 chicken–and–egg 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

The Enemy is Us

By George P. Brockway, originally published March 13, 1995

HARDLY A DAY goes by without your being asked by a political party or a news organization or some other public-spirited body to name the three or five or 10 most urgent problems facing America today. If you subsequently reflect on your answers, you are likely to realize, whether sadly or cynically, that little or nothing will be done about any of the problems, even those that have a large majority worried about them.

The reason is simple: We don’t have the money.

Everyone knows we can’t have universal health care; we can’t have a welfare system we’re not ashamed of; we can’t have a superaccelerator; we can’t improve our schools and colleges; we can’t keep our libraries and museums open as long as they were 60 years ago; we can’t clean up the pollution of our air and water; we can’t fix our roads and highways; we can’t clear our streets of garbage; we can’t hire enough cops and judges or build enough jails to curb crime – because we don’t have the money. Everyone knows this, and everyone, from the President to this year’s kindergarten graduate, says it every day.

But everyone is wrong. What we don’t have is intelligence. What we don’t have is good will or strong will or, honestly, any will at all. What we don’t have is the ability to learn from our experience. We don’t even have common sense and ordinary decency. Pogo was right: We have met the enemy and they is us.

“Enemy” suggests a couple of lessons from World War II. When Germany started the War, the papers were full of prophecies that despite its possible superiority in tanks and airplanes and training, it would surely lose. You could try all day and never guess why; so I’ll tell you. Germany would lose because its gold reserves were too low, even though Hjalmar Horace Greeley Schacht had been trying to conserve them by bartering instead of paying cash for the things it needed. It didn’t have the money. All we had to do was to sit back and wait for it to collapse.

Five and a half desperate and bloody years later, collapse did come, but not because the Germans lacked gold. They lacked manpower. At the end, they tried to defend their “heartland” with half-trained regiments of teenagers and retirees. They were overwhelmed.

During the War we had a money problem too. After all, when Germany attacked Poland we were slowly pushing our way out of the Great Depression. Then as now, the Federal budget deficit was on everyone’s lips. We were on the road to serfdom (at the time inflation was more a promise than a threat). By 1945 the national public debt reached $235.2 billion, or 111 per cent of Gross National Product. That sounds like bankruptcy if you have heard Warren B. Rudman and Paul E. Tsongas making a fuss over the present ratio of 66.8 per cent. Given our clearly not having the money to pay for the War, we should have surrendered and undertaken the close study of German and Japanese management practices from the ground up.

Yet somehow, before the year was out, we won the War. More than that, as we demobilized our Army and Navy, we enacted the GI Bill of Rights, enabling the wartime generation to be the first in history to have a college education and to buy their own homes. Two years later we still didn’t have the money, but we started the Marshall Plan and saved Europe. Afterward we enjoyed a quarter century of more rapidly rising wages than we’ve had since, higher corporate profits after taxes than we’ve had since, lower inflation than we’ve had since, and lower unemployment than we’ve had since – all at once. We could have done more (President Truman tried to get universal health care almost a half century ago, but was blocked by the American Medical Association and the Republican Party); nevertheless, what we did do was better than we have managed lately.

Let’s look at a somewhat less impersonal situation. Think about the Baby Boomers. Their parents and grandparents won the War and passed the GI Bill and saved Europe with the Marshall Plan. Of course, this increased the national debt left to their children. Now I ask you: Would the Boomers have been better off if they had not been saddled with a victorious America, prosperous parents, and a recovered Europe?

Next, let’s think about the Boomers’ children – the present younger generation that we are worried about saddling with debts we don’t have the money to pay. Are we doing them (or the nation) a favor by cutting the deficit so that those who happen to survive the measles (we don’t have the money to vaccinate them all) will grow up half educated and in dangerous, squalid surroundings? Or will we do anyone a favor by leaving children essentially uncared for while we force their mothers to work at jobs that won’t pay enough to lift them out of poverty?

Finally, think of your own children. Where are you going to find $125,000 apiece to send them through college? Should you go into debt, along with them, or should you give the whole thing up? And what about your mortgage? If you have one, it is because you want a better place to live and to raise your children than you could otherwise afford. If you die before the mortgage is paid off, your estate will have to pay the balance and your children’s inheritance will be diminished. Is that mortgage against your children’s interests?

Like all good rhetorical questions, these have obvious answers. The resulting problems have equally obvious solutions, if we stop long enough to consider the distinguishing marks of the capitalist system we praise so mindlessly.

MODERN CAPITALISM depends on ongoing indebtedness to support ongoing investment in ongoing production that will provide ongoing income. This is something quite new under the sun. For convenience we will call what we previously had mercantilism. To be sure, the two systems have run together, and certainly are not disentangled yet, but let’s try to focus on their differences.

To begin with, rather than burdening themselves with ongoing indebtedness, good mercantilists followed Polonius‘ advice: “Neither a borrower nor a lender be.” If they did borrow, they did so for a specific purpose and paid off the loan as quickly as possible. In contrast, AT&T, industrial giant though it is, rolls over its massive debt as that comes due. Alexander Hamilton foresaw that a national debt, widely held by prominent citizens, would be a stabilizing and unifying element in the new republic, and so it has been.

