Junk Mail From Concord

By George P. Brockway, originally published November 7, 1994

I’M ON A NEW mailing list, and I suppose you are too. The soliciting organization calls itself the Concord Coalition, and it seems to be the plaything of former Senator Warren B. Rudman, Republican of New Hampshire, and former Senator Paul E. Tsongas, Democrat of Massachusetts.

If I didn’t know anything about the two ex-Senators and had to judge them solely by the mailing piece, I would have difficulty deciding whether they are extraordinarily stupid or extraordinarily slick. Either way, they are dangerous, and are likely to make the next few years less pleasant than we might have found otherwise.

Let’s talk about the slickness first, because that’s more fun. Their bag is deficit reduction. In his “Dear Friend” letter to me, Mr. Rudman writes, underlined, “Our goal is nothing short of changing public opinion to demand less, not more, deficit spending and force the elimination of the deficit.”

Now, if you read that quickly, you may get the idea the Coalition is out to lobby the President and Congress to do something about the deficit. But that can’t be its intention. The letter asks me for a “special tax-deductible dues contribution,” and so far as I know, you cannot get a tax exemption for your organization if you are planning to lobby the Legislature. Common Cause doesn’t have tax exemption, nor does the Council on Foreign Relations, nor the National Association of Manufacturers nor the National Organization for Women nor the National Rifle Association nor the Academy of American Poets nor the American Automobile Association.

Some of the organizations on my little list play pretty hard ball, but most of them do not back candidates, and it is impossible to say with a straight face that the Concord Coalition is less “political” than they are. Either the Coalition is led by a couple of mighty shrewd lawyers, or is encouraging violation of the law right off the bat. They are cute enough, however, to add in a postscript that “contributions are tax-deductible to the extent permitted by law.” (Personal subscriptions to THE NEW LEADER are also tax-deductible “to the extent permitted by law,” which, I regret to say, is not to any extent at all.)

And that’s not the worst of it. The bookkeeping reason for the deficit is that our expenditures are too high and our taxes are too low. The Coalition proposes that tax collections be reduced by the amounts otherwise payable on the contributions they receive. By its very existence it is increasing the deficit it is complaining about. If that isn’t cynicism, what is it?

It may be stupidity.

But I doubt it. Both Mr. Rudman and Mr. Tsongas are grown men, and they are both (I think) lawyers. They have both spent a lot of time thinking about taxes, and presumably they both can add and subtract. Rudman also makes a point of the fact that “the hundreds of hours that Paul and I are putting into the Concord Coalition are strictly on a volunteer basis.” Not to worry. They are both entitled (I think that’s the word) to comfortable government pensions, complete with cost-of living adjustments (aka COLAS), not to mention better health insurance than you will ever see. Besides, if theirs truly is a tax-exempt organization, their expenses of running hither and yon to appear on talk shows are deductible. But not otherwise, although the expenses might be legitimate charges against whatever contributions they manage to collect.

Well, that’s all good for a chuckle or two in this winter of our discontent[1]. But what will happen to the economy if the Concord Coalition gets its way won’t be very amusing. And given the results of the recent election, one would be ill-advised to bet it won’t succeed without even trying.

So let’s look at the deficit. The estimate for 1995 (the fiscal year that started last October 1) is $176.1 billion. That’s down substantially from the $220.1 billion deficit of fiscal year 1994. In relation to the Gross Domestic Product, it is the smallest deficit we have had since 1979. But it is still a lot of money.

Suppose that, by constitutional amendment or otherwise, the whole deficit could be wiped out. What would become of all that money? Would you and I get refunds for our share of it? Or would the government deposit it where it could earn interest – say, in a Texas savings and loan bank (if any survives)? Or would it be stashed away in Fort Knox? Or could we use it to pay off our trading debts to the Germans and the Japanese?  Or to buyback the bonds they have bought from us? Or would it be an advance payment on the following year’s budget?

The correct answer, of course, is, None of the Above. And the reason for the answer is that all those billions do not exist, because as I’ve said before, and say again here in a minute, money is debt. Not only does the money not exist, the goods and services the money was budgeted to buy do not exist, either. Maybe you and I did not want those goods and services, anyhow.

