Interest Rates I Have Known

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The New Leader

Beware of Your Cronies

By George P. Brockway, originally published January 26, 1998

THE PAPERS say the East Asian Debacle (previously known as the East Asian Miracle) was caused by something new under the sun called “crony capitalism.” It seems you have crony capitalism when one man (guided by family values and assisted by sons, nephews, in-laws, and pals) runs the show, which includes not only the government but most of the standard and all of the illicit ways of making money.

What’s so new about all that? Joseph A. Schumpeter, once the intellectual guru of conservative economics, in his presidential address to the American Economic Society just before his death in 1950, said: “Capitalism does not merely mean that the housewife may influence production by her choice between peas and beans; or that the youngster may choose whether he wants to work in a factory or on a farm; or that plant managers have some voice in deciding what and how to produce. It means a scheme of values, an attitude toward life, a civilization-the civilization of inequality and the family fortune.” This is the world of Thomas Mann‘s Buddenbrooks, in which everyone of importance knew everyone else of importance.

At about the same time C. Wright Mills, a sociologist as liberal as Schumpeter was conservative, published his analysis of what he called The Power Elite. A comparatively small group of men (almost exclusively men), well known to each other and generally congenial, they controlled what Lenin referred to as the “commanding heights” of industry and finance.

On a much less exalted level, I must confess that in my days as head of a publishing house I couldn’t boast with Will Rogers that “I never met a man I didn’t like,” and I found it much easier to do business with people I did like. I had my cronies, and I don’t doubt that J. P. Morgan had his too.

So I don’t see what’s so new about crony capitalism. Nor do I understand why the Debacle was a surprise to anyone who reads the papers occasionally. And I particularly fail to understand why it was a surprise to American bankers and businessmen and politicians, their economic advisers, and even to the journalists who reported on crony capitalism before it had a name[1]. The story of the young man who got whipped in Singapore may have had only a tangential bearing on economics, but the story of how Nike sports shoes are made is certainly relevant, and it is only one of many such stories.

Ten years ago I attended a conference at Brigham Young University on the ethical problems of doing business with the Pacific Rim. Most of those present had done business on the basis of figures that later proved to be largely imaginary, had contracts changed on them in midstream, and had difficulty getting a straight answer from a trading partner. One of the most articulate speakers was an officer of one of the largest American banks. Do you suppose he was the only American banker who knew what the score was?

However that may be, all the big American banks are now at least somewhat entangled in the East Asian Debacle, as are scores of American producers and retailers, especially of sporting goods, electronics and T-shirts. During the past few years, as our stock exchanges have become crowded with baby-boomers driven frantic by the prospect of bleak golden years, dozens of mutual funds and investment trusts have also become active players in East Asian markets.

It is these people whom the International Monetary Fund, prodded and abetted by us, is trying to rescue. Although we have kowtowed to the various swarms of cronies in the past, and hope to be able to do so in the future, it is not their skin but ours that we are trying to save.

Our business press is nevertheless full of good advice for the East Asians: Their banking systems should be more “transparent” (meaning, I suppose, that bankers shouldn’t talk in conundrums like Chairman Alan Greenspan); their industrial accounts should conform more closely to practices generally accepted in the First World; and someone (say, the IMF) should be watching to see that things are done right.

This advice seems reasonable enough; yet it sounds to me pretty much like regulation and bureaucratic intervention and all that Old Democratic New Deal stuff that we’re trying to clear away as we prepare the bridge to the 21st century. One must wonder how policies said to be bad for us can be good for East Asians, particularly since the IMF combines deregulation and privatization with balanced budgets and high interest rates to produce austerity.

Austerity and economics, of course, are mutually contradictory ideas. Economics has to do with the production and distribution of goods and services, and austerity means not consuming or using them. To be sure, the latter is supposed to lead to the former, but there is really no reason to expect it to do so and there is little evidence that it ever has, except in wartime or in some command societies.

Invariably austerity, while it may cause the leisure class some annoyance, is devastating in its effects on everyone else. Such devastation is intended. The theory is that otherwise the poor and middle classes will spend any money they are allowed to have on food, clothing and shelter, thus depriving entrepreneurs of money to invest. (How many cases can you cite where producers of mass-market goods achieved success by expanding production when no one among the masses had any money to spend?).