Second, instead of investing in ongoing enterprises, mercantilists looked for big deals where they could make a killing. The merchants of Venice took shares in a particular voyage of a particular galley. As recently as a hundred years ago, most American corporations were chartered in New Jersey or Delaware because other states would grant charters only for limited and specific purposes. In contrast, a modern corporation is usually at least moderately diversified and is, theoretically anyway, immortal.

Third, because of its ad hoc investing, the characteristic mercantilist form of profit is the capital gain, which is realized when the investment is withdrawn and the enterprise ceases. In contrast, the characteristic capitalist investment continues indefinitely, produces a regular flow of goods, yields regular dividends, offers regular employment, and pays regular taxes.

When money was gold or silver or some commodity, or was convertible to some commodity, the amount of borrowing that could be done in an economy was limited by the amount of the money-commodity. Today, when money is realized credit or debt, the amount of borrowing is limited by the amount of unused resources, especially labor, available to the economy[1].

In the United States at present we have upwards of 17 million potential workers who are either unemployed, underemployed, discouraged, or turned off. That’s about an eighth of our work force and represents an enormous available resource, greater than the labor power of most nations of the world. We also have all the urgent, if not desperate, needs we mentioned in the beginning. Our problem is to use this resource to meet those needs.

Modern capitalism has tried to do that and has failed. It has been an enormous economic success in many ways, but the market, as economists rather coolly admit, has imperfections. The state, therefore, has to create the jobs – and that will take money. Let’s say it will take $20,000 for each of the 17 million people in our “resource,” or $340 billion.

Well, $340 billion sounds like a lot of money, but it is really only 5 per cent of the current Gross Domestic Product (GDP). It is little more than half of what I call the Banker’s COLA (the extra interest the Federal Reserve Board encourages lenders to charge to “protect” themselves from inflation, which is itself a principal cause of inflation).

Most of the money would be borrowed, just as businesses borrow the money they require. During World War II the Treasury and the Federal Reserve cooperated to keep the prime rate at 1.5 per cent. If the government borrowed the entire fund at 1.5 per cent, the interest would be $5.1 billion per annum – less than one tenth of 1 per cent of the GDP. The additional taxes paid by newly employed workers would far more than cover that[2].

There remains the nagging mantra: We don’t have the money. Do we not? What do you think has pumped up Wall Street so that bored TV anchors tell us “trading was moderate” on days when half again as many shares change hands as in the frenzy of the Crash of 1987? Why must brokers and bankers weary themselves thinking up $14 trillion worth of “derivatives” (three times as much as our total national debt) for people who don’t know what to do with their money, while others search out ways to speculate on growth industries in Tashkent, now that they have ruined Mexico? No, we have the money, all right. What we lack are brains and guts.

The New Leader

[1] Ed.:  I’m sure this is accurate but I don’t follow.  If a reader could comment with an explanation I’d be obliged

[2] For each 10% of tax the people earning the newfound $340 billion pay $34 billion is returned to the Treasury vs an interest cost of $5.1 billion

The Reserve Takes Flight Again

By George P. Brockway, originally published September 23, 1993

On July 20, Federal Reserve Board Chairman Alan Greenspan announced a fundamental change in the way the august body he heads looks upon the economy. This is not merely a tactical shift, as from easy money to tight money – although the Board’s volatility on the tactical level is bad enough – but a basic rethinking of how the economy works and what the Board should therefore do. It is the second such revision in Greenspan’s six and a half years as chairman, and the fourth in something under 14 years. So many radical rethinkings in so few years suggest an unseemly flightiness in an institution whose primary excuse for existence is to provide financial stability beyond the turmoil of partisan politics.

Let’s look at the record. On October 6, 1979, Paul A. Volcker, the then new chairman, revealed that thereafter the Reserve would “be placing greater emphasis on day-to-day operations of the supply of bank reserves, and less emphasis on confining short-term fluctuation in the Federal rate” (the rate at which banks borrow reserves from each other overnight or for a day or two). Monetarism had taken charge.

For the next six or seven years we heard a great deal about M1 and its velocity. (In case you’ve forgotten, M1 is cash and traveler’s checks and checking deposits; M2 is all that plus most savings accounts, money market funds, and other odds and ends.) Milton Friedman, the leading monetarist, wanted M1 to grow annually between 3 and 5 per cent. Expansion beyond 5 per cent, he claimed, would cause inflation – instantaneously if the expansion was anticipated, or with a lag of a year if it was not. Not only that, but the inflation would accelerate without limit. By 1986, expansion beyond 5 per cent was surely anticipated by all rational economic agents, because it had not been below 5 per cent for 10 years. Yet in 1986, when M1 jumped 16.8 per cent (and M2 jumped 9.4 per cent), the Consumer Price Index (CPI) rose only 1.9 per cent – its smallest rise in 22 years. Monetarism clearly missed the call, and missed badly.