Maybe we thought it was wasteful to spend money on them. Even so, we had better stop a minute to consider what their nonexistence means to the economy – that is, to us.

First off, we can’t cut government expenditures by $176.1 billion without firing people. And they won’t all be lazy, faceless bureaucrats, because the Federal government is not only the nation’s largest employer, it is the nation’s largest purchaser of stuff produced by the private sector. (Where did you think the paper for the paperwork comes from?)

The point is that the people who will lose their jobs are fellow citizens; so when we talk about the number of them, we should never forget that they are ordinary people like you and me. The number is very large. I estimate it at 3,785,631, which I arrive at as follows: (1) The way the pie is cut in our economy today, labor gets about two thirds of it, and two thirds of$176.1 billion is $117.4 billion. (2) The median income of full-time workers in the United States is $31,012. (3) Divide (1) by (2) and you get 3,785,631 new recruits for the army of the unemployed, the great majority of them obviously from the private sector.

That should push our total unemployment over 10 million. In fact, when you consider the lost purchasing power of those 3.7 million people, and the lost business of those who used to sell to them, there is little doubt that trimming $176.1 billion from the Federal budget will enable us to set a new post-Depression unemployment record, not to mention anew record for relief expenses.

I know, of course, the answer Messrs. Rudman and Tsongas would make to the foregoing, because I have heard Newt Gingrich touting a balanced budget amendment that would codify the problem. They’d say cutting $176.1 billion out of the Federal budget would so stimulate the private sector, overjoyed to get all that government off its back, that it would forget it had ever coined the word “downsizing[2]” and would invest and expand its businesses to take up the slack and then some.

I would not be surprised if the private sector talked that way; but I would be astonished if it acted that way, because when business people forget about politics and mind their businesses, they are not quite so stupid as they sometimes sound. If they are not already investing and expanding, there would be no reason for them to change course if the deficit is cut. Taxes won’t be a reason; the deficit is caused because taxes do not cover expenditures now. Budget balancing won’t be accomplished by lightening up that side of the scales. Besides, the only taxes likely to be cut are capital gains taxes; that will be dandy for speculators, but it will do nothing good for producing entrepreneurs and will probably increase the interest they have to pay. (I forgot:

There is likely to be an attempt to get a cut for the middle class, too, meaning people with adjusted gross incomes over $250,000.)

No, I think we can expect downsizing to continue, no matter what is done with the budget.

AS CONSTANT readers know, I’m a mild-mannered chap; so I find it difficult to believe the Concord Coalition is just another Trojan Horse. If they are really naive instead of slick or stupid, their naiveté goes pretty deep into their misunderstanding of economics. They don’t begin to understand money and its role in the capitalist system.

They have possibly never wondered where the Federal Reserve notes in their pockets came from and what makes them worth more than the paper they are printed on. They have possibly never looked closely at a dollar bill. It says right on its face, “This note is legal tender for all debts, public and private.” What does that mean? It means that it was issued by the government in payment for some good or service, and that, in the end, the government will take it back in payment of some fee or tax. In the meantime, the government owes a dollar to whoever holds the note. It is an acknowledgment of debt.

In the capitalist system, not all debt is money, but all money is debt. If the Concord Coalition gets rid of the $176.1 billion deficit, that much of the money supply will be washed out. Now, if business is to continue merely at its present sluggish pace, the $176.1 billion will have to be replaced from somewhere. Since it seems unlikely that private business will kick its downsizing habit any time soon (why should it, with GATT on the horizon?), state and local governments will have to pick up the slack and go deeper into debt to the tune of $176.1 billion. Needless to say, slumping Federal services will force them to do some of that, anyhow. Deficit reduction turns out to be a scam shifting some Federal burdens to the states, probably (I regretfully suspect) in the expectation that the burdens will be either fumbled or financed with a regressive sales tax.

As you will no doubt remember from “In Pursuit of a Fiscal Fantasy” (NL, 6/14-28/93), the government can be in debt forever and ever, issuing new bonds to pay off those that come due. The only thing it has to be able to do is pay interest on the loans, and that would be no problem at all if the Federal Reserve Board were at least moderately committed to the national welfare. Most of the Fortune 500 companies, and indeed almost all companies of every size, are constantly rolling over their debt this way. Capitalism is a system based on borrowing and lending.