The theory is both callous and erroneous. Its callousness accounts for the success of the East Asian Miracle, and its fallacy accounts for the Debacle. Following the advice of Western (why is that word acceptable, while “Oriental” isn’t?) economists, the East Asian countries embarked on ambitious export programs.

Since what is consumed at home can’t be exported, domestic consumption was discouraged-first by holding wages down, and second by energetic pro-saving propaganda. The low wages had the essential advantage of improving the East Asian competitive position in the world markets. The saving reduced home demand for consumer goods and gave the banks a little extra to speculate with in real estate.

Led by Japan (which, after all, had been sufficiently Westernized to defeat Russia in 1904-5 and had taught its neighbors the work ethic in the Greater East Asia Co-prosperity Sphere in the 1940s), the East Asian Miracle was a remarkable phenomenon. From every point of view, it was more successful than the contemporaneous development programs of India and South America (which stagnated), and of Sub-Saharan Africa (which slid backward).

But the system was fundamentally unstable. It depended on controlling imports at the same time that exports were promoted. An excess of exports over imports is defined, in conventional economics, as an increase in Gross National Product. So the East Asians restricted imports as the way to get rich.

HOW, THEN, were we to pay them for their exports? If the Japanese demanded yen, which we didn’t have, they had to sell yen to us for dollars, which we didn’t have. They could use quite a few dollars to buy oil and other things they needed for their industries, but they still had billions of dollars left over. In the wonder-working years of former Federal Reserve Board Chairman Paul A. Volcker they happily used many dollars to buy U.S. Treasuries that paid 15 per cent interest or more. That was fun, but of course the interest was paid in dollars; so in the end all they had to show for their hard work and ingenuity was a lot of money in their banks, by far the biggest in the world.

Most East Asian banks can own industries, play the stock market, dabble in real estate, and do other speculative things American banks hope to do in the next century. In Japan, whose area is slightly less than that of Montana, the value of real estate ballooned to double that of the entire United States. When the balloon burst in the early 1990s, Japan went into a recession it has yet to shake.

Next to “supply and demand,” the two most holy words in contemporary economics are “market discipline.” But there was no discipline in this Debacle, and no significant penalty is proposed for anyone but the poor and defenseless. President Suharto and his family in Indonesia may lose a few fortunes, but they will still have many left.

The cronies could not have done it alone. American banks and businesses were not hijacked, as by Malay pirates of yesteryear. They eagerly took well-understood chances because they counted on the spread between American and Asian wages to make pots of money for them very fast. And it did. The East Asian Miracle was erected on the backs of American working men and women who lost their jobs because of the wage spread, and the East Asian Debacle will fall on the backs of East Asian working men and women who are now losing their jobs because of the notion that austerity is good.

Congressmen oppose an East Asian bailout on the ground that it will use our money to save banks and businesses from the consequences of foolish or greedy investments. But if the banks and businesses are not rescued, we will, as Treasury Secretary Robert E. Rubin and Chairman Greenspan warn us, suffer at least a slowing of our economy, and this will, as always, be most damaging to those among us least able to bear it.

The East Asian bailout may cost us billions of dollars-many billions more than the Mexican bailout of two years ago, and perhaps more than the Savings & Loan bailout of only yesterday. It may not be successful. In that case we might be swamped, too, dragged down into a worldwide depression.

If the bailout is successful, our bankers and businesspeople may get our money back, or most of it, without learning a thing from the experience. At best, they might come away with a fuzzy sense that crony capitalism is not all it’s cracked up to be, and a warm feeling (which is not the same as contrite gratitude) that Uncle Sam will take care of them no matter what they do.

For the rest of us, the lessons are with us always, because we don’t seem to learn them. In general ethics, what we do unto others we do to ourselves. In the special branch of ethics that is economics, any system built on the shaky backs of the downtrodden will be forever unstable.

The New Leader

[1] Ed:  Perhaps they should read Charles Kindleberger

What Greenspan Really Told Congress

By George P. Brockway, originally published July 17, 1995

TODAY’S LESSON will be in two parts. The first will be an exhibition of a complaint; the second an exhibition of a gleam of hope for better times in this nation and this world and even this dismal science.