The Federal Reserve Board was left without a theory – that is, without a coherent idea of what it was doing or why. For the rest of Volcker’s term, the nation was forced to rely on seat-of-the-pants judgments of officials whose cerebral judgments had proved sensationally wrongheaded.

In the spring of 1987, Alan Greenspan succeeded to the chairmanship and at once set three economists to work on an equation intended to use M2 to prophesy the price level two or more years ahead. Also, true to the teachings of Ayn Rand, he cut expansion of M1 and M2 back below the 5 per cent target. And what did the CPI do? It surged ahead 4.4 per cent in both 1987 and 1988.

Nevertheless, on June 13, 1989, the Reserve went to extraordinary lengths to publicize what two years of labor by those three economists had produced. If you yearn to know more about P-star (as their equation was called by insiders), I refer you to “The Reserve’s Silly New Equation” (NL, June 12-26, 1989), in whose last sentence I wailed, “How long must we allow ourselves to be deluded by silly equations?” Well, the Reserve seems at last to have abandoned this equation, or the theory behind it, which, Greenspan said last month, “has been downgraded as a reliable indicator.”

Of course, the money supply never was a reliable indicator, for the simple reason that no one can say what it is. The Federal Reserve owlishly publishes aggregates it calls M1, M2, M3, and L. L is about six times M1. Friedman once said the number used did not matter, so long as one stayed with it. Since the tracks of the different aggregates have been substantially different, it would appear to have made some difference.

You would think that by this time we might all agree to stop fretting over the money supply. Yet the Reserve, perhaps for ritualistic reasons, has adopted a new target for M2 growth (1-5 percent), even though it acknowledges that hitting (or missing) the target won’t indicate anything special.

The downgrading of M2 does not mean the Chairman is without any indicator. He has mentioned only one aspect of his new one (and that I will discuss presently), but he has used it with results that can hardly be called encouraging. In his July 20 testimony before Congress, he forecast a second quarter growth rate of 2.5-3.0 per cent. Nine days later, the official number proved to be 1.6 per cent.

I think I can promise you that the new indicator will continue to get things wrong. According to Greenspan, “one important guidepost” of the new indicator win be the so-called “real” interest rate: the actual rate minus the rate of inflation. When, as now, the Federal funds rate is about 3 per cent and the CPI rate is about 3.5 per cent, the “real” Federal funds rate is negative 0.5 per cent. Anyone lending $1,000 at 3 per cent gets back $1,030 at the end of a year, but his purchasing power will have shrunk to $993.95. So why should he lend? Because if he buries his money like the slothful servant in the Parable of the Talents, he will still have his $1,000 but his purchasing power will shrink to $965.

Greenspan thinks that’s unfair and hints about raising the Federal rate one-half a percentage point or more to make things even. Naturally, if he raises the Federal rate, he effectively raises others, including those that are far from negative.

What Greenspan is threatening is a Cost of Living Adjustment (cola) for bankers. It is well understood by bankers and economists that colas on workers’ wages are inflationary and should be resisted. How are bankers’ cola different? In a word, they aren’t, and they cost the economy (that is, you and me) about $500 billion a year (see “Bankers Have the Classic COLA,” NL, January 9, 1989).

Although bankers do most of the talking about the interest rate, their role in lending is comparatively passive. If no one wants to produce a better mousetrap or buy a better automobile or take a flyer in the stock market, bankers must sit on their cash. Putting consumers and speculators aside for the moment, consider a company with plans for a better mousetrap, requiring investment in a factory, equipping it with machinery, buying supplies, hiring workers. The company figures all that to cost $10 million. For convenience, let’s say it can borrow at prime, currently 6 per cent, for an annual interest expense of $600,000. It feels it can just about swing it.

Now suppose Greenspan gives bankers a one-half percentage point cola. At 6.5 per cent, the interest expense is up to $650,000 – an increase of 8.3 per cent in cost, and a decrease of 8.3 per cent in the amount of money the mousetrap company can afford to borrow.

The company then has three options: (1) Abandon or scale down the expansion and the jobs it would have created. (2) Raise prices to cover the added cost. (3) Make do with lower profits, which would make future borrowing still more expensive. These options are faced every day by every company, large or small. Even rich companies that do not need to borrow must consider the opportunity cost of using their own money instead of lending it out.

If investment is as important as everyone says it is, and if stable prices are as important as the Reserve says they are, Greenspan’s half point adjustment would be bad for every company and for the whole economy in one of the ways I’ve noted, and quite possibly in all three ways. Not only that, but the bond market would fall, as it necessarily does when interest rates rise. The stock market would surely follow later, for the same reason – and, considering its present fragile highs, could very well crash.

The interest rate, not the money supply, is what the Federal Reserve Board can control directly and assuredly. It sets the Federal funds rate and the discount rate, and it controls them by buying or selling Treasury bonds on the open market. In order to buy, it offers a high price, which is the same as a low interest rate. The banks that sell bonds thus increase their cash reserves, putting additional downward pressure on the interest rate.

If all this activity increases borrowing, as it is likely to do, it will increase the money supply, because money is negotiable debt. But who cares? It is the interest rate that matters to the economy, and it is through stabilizing the rate at a low level (about half what it is today) that the Reserve could (if it would) do its bit to stabilize the economy.