You and I could do the same if we were immortal. As it is, we don’t hesitate to go into debt to provide our family with a better place to live and to give our children the best education possible. Would we have done our children a favor if we had not made the commitment, even though some of the debt may still be unpaid at our death?

On reflection, you have to say that the Concord Coalition is not only slick but stupid.

The New Leader

[1] Ed. – Which raises the question, what did the Shakespearean data base administrator say when he found snow in his VTOC?

[2] Ed. – we recommend you read this when considering “downsizing”: http://wp.me/p2r2YP-hx

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

Who Killed the Savings and Loans?

By George P. Brockway, originally published September 3, 1990

THE WAY WE’RE going, we’re not getting close to the truth about what happened to the savings and loans. It’s much easier to be bemused by the amount of money lost in the disaster, to be shocked by the skulduggery involved, to be flabbergasted by the bad judgment of rich men, to be titillated by political charge and countercharge.

The $500 billion fiasco has been a long time in preparation. The first official action leading up to it was taken as early as March 1951, when the Federal Reserve Board got the Treasury to agree to a slight advance in interest rates. In his Memoirs, President Harry S. Truman criticizes the Reserve for failing to live up to its part of the agreement; but as William Greider points out in Secrets of the Temple, the issue became moot with President Dwight D. Eisenhower‘s election. Wall Street won out over Washington. The Reserve has, ever since, been undisturbed in following its gleam.

When the media go beyond personalities, they explain that the S&Ls failed because they borrowed short and lent long. That is, they accepted deposits that could be withdrawn at will (30 days’ notice was often reserved but seldom enforced), and they lent against mortgages running 30 years into the future.

The curious fact, however, is that the S&Ls were deliberately set up to act in this way from their beginnings in the Great Depression. They were designed to perform two functions: First, they would offer a safe depository for the small savings of the middle class; second, they would aggregate those savings and lend them to finance middle class home ownership. Because the functions were restricted, it was understood that expenses would likewise be restricted. S&Ls, it was reasoned, could therefore offer a little bit more than the going rate on the deposits and charge a little bit less than the going rate on the mortgages. And so it was.

The new S&Ls were successful for more than 30 years. They were substantially responsible for the United States’ achieving the highest rate of home ownership in the world (a rate considerably higher than the present one). They were also substantially responsible for a rebirth of personal savings following the Depression. My wife and I were able to buy a home and start saving at a far younger age than either our parents or our children.

For all those years that they were contributing to the wealth and happiness of the American people, the S&Ls were borrowing short and lending long. Obviously, something else caused the downfall.

Plenty of people are ready to tell you the problem was inflation. Inflation is always bad for lenders. If the price level is rising at a rate of 5 per cent a year, anyone lending $100 today will receive back only $95 in purchasing power a year from now. At the same time, naturally, inflation is good for borrowers, who borrow $100 today and pay back $95 in purchasing power next year.

But look at the performance of the S&Ls over the long run-specifically, over the life of a mortgage. In that run of 20 or 30 years a go-getting middleclass American will both a borrower and a lender be. He/she will borrow at the beginning and save toward the end. They will gain from inflation (if any) when they are young and lose to inflation as they approach middle age. From their point of view, there is much to be said for this balance. From the point of view of the lending bank, inflation is not without its compensations. Inflation of real estate prices has the advantage of improving the quality of the bank’s portfolio. Foreclosures will be fewer, and losses in each foreclosure will be lower. Taken by itself, inflation no more explains the S&L debacle than does the borrowing-short-lending-long story.

Now we reach the root of the matter: What devastated the S&Ls was a tremendous rise in the interest rate.

The first noticeable sign of things to come was a period of tight money in 1955-57, but no one expected the trouble we’ve seen. The Federal Funds rate in those years jumped from 1.78 percent to 3.11 per cent, and continued to rise. By 1965 the average S&L was earning only 0.5 per cent on its capital. Crises followed in 1966, ’69, ’74, and ’78. High T-bill rates and the new money-market mutual funds drained the S&Ls of deposits.