Milton Friedman has long contended that the Federal Reserve Board has used its great powers so erratically in the past that it should be put under strict statutory regulation. He may be right. But he would regulate the growth of the money supply within a narrow range, even though he doesn’t know what the money supply is, and the Board has shown it doesn’t know how to control it, whatever it is.

That there is a determinate money supply, and that its size determines the price level, is an old mercantilist idea. It was valid enough when money was something rare and tangible and not readily reproducible, like gold or silver. The capitalist system turns on borrowing, however, and borrowing depends on the interest rate, and the lower the rate the greater the economy. How long must we allow ourselves to be deluded by archaic ideas?

The New Leader

The Long And Short of Interest Rates

By George P. Brockway, originally published October 7, 1991

PEOPLE are beginning to growl that recovery from the recession is being delayed by the slow growth of the nation’s money supply, which seems in danger of falling through the bottom (or “lower parameter” if you want to be fancy) of the Federal Reserve Board’s target. The said target is to keep the annual rate of increase between 2.5 and 6.5 per cent.

Now, suppose that the Reserve agrees that the money supply is in danger of falling through its bottom. Resolved to their own selves to be true, they have to increase it. What do they do? The most obvious thing would be to coin some more coins and print some more paper money. But what would they do with it?

You may be sure that they wouldn’t send a packet of the stuff to each of us by Express Mail. Nor would they add to our savings accounts (although they firmly believe we ought to save more).

Instead, the Reserve would make it easier and more profitable for the banks to lend us money. We have some credit, represented by a plastic card that we show to a shoe clerk, who makes a copy of all the numbers, has us sign it, and hands us a pair of shoes. We have spent our credit like money, except we now are in debt to the bank that sent us the card.  Our credit has become money by becoming debt. Businesses create   money in the same way when they take down their line of credit extended by their friendly banker.

This pleasant arrangement expands the money supply, but it is limited in various ways – the chief one being the interest rate, the price banks charge us for the use of money. There are those whose doctrine requires them to pretend that the Federal Reserve Board has no control over interest rates, that they are made in the market, if not in heaven, by an invisible hand, and no mere mortal can do anything about them. More sophisticated observers recognize that the Reserve really and truly does determine short-term interest rates. When the Board sets the Federal Funds rate or the Discount rate, it is setting a rate at which banks can borrow (short term) from each other or from the System. When the Federal Open Market Committee buys or sells bonds, it raises or lowers the price of bonds and consequently is lowering or raising the interest rate. If the Board did not set at least short-term rates in these ways, it would be hard to ascribe any significance to its activities.

Indeed, the fact is that whenever the Reserve fears the money supply will fall through the lower parameter, it lowers the interest rate. It claims to control the money supply, yet all it can actually control is the interest rate.

If that is the case, why doesn’t the Board say so? I regret to have to tell you that it is possessed by doctrines that might have made sense in the days of mercantilism but have nothing to do with a modern capitalist economy.

In the days of mercantilism money was a commodity-gold, silver, sea shells, or some such. Trade was essentially barter. You swapped grain for silver, and then you swapped the silver for candles. At any given time (say, 1492) there was a certain amount of silver in circulation, and other commodities traded at more or less stable prices in terms of silver. Christopher Columbus (whether he discovered America or not) made a historical difference. The European supply of silver multiplied rapidly, while the supplies of other commodities, being agricultural products or custom made goods, expanded slowly, if at all. Some of the increasing supply of silver was swapped for the stagnant supplies of other commodities, whose prices rose.  Hence the notion that prices depend on the money supply.

Although the Federal Reserve Board seems not to have noticed, the modern economy is quite different from that of pre-Industrial Revolution days. As Karl Polyani rather sorrowfully pointed out, goods are now produced for the market, rather than on special order. While occasional shortages are far from impossible, industry is so organized that if a demand for an especially cute T-shirt suddenly develops, the supply can be replenished in a few hours or days. Since the supply of most commodities is now indefinite, if not infinite, the supply of money has no substantial effect on prices.

The way the interest rate is managed does, however, have an effect on prices. Here, again, is a historical change the Reserve has failed to notice. A frequently cited survey, published in the Harvard Business Review in 1939, reported that business people then paid little attention to the interest rate in making their plans. A few years later I was a business planner myself, and I assure you that’s the way it was. After all, the prime rate, held down by an “accord” between the Treasury and the Federal Reserve, was only 1.5 per cent. The accord was annulled in 1951, whereupon the Reserve embarked on its long and still-continuing hunt for the inflation snark, with the result hat today interest is one of the most prominent and most unpredictable costs of doing business.

Here, yet again, is a historical turning – one that has been missed by most mainstream economists but has been forcefully called to the attention of most businesspeople. If you have ever met a payroll, you know that your costs are an inescapable factor of the prices you charge. When your costs go up, so must your   prices, if you propose to stay in business. For 40 years now the Reserve has been idiotically trying to control inflation by inflating the cost of doing business.