When on October 6, 1979, the new chairman of the Federal Reserve Board, Paul A. Volcker, announced that thereafter the Reserve would concentrate on the money supply and let the interest rate go as it pleased (it pleased to go up), the S&Ls’ fate was sealed. In March 1980, the grandiloquently styled Depository Institutions Deregulatory and Money Control Act confirmed the seal. Practically unrestricted competition, coupled with $100,000 deposit insurance, guaranteed that the Savings and Loans, trying to escape the consequences of high interest, would engage in a binge of blue-sky financing and outright thievery. The only surprise is that the binge lasted for a full decade before the general collapse.

But what could the Federal Reserve do? Doesn’t inflation cause the interest rate to rise? When all is said and done, isn’t the culprit the usual suspect-inflation? It’s too bad – $500 billion too bad – that the S&Ls got caught in the crossfire of the Federal Reserve’s war with inflation, but the war must go on, mustn’t it?

Given the size of the S&L disaster, I suggest that the Reserve ought to have a pretty convincing explanation of the necessity for its actions. Chairman Volcker used to tell us that the interest rate was none of his doing but was the doing of the impersonal market. To the best of my knowledge, his successor, Alan Greenspan, has not said him nay. Well, if the Federal Reserve does not control the interest rate, I don’t know what it does do – unless, as W.S. Gilbert sang of the House of Lords, it does nothing in particular and does it very well.

Of course, the Reserve claims to control the money supply. Its Federal Open Market Committee buys or sells government bonds (it could trade in other assets as well, but prefers not to). If it wants to contract the money supply, it sells government bonds until enough banks buy enough of them to reduce their cash reserves and hence their loan-issuing power. If it wants to expand the money supply (a stratagem that rarely crosses its mind) it buys government bonds and builds up the banks’ reserves.

There’s more to buying and selling than stamping your foot and saying that’s what you want to do. Your price must be right. If you want to sell, your price must be enticingly low. A low price for a bond (or any asset) yields a high rate of return. Not only are banks eager to buy high-interest Treasury bonds, they are also quick to adjust upward the rates they charge their customers, whose credit, after all, is less solid than that of the U.S. Government. In the same way, when the Open Market Committee buys bonds at a high price, it drives the interest rate down.

Because the money supply is not a precise figure (the Reserve publishes four different major and two minor ways of measuring it), the effects of this activity on the money supply are not precise. But it certainly does have determinate effects on the interest rate, and that certainly has definite effects on the cost of living.

ALL OF WHICH brings us back to 1951. In the preceding decade the Federal Reserve Board and the Treasury worked together to maintain the price of government bonds, and the prime rate for most of those years  – despite their including World War II and the first year of the Korean War remained steady (believe it or not) at 1.50 per cent. In 1951 the Reserve, worried about inflation, managed to break free of the agreement with the Treasury and thereafter devoted itself to controlling inflation by managing the money supply.

As it happens, 1951 is the midpoint between the founding of the Reserve in 1913 and 1989, the most recent full year for the Consumer Price Index. Several fat volumes would be required for an exhaustive economic history of each period, and a thorough analysis of the impact of those histories on the CPI would be beyond reasonable achievement. Yet some events are clearly more significant than others. For obvious reasons, wars are held to be especially inflationary, while depressions are deflationary. World Wars I and II and the start of the Korean War occurred in the first period, while the Korean War truce talks and the Vietnam War occurred in the second period. The recession of 1920 and the Great Depression occurred in the first period, while there have been five (or six, if you count what’s going on now) recessions in the second period. So we may say with some justice that the control of inflation should have been no harder in the more recent period particularly since the Federal Reserve Board had now proclaimed this to be its primary objective – than in the earlier one.

How, then, do the two periods compare? From 1913 to 1951, the Consumer Price Index (1982-84 = 100) rose from 9.9 to 26, an increase of 163 per cent. In the later period, from 1951 through 1989, the index rose from 26 to 124, an increase of 377 per cent. In other words, during the 38 years that the Federal Reserve

Board has been deliberately and ostentatiously fighting inflation, the inflation rate has gone up more than twice as fast as it did in the previous 38 years. On the record, the burden of proof is on the Federal Reserve Board to show that its policies, which have resulted in the destruction of the S&Ls, have been effective by any standard whatever.