In short, the price of money matters. Unhappily, it is widely believed – even by many who agree the Reserve can set short-term rates – that long-term rates are set by the “market” anticipating what the future will bring. Some say that the market anticipates the future rate of inflation; others that the market anticipates the short-term rates the Reserve will set in the future. In the former case, long-term lenders think of themselves as lending purchasing power and want to get their purchasing power back, with interest. In the latter case, long term borrowers guess that borrowing will be more expensive in the future than in the resent because the Reserve will, in its anti-inflation battle, allow (or force) short-term rates to rise.

It will be seen that the customary policies of the Federal Reserve Board work to reinforce both groups. Inflation, of course, is the Board’s panatrophy, and raising the interest rate is the Board’s panacea. What borrowers and lenders anticipate in, the long future is that the Board will continue to pursue the policies it is pursuing today. They may be wrong, just as prophets may be wrong about what the Board will do tomorrow morning. he point is that, regardless of the Federal Reserve Board’s intentions, its actions effectively control the long-term interest rate as well as the short-term rate.

THE SAME POINT may be reached from another direction. Keynes deplored the fact that most professional investors and speculators “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence.” In the 55 years that have passed since Keynes published this judgment, three months or a year has come to seem an unusually long time to hold an investment.

The bond market is a place where people buy and sell bonds in which at least the seller did not intend to invest for keeps. Portfolio managers and professional traders treat long bonds and short bonds alike, and treat both as they treat stocks. They rank them according to their relative safety and relative liquidity and so on; and in that ranking it will happen that some long bonds are judged more liquid than any common stock. (After all, common stocks are “longer” than long bonds because they do not promise to return your money.) In all cases, long-term or short-term, the traders’ question is what the market will bear tomorrow, not what will happen over the next 30 years.

This being so, the long-term interest rate is not a separate problem. Even new bond issues are priced in relation to the current market, and that is priced in relation to short -term interest rates. Therefore, all interest rates respond to the activities of the Federal Reserve Board.

But may not international rates restrain those activities? In response to that question apologists for the present system will surely warn us about a flight from the dollar. We will be reminded that former Board Chairman Paul A. Volcker was tireless in arguing that interest rates had to rise to attract foreign money to finance our budget deficit. Rates had to stay high to keep the foreigners from pulling their money rugs  out from under us. Treasury Secretary Nicholas F. Brady has a similar fear of flying.

Who are the foreigners whose money is so important to us? Everyone knows that mainly they’re the Japanese. That knowledge should give us furiously to think. For the money that lands on our shores takes off from theirs. The flights to the dollar are flights from the yen. Yet their economy has been outperforming ours for the past many years. Have they outperformed us because they sent their money to us? Hardly. But their domestic saving and their currency’s flight had the same cause. Both were the result of their comparatively low interest rates and correspondingly high production (not productivity, but production). It was their expansion of employment and plant and output that made them prosperous.

Don’t let anyone tell you that Japan’s interest rate was so low because Japan’s savings rate was so high. In the first place, you have to produce a lot before you have a lot to save. You can’t save what does not exist. In the second place, Japan’s recent hike in its interest rate was not caused by a fall in savings but by the cold -blooded and wrong-headed decision of its central bank. The increased interest rate will reduce economic activity, and reduced savings will follow as a consequence, not as a cause.

The Federal Reserve Board’s money growth target is irrelevant. The Reserve should set the short-term interest rate at least as low as it did during the 1942-51 accord with the Treasury. The long-term rate conformed then, and it would do so today.

 The New Leader

Don’t Bet On The Banks

By George P. Brockway, originally published February 11, 1991

I CAN’T THINK of a single good reason why the rest of the financial sector, led by the commercial banks, should not eventually follow the S&Ls to the woodshed. In a few cases the usual arguments about “the others” being more experienced or diversified may carry some weight, but in general their problems and those of the S&Ls have similar causes and will have similar consequences.

There is more than a trace of poetic justice here; the commercial banks lobbied hard for the deregulation that did in the S&Ls, and the same deregulation has returned to plague its champion.

Only 11 years ago, the states had usury laws that set the maximum interest rates for different loans. There were, of course, exceptions of various degrees of complexity, but the important point is that there were limits to what could be charged. The Federal Reserve Board set limits in the other direction, the most discussed being Regulation Q. To give the S&L’s a chance to survive, and to offset their being restricted essentially to home financing, Regulation Q allowed them to pay savings accounts a fraction of a point more than the commercial banks.

That system was a casualty of the Federal Reserve Board’s sensational and long-running battle with inflation (see “Who Killed the Savings and Loans?” NL, September 3, 1990). It took almost 30 years for the system to start to break down, and the collapse is not yet complete.

The reason for the long Untergang is the inherent stickiness of finance. In any 12months the nonfinancial sectors (public and private) make new borrowings equal to less than one-twelfth of their total indebtedness. The other eleven-twelfths includes 30-year mortgages still paying 4 per cent interest, 20-year Treasuries paying 15.75 per cent, credit card freaks paying 19.9 per cent, and all sorts of things in between.

With this big backlog (currently about $8.3 trillion), even very large shifts in the interest rate on new loans have only a lethargic effect on the nation’s overall interest rate. The overall rate was 9.55 per cent in 1979-when former Reserve Chairman Paul A. Volcker took well publicized command of the inflation battle-and reached 10.61 per cent a year later. As a result of Volcker’s policies, however, the average prime rate on new loans jumped from 12.67 per cent in 1979 to 15.27 per cent in 1980 and topped out at 21.5 per cent that December and the following January. Since what is comparatively slow going up is also comparatively slow coming down, the average interest rate is higher today than it was in 1980, although the prime is less than half its 1980 peak.

The stickiness of finance enabled the S&Ls and the commercial banks to withstand the surge of interest rates as long as they did. It is probable that the bankers (of all kinds) do not yet know what hit them; certainly the Federal Reserve Board (called the nation’s central bank by its present chairman, Alan Greenspan) does not know. So I’ll give them a hint. If they pay high interest to attract funds, they must charge high interest to cover their costs. And if businesses must pay high interest, they must charge high prices for their goods. At this point, the bubble gets very thin. Consumers do not have money to pay high prices, particularly if many have lost their jobs.

You can charge whatever amuses you for a book or a loaf of bread or a new broom to sweep things clean. Only the book or bread or broom business will be affected. But when you charge too much for the use of money (and it is the Federal Reserve Board that ultimately sets the rate), all businesses, all banks and insurance companies and “institutions,” and all men, women and children are affected.

The S&Ls were driven to the wall first, but the death march of the commercial banks is gathering momentum. Both S&Ls and commercial banks cheered when the state usury laws were suspended, and rushed to expand their real estate business. They are now suffering from a surfeit of residential condos, motor inns, office buildings, and shopping malls. The commercial banks greedily participated in the Great Recycling of OPEC’S profits and as a result will have to face up to their losses in the Third World. Many S&Ls and commercial banks have stuck themselves with junk bonds. How many will survive the recession?

Well, the Bush Administration proposes to help them by getting rid of two of the few remaining New Deal banking reforms. The most important of these keeps commercial banking separate from investment banking, insurance and especially ordinary business. The other restriction keeps commercial banks from branching out beyond a state’s borders.

In the cheery days of President Ronald Reagan, these regulations were anathema simply because they were regulations, and because, as some sports-minded journalist noticed, not one American bank ranked among the top 10 in the world. Even more shameful, most of the giant banks were Japanese. Once again it seemed that they knew something we didn’t know.

In the drearier economic days of President George Bush, less is said about the Japanese banks, for they have fallen on harder times. The index of leading stocks on the Japanese exchange fell 38.7 per cent in 1990, and the Japanese banks (this is one of the secrets of their size) have long positions in those stocks. They have long positions, too, in a rapidly falling real estate market, which they can speculate in (unlike American banks) as well as lend money on.

A few years ago, proposals to permit interstate Banking and to allow banks to own brokerage houses and insurance companies (and vice versa) would have caused a considerable hullabaloo. The large banks were in favor of changing everything; they wanted to get on that top 10 board with the Japanese. Likewise the big stock brokerage houses and insurance companies and all-in-one companies such as Sears, Roebuck. Smaller operators (except those who wanted to sell out for capital gains) preferred the existing conditions-although some would not have objected to dabbling in additional financial services, provided that other financial servers couldn’t dabble back.

Today, the Bush banking moves are not stirring much controversy. A professor of finance suggested recently in the New York Times that this is because they don’t go far enough, that there is nothing to shout about. But commercial banks are in trouble, and since the trouble is no longer confined to Texas and Oklahoma, there is little reason to expect greener pastures in other states. Nor is the solution to be found in putting them together with the problem plagued brokerage houses, insurance companies, pension funds, investment banks-and Sears, Roebuck. A couple of dozen such financial smorgasbords would likely result in a couple of dozen concentrated headaches, if not hemorrhages.

To be sure, the Administration promises to supervise the banks closely to prevent their making more bad loans. Does that mean they are not supervised closely now? Yes, it does. You see, supervision costs money, and you’ve heard about the deficit. Increased costs will have to be matched by increased taxes-in this case, Federal insurance fees. Higher insurance fees will mean lower interest on deposits, and that means money-market funds and Treasury bills will attract cash away from the banks. To keep their deposits, banks will have to pay higher interest, and to do that they’ll have to make more loans at high rates. Sound borrowers won’t pay high rates; so the banks will have to hunt for riskier deals (see “Big Is Ugly,” NL, September3, 1984). And that’s what got them where they are.

In short, interest rates aren’t innocent.  If you refuse to control them, you destabilize the financial sector-and the whole economy. If you manipulate them in a fallacious attempt to contain inflation, you bring on recession (See “Bankers Have the Classic COLA,” NL, January 9, 1989). And that’s what the Federal Reserve has done.