As I have argued previously (“Bankers Have the Classic COLA,” NL, January 9, 1989), a high interest rate causes rather than cures inflation. This will always be true because the outstanding nonfinancial debt in the nation is greater than the GNP. At the present time, the former stands at about $9.75 trillion, and the latter is about $5.4 trillion. Thus each percentage point in the interest rate is paid for by an increase of $97 .5 billion in the general price level, while a one point increase in inflation costs only $54 billion. With interest rates currently running about six points above normal, this year’s net cost of the Federal Reserve Board’s inflationary policies will be $261 billion – or considerably more than the budget deficit everyone moans about.

In comparison, the cost of the S&L mess is small potatoes. Nevertheless, it must be added to the other costs the Federal Reserve Board is responsible for. Several Presidents and Congresses have undoubtedly acted stupidly in regard to the S&Ls, but the S&Ls would still be operating and prospering to the benefit of us all if it were not for the stubbornly misguided behavior of the Federal Reserve Board.

 The New Leader

The Reserve’s Silly New Equation

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

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.

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

 

Vale, Volcker

By George P. Brockway, originally published June 1, 1987

A COUPLE OF years ago, Mayor Edward I. Koch was asked who was responsible for pulling New York City back from the brink of bankruptcy. In one of his formerly frequent bright moments, he replied. “Well, I suppose someone has to get the credit, and it might as well be me.”

It is worth remembering that New York had been pushed to the brink by Walter B. Wriston’ s Citibank, David Rockefeller’s Chase, Donald T. Regan’s Merrill Lynch, and the rest, because in their self-advertised wisdom they thought it safer to lend our money to Argentina, Brazil and Mexico. Well, I suppose someone should get the credit for the mess our banks and the debtor nations are in, and it might as well be them.

But they don’t deserve all the credit. They should share it with Paul A. Volcker, for they couldn’t have raised the interest rate to usurious heights without his help. That may not be a nice thing to say about a man who is now retiring from government after many years of undoubtedly self-sacrificing service. Unhappily; I have some even less nice things to say. I say them not only in sorrow but also in anger, because people have been hurt-have had their lives ruined-by the lordly mistakes of this big man, and because his smaller successor as chairman of the Federal Reserve Board, Alan Greenspan, is apparently ready to keep making most of the same mistakes (besides, when the wind is north-northwest, declaring his devotion to Ayn Rand and longing for the gold standard).

Let’s briefly examine the Volcker record in five areas- (1) inflation, (2) general welfare, (3) economic output, (4) foreign trade, and (5) the deficit and then look more closely at his underlying theory. Volcker is admittedly not single-handedly responsible for the bad things-or the good things, if any-that can be pointed to in each case. He had a lot of help from Ronald Reagan, from legions of people who were sure they were doing what the President would have wanted had he been paying attention, and -yes- from you and me. Nevertheless, even if Paul VoIcker wasn’t, as the commentators liked to say, the second most powerful man in the world, he is, as they also say, a legend in his own time. It’s really what he stands for that I will [be] talking about.

1. Inflation. There is no doubt that VoIcker’s present fame is based on his claim to have been the tamer of the inflation dragon. He took office at the Fed in October 1979 and immediately began his attack. What really happened? From that December through December 1986, the Consumer Price Index (CPI) rose 51.06 per cent in constant dollars. In comparison, the increase from 1972 through 1979 was considerably greater, 73.50 per cent, but from 1964 through 1972 it was considerably less, 34.88 per cent. And if we go back to the bad old days of Harry S. Truman, we find that the increase from 1948 (following the jump when wartime controls were suddenly ended) through 1952 was only 10.26 per cent. On the record, VoIcker, the great inflation tamer, turns out not to have been all that great.

2. General Welfare. VoIcker never made a secret of the fact that his program was going to hurt. That may have been, as Ring Lardner would have said, one of its charms. Again using constant dollars, we find that from 1964 through 1972 the median family income increased 25.46 per cent; from 1972 through 1979 it increased 1.56 per cent; but in the VoIcker years, from 1979 through 1985 (the latest Economic Report of the President doesn’t have 1986 figures for this), the median income fell 4.56 per cent. Given that more families had multiple wage earners in 1985 than earlier, the drop in family income was even steeper.