A GOOD DEAL of the trouble lies in the fact that few bankers understand how the capitalist system differs from the mercantilist system. In Legal Foundations of Capitalism (one of the neglected great books),

John R. Commons explains the shift from property as use-value to property as exchange value. This did not start in the United States until the first Minnesota Rate Case a century ago, and most bankers are still out of date. They remain mainly interested in fixed assets that can be attached, not in going concerns that generate cash flow and profits. Hence their fatal fascination with real estate and the idiotic recycling that transformed OPEC profits into loans that are in effect gifts of American money to rulers of Third World nations.

Willard Butcher, when he was chairman of Chase Manhattan, once delivered himself of a perfect example of bankerly thinking: “Is Mexico worth $85 billion?” he asked rhetorically. “Of course it is. It has oil, gold, silver, copper. … “All these assets are physical. You can touch them, and you can attach them. But they aren’t worth much if they can’t be sold at a profitable price, and when usurious interest rates are charged profitable prices are impossible.

On an arguably more modest level, I came up against this sort of thinking at another bank while I was in the publishing business. The bank examined our balance sheet and advised us that our inventory was too low. Did we have an unusually large number of titles out of stock? I asked. No, on that point our record was exceptionally good. Did we allow titles to go out of print too quickly? No, rather the contrary. Were we slow to fill orders? No, again. Our record here was the best the bank knew of. Did our practice of printing in relatively small quantities (this was before the Japanese made “just in time” inventory control famous) result in significantly higher unit costs? No, yet again.

You’d have to say that we were managing our inventory as well as anyone in publishing. Nevertheless, the bank insisted it was too low. The unspoken (or unrecognized) reason was that our low inventory meant we did not have much for the bank to attach if we got in trouble. It never crossed the bank’s mind that too much money tied up in inventory might get us in trouble, and that if we couldn’t sell the inventory profitably, the bank certainly would be unable to do so.

Commercial bankers aren’t the only people still living in a precapitalist world. Our financial system as a whole (S&Ls, banks, insurance companies, pension funds, “institutions” and supervisors) continues to be essentially mercantilist. Its ideal profit, like Bush’s, is a capital gain. In this understanding it is joined by mainstream economics, which analyzes business as a disconnected series of market-clearing ventures, not as a going concern. Until these two powerful sectors of our society are brought into the modern world, stagnation, punctuated by bankruptcies, is likely to be our lot.

 The New Leader

Mercantilism Revisited

Originally published October 7, 1985

 

I have been happily working my way through Fernand Braudel‘ s tangled, lumpy, unmade-bed of a book whose three volumes have the overall title Civilization and Capitalism: 15th-18th Century. About halfway into the second volume Braudel makes some observations about mercantilism, and they have given me furiously to think.

Every American boy or girl who paid even the slightest attention in school knows that mercantilism was a bad idea. It bled the colonies for the benefit of the homeland, and consequently the colonies revolted. Those who listened a little longer also know that the mercantilist striving for a “favorable” balance of trade meant exportation of goods and importation of precious metals, a policy that is ultimately self-defeating because, as Midas found out, gold and silver are not good to eat. Braudel knows all this, too.

As an example of mercantilist foolishness, he tells us that in 1703, toward the start of the War of the Spanish Succession, the English were advised to send “grain, manufactured products and other goods” from home to their troops fighting in the Low Countries. They could have bought these supplies easily and presumably more cheaply on the Continent, but the government was” obsessed by the fear of losing its metal reserves.” Any follower of Adam Smith or David Ricardo can see that this policy led England to waste real wealth (usable goods) and save nominal wealth (unusable metal).

In the world of theory, the mercantilist passion for a favorable balance of trade seems indefensible. It is surely more sensible to collect what you can use than to squirrel away what is of little or no use in bank vaults. But as Braudel reads the historical record of the actual world, he is forced to recognize that the mercantilist policy was in fact successful. “In any case,” he writes, “every time we have to deal with a comparatively advanced economy, its trade balance is in surplus as a general rule.” Flying in the face of classical economics, the more advanced economies exported usable goods and imported gold and silver.

The classical theory fails here (as elsewhere) because it is both ahistorical and asocial. It describes an instantaneous slice of a world without time; and it concerns things, like the GNP, not people, like you and me. Criticism of the English policy of 1703 silently assumes that purchasing war materiel overseas would have had no effect on English farms and factories. The assumption is that the goods purchased on the Continent would have been added to those produced at home, and that the English wealth would have risen accordingly. But in the real world, English farmers, deprived of part of their market, would have cut back production expenses (which is another name for employment) even if production stayed high for a time. And English manufacturers of soldier suits and the like would surely not have continued producing them if the government didn’t buy them. Their employment, too, would have fallen. These drops in employment would have meant a decline in the English standard of living. The mercantilist policy preserved that standard of living (such as it was); the classical theory would have reduced it.

Carlo M. Cipolla, in Before the Industrial Revolution (a marvelous book that covers roughly the same ground as Braudel in about one-tenth the space), has an excellently apposite quotation that dramatizes the failure of the classical theory. In 1675 one Alfonso Nunez de Castro wrote, “Let London manufacture those fabrics of hers to her heart’s content; Holland her chambrays; Florence her cloth; the Indies their beaver and vicuna; Milan her brocades; Italy and Flanders their linens, so long as our capital can enjoy them; the only thing it proves is that all countries train journeymen for Madrid and that Madrid is the queen of parliaments, for all the world serves her and she serves nobody.” As it turned out, for lack of trained journeymen Spain fell into a slough of stagnation it has yet to escape three centuries later.