The fate of the poor was much more dramatic. The number of our fellow Americans living in poverty actually declined 32.13 per cent from 1964 through 1972; it held unchanged from 1972 through 1979; but it jumped 26.81 per cent in the Volcker years.

On October 19, 1979, shortly after taking office, Volcker proclaimed, “The standard of living of the average American has to decline.” He made it happen.

3. Economic Output. Volcker’s rationale for hurting people was that inflation would thus be controlled, and the rationale for controlling inflation was that prosperity depended on it. As we have seen, inflation was only slightly restrained; perhaps it will be said that is why the recovery has been so lackluster.

The GNP rose (in constant dollars) 32.19 per cent from 1960 through 1972; 22.38 percent from 1972 through 1979; and only 12.30 per cent in the Volcker years. Since the working-age population increased 8.19 per cent in the last period, and more people produce and consume more goods, the Volcker recovery has been overpraised.

4. Foreign Trade. Everyone knows that our recent performance in foreign trade has been abysmal. If the monthly deficit on current accounts falls a point or two, it is hailed as a triumph. Everyone knows, too, that the strong dollar of recent years has made it difficult for American industry to compete either at home or abroad. What few remember, however, is that the strong dollar was a deliberate objective of Volcker’s policy, announced as early as October 17, 1979. It was supposed to stabilize international trade, and it sure made it fun to travel in Europe and to buy Volvos and Mazdas and madras shirts in the U.S. All this naturally contributed to the trade deficit and put Americans out of work. It also made it easier to sell American bonds-not goods but bonds-abroad. Volcker wanted the strong dollar because it made it easier to finance the American deficit-again a way to achieve a questionable result by imposing unquestionable hardship on millions of people.

5. The Deficit. The deficit question is a phony, and so is the problem of financing it; and I don’t mean merely that it wouldn’t have seemed important if it hadn’t been for the Kemp- Roth tax cuts. Volcker certainly isn’t to blame for those. He is to blame, though, for crying wolf over the deficit.

There are a few ways a national debt is like a personal debt, and one of them is that the amount of debt a nation can bear is a function of its income. Poor people and poor countries have trouble with small debts; rich people and rich countries can carry big debts. The United States’ debt is always thought enormous by knee-jerk conservatives; this was one of Reagan’s arguments against Jimmy Carter. In 1979 the Federal debt held by the public (some of it, of course, is held by government agencies, mainly Social Security) was 26.33 per cent of GNP. That was one of the lowest ratios in years, but Reagan promised to wipe it out and Volcker strengthened the dollar to help him. By 1986 the debt had risen to 41.94 per cent of GNP. This is a lot hairier than the 1979 animal, but even so it’s not a real wolf.

For something like a real wolf, we can go back to 1946, the last year of World War II, when the Federal debt held by the public was 113.62 per cent of GNP. If there is validity to the notion that a high debt/GNP ratio induces or requires a high interest rate, the 1946 rate should have been wild. Yet in that year, three-month Treasury bills paid all of three-eighths of 1 per cent, and the prime was 1.5 per cent.

Now consider this: During the Volcker years the Federal debt held by the public increased by $1,102 billion, and the interest paid on that debt amounted to $844 billion. Suppose the 1946 rate had been paid instead of the Volcker rate. The interest bill would have been reduced by about $812 billion, while the debt itself would have increased only $290 billion. At the same time, the debt/GNP ratio would have fallen to 2.46 per cent-hardly anything to get excited about (except as probably too low), and certainly below the urgent need for foreigners to invest in our bonds.

It comes down to this: Volcker allowed interest rates to soar, partly to reduce the average American’s standard of living, and partly to encourage foreign investment in government bonds. He was successful on both counts. But if the rates had been lower, the deficit would have been minuscule, and the foreign investors wouldn’t have been needed. High interest rates simply gave a lot of money to rich foreigners-and to rich Americans, too.

I HAVE ALREADY said that Volcker’s attack on the inflation dragon was not outstanding. I now make the heretical claim that his maneuvers with the interest rates indeed caused inflation to be greater than it might have been.