In the infrequently noticed catch-all Chapter 23 of The General Theory of Employment,  Interest and Money, John Maynard Keynes includes some “Notes on Mercantilism … ” He observes that a favorable balance of trade, by bringing in gold and silver, increased a country’s money supply, which forced down the interest rate (Federal Reserve Board  please note), which stimulated investment.

Let’s carry the argument a step further. Investment is not stimulated rationally, that is – for its own sake. From the point of view of the investor, the purpose of investment is to produce goods that are in demand. From the point of view of the nation, the purpose of investment is to provide employment for its citizens, and to produce things that are wanted. Since employed citizens are able to make purchases create demand – these two purposes can work together, though they do not necessarily do so.

In the early modern world of the mercantilists, the interest rate was, as Keynes said, held down indirectly (and very possibly unintentionally) by fostering a favorable balance of trade. To have a favorable balance of trade, a country must export more goods than it imports. To export more goods, it must produce more goods. To produce more goods, it must employ more people. The secret of mercantilist success lies in the increased employment of labor.

For the power of labor is very great. Even putting to one side the facts that capital is the result of past labor, and that natural resources can be exploited only by labor, labor power is our ultimate power. The laziest, least competent, least efficiently applied labor will today produce far more than it needs to sustain itself. What Marx called surplus labor is exponentially greater than the 11.1 per cent his admittedly arbitrary calculations yielded. Hesiod (eighth century B.C.) was closer to the mark when he wrote in Works and Days: “From men the source of life has been hidden well/Else you would lightly do enough work in a day/To keep you the rest of the year while you lounged at play.”

Less poetically, we know that agriculture now produces more food than we should or can eat, more than enough natural fibers to clothe us, more than enough lumber to house us, with less than 3 per cent of our labor force (or less than 1.5 per cent of our population). Since even at our present Reaganite shabbiest, we allow almost no one to fall through the safety net and actually starve or freeze to death, it is plain that we do not need additional workers to provide for their own subsistence. Therefore, the output of every previously unemployed worker we manage to put to work will raise our standard of living a bit more above subsistence. And we can do this without importing gold or silver to control the interest rate. We simply have to get some sense into the Federal Reserve Board.

READING Braudel on mercantilism in the War of the Spanish Succession, I was struck by the parallels with our current business “recovery.” As I remarked in this space a year ago (” All You Need to Know about the Deficit,” NL, October 29, 1984), military spending increases aggregate demand, which increases employment. Any spending increases demand, for the simple reason that spending is demand. There are limits to some sorts of spending. Keynes cites the uselessness of two railways from London to York. On a more personal level, once you have a television set in every room of your house, your demand for television sets tends to subside. But military spending (because it does not and cannot face a test of profitability or indeed usefulness) has the political advantage of being supported by conservatives who insist the rest of the government be “businesslike.”

As far as the GNP is concerned, it doesn’t make much difference what the government spends its money on. The spending increases employment even when the newly employed people produce battle tanks that won’t run on rough terrain and fighting planes too complicated to service in the field.

The increase in the standard of living would of course be greater if the newly employed people rehabilitated highways and subway systems instead of battleships that were militarily useless two generations ago. It would be greater if the newly employed people built housing here on earth instead of stations in space. It would be greater if the newly employed people were cleaning up existing toxic wastes instead of producing new poison gases that will have to be burned or buried. Yet no matter how useless the things they produce, the newly employed people earn newly augmented incomes that they spend (up to a point), thereby increasing their own standard of living. And the addition of their new demand to the previous aggregate demand calls forth still further employment, and so on.

This outcome can be dramatized by asking what would happen if our present peacetime military budget were cut back, not to a rational peacetime level, but merely to the level of 10 years ago, when we were still winding down a war in Vietnam. The military budget would then be reduced by approximately $200 billion (or roughly the size of the deficit everyone fusses about). If such a reduction were not immediately offset by an increase in domestic spending, can anyone doubt the economy would forthwith crash into a depression that would make the Nixon-Ford recession of 1975 and the Reagan- Volcker depression of 1981-82 seem like paradise?

A deficit, in short, has the same salutary effect on the GNP as a favorable balance of trade; and gold and silver have nothing to do with it. As it happens, we are giving mercantilist theory another and more direct test. Our strong dollar, which is a euphemism for an unfavorable balance of trade, enables some of us to buy Pakistani sports shirts and Japanese automobiles at bargain prices. These bargains for some people, however, cause unemployment and underemployment for many people in North Carolina and New York and Michigan and ultimately throughout the nation. Critics of the mercantilist theory of a favorable balance of trade should ask themselves why an unfavorable balance has such unhappy consequences. I’ll give them a hint: We perversely distribute the benefits of our economy in a way that additionally punishes those who lose their jobs by denying them income to demand the bargains.

The New Leader