First, let me make a minor observation. The inflation rate is not a figure you read off an instrument, like barometric pressure. It is a statistical construction, and one of its factors is the interest rate.  Consequently, interest rates and inflation rates have a tendency to go up and down together. This is an arbitrary and possibly small effect, and one that could be eliminated by slight pressure on a computer key; nonetheless, it stands as a real fact in the real world.

Second, let me make the much more important observation that speculation is vastly stimulated by volatile interest rates. Volcker says that if the strong dollar weren’t available to bring in foreign money, Federal borrowing would crowd producers out of the money market. But speculation can always crowd out production, and that is what Volcker’s policy has encouraged.

There is a still more serious effect than either of these. If you are running a business and your friendly banker says he wants 20 per cent to renew your 10 per cent loan, your first defense is to increase your prices. Moreover, the loan isn’t the only thing that bothers you, because what economists call the “opportunity cost” of the money you and others have invested in your business increases as well. That is, whoever invests in your business passes up the opportunity to make easy money by being a lender rather than a borrower; so you have to raise prices to take care of that, too, and keep your colleagues from wanting to sell out.

A significant aspect of these increases is that they are percentages. What’s more, similar percentage increases are being made by everyone who supplies you with raw materials or rents you office space or provides shipping services for you. Every company below you in the production chain is adding a percentage to its prices, and you add your percentage on top of their inflated prices, and the companies above you in the chain do the same. The result is that, as Adam Smith observed in a little-noticed passage, prices are increased geometrically, whereas a wage increases pushes up prices only arithmetically.

The immediate impact of an increase in interest rates, therefore, is an increase in inflation. Of course, the intended decrease in the level of business follows sooner or later (it took Volcker almost three years to get things down to where he wanted them). Sooner or later, people can’t afford the new prices. Businesses can’t sell as much as they used to. Workers get laid off. Unions get afraid to strike. Wages are held down, and so price increases can be relaxed. This is what Volcker frankly worked for. But true to Adam Smith, we see that when wages go down (empirically, when any cost-including interest-goes down), prices fall only arithmetically; and if interest rates remain high, the net pressure on prices will continue to be upward.

Even a very severe depression (and Volcker made us one) will at best slow inflation; it will not stop it as long as interest rates remain high.

Volcker’s announced policy was to control the money supply (Ml) and let the interest rate take care of itself.

His theory was that a controlled money supply would raise the interest rate, and that a drop in the inflation rate would take place. He was never able to keep M1 growth within the guidelines advocated by Milton Friedman. It’s just as well.

As the table above shows, in 1981 a minor fall in Ml growth (one of only two such occurrences in Volcker’s career) was accompanied, not by a rise, but by the second largest fall in the prime rate, and followed by the largest fall in the CPI. On the other hand, in 1985 the biggest jump in Ml was accompanied by a substantial fall in the prime and followed by the most dramatic fall in the CPI. In general, the figures in the table can be made to support Volcker’s theory only by appeals to “lags” and “anticipations” and other statistical gyrations of the sort J .B. Rhine used to “prove” extrasensory perception. For true believers in the Volcker magic, when 1980’s slight tightening of the money supply was followed by a slightly lower inflation rate, that “proved” the theory. But when 1984’s greater tightening was followed by an increased inflation rate, that “proved” businessmen had expected the tightening and had moved to offset it. Either way, Volcker’s theory was a winner. But such pseudo-logic can equally “prove” the opposite.

In short, there is no way on earth to construct a valid correlation of changes in the money supply, interest rates and inflation rates that will support Volcker’s theory of what he was doing. And there is no way on earth to deny that what he did reduced the standard of living of average Americans and forced millions more into poverty. The theory that I (and Adam Smith) have advanced (for a somewhat fuller exposition, see my note in the Winter 1986-87 Journal of Post Keynesian Economics) goes at least part way in showing why Volcker’s theory was wrong.

A case can be made for many Volcker virtues, especially in impeding somewhat the rush to deregulate banking. But the false legend of big Paul Volcker and the dragon is one that shouldn’t be told to children-or to grown-ups, either.

The New Leader