The complaint concerns the press, particularly the business press, which is so busy collecting meaningless quotes from pseudo-prominent bankers and brokers that it fails to notice the story it is presumably covering. For example, on July 19 Chairman Alan Greenspan of the Federal Reserve Board, who is as entitled as his predecessor to be called “the second most powerful man in America,” appeared before a subcommittee of the House of Representatives in accordance with the provisions of the Full Employment Act of 1978, otherwise known as Humphrey-Hawkins.

Now, Humphrey-Hawkins has not had a good press. In his excellently useful Presidential Economics, Herbert Stein says that its “goals are so unrealistic and inconsistent that they are not taken seriously by anyone.” Still, it is the law of the land, so Greenspan duly appeared on the Hill, surrounded by advisers and armed with a prepared statement plus supporting documents. At least some of the Washington press corps came to pick up the handouts and perhaps lend an ear to part of the subsequent testimony. It was a routine assignment.

The shape of a Greenspan news story is now well established. The question always is, will-he-won’t-he raise (or lower) the interest rate? The Chairman always answers it, to the delight of his audience, in his personal version of Casey-Stengelese. Thereupon the reporter interviews a clutch of brokers’ economists for their differing interpretations of what he said, and offers the thoughts of a smaller clutch of Congress people or government officials.

And so it was with the New York Times account of the latest Humphrey-Hawkins affair. Three brokers’ economists were interviewed – one from Minneapolis (thus showing that the Times is a national newspaper), one from New York, and Allen Sinai. Sinai is from New York, too, but he is quoted in almost every story and I assume must be considered universal. Of the Congress people, the Times made do with a mildly querulous comment by subcommittee member Joseph Kennedy II (D.-Mass.) and a reverential tribute to the Reserve and its leader

By House Banking Committee Chairman Jim Leach (R.-Iowa). All in all, the 28-inch Times story (counting picture and headlines) did not do much more than, as the saying goes, keep the advertising columns separated (a problem we rarely have at THE NEW LEADER).

As it happened, however, Chairman Greenspan interspersed among his answers to questions from the Congressional panel several profound, profoundly astonishing and profoundly hopeful observations. The Times missed them all, and so did the Wall Street Journal. That’s the complaint I promised.

But fortunately for you and posterity, I was channel-surfing[1] the next day and came upon CNBC, which was using clips of the Humphrey-Hawkins hearings to keep sections of its Money Wheel separated. The first clip I heard stopped me short.

“I don’t believe,” Greenspan was saying, “that any particular unemployment rate – that 5 per cent or 5.5 per cent or whatever numbers we’re dealing with is something desirable in and of itself. I don’t believe that.”

Well, you may be sure that I stopped surfing and anchored myself to CNBC. At considerable trouble and expense I also now have the whole thing on videotape. If you want a good journeyman definition of the barbarous notion of a natural rate of unemployment, you can do worse than settle on “a particular unemployment rate that is something desirable in and of itself.” In his December 29, 1967 speech that named the cruel notion, Milton Friedman put it as follows: “At any moment of time, there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wage rates.”

During the 28 years since Friedman made his speech, one or another of several theories of a natural rate of unemployment has swept through the economics profession. Some of the theories depend on productivity rankings; some on a distinction between nominal wages and real wages; some on both; some on neither. But all agree that the rate of unemployment is so linked to the price level that as one goes up, the other goes down. The linkage is not explained; it goes without saying. Everyone presumes that a fall in unemployment will “force” the Federal Reserve Board to damp the “inevitable” inflation by raising the interest rate. In fact, this presumption explains most of the gyrations of the interest rate during Greenspan’s tenure. (For a detailed refutation of the linkage, see the September issue of the Journal of Economic Issues self-advt.)

Now we have heard Chairman Greenspan repudiate the natural rate nonsense. If the second most powerful man in America can do that, there is hope for the rest of us.

From December 29, 1967, to date, economic thought in the United States has been stopped dead because the fundamental economic problem was solved. To be sure, it was solved the way Ko-ko explained the solution of his problem to the Mikado: “Your Majesty says, ‘Kill a gentleman,’ and a gentleman is told off to be killed. Consequently that gentleman is as good as dead-practically, he is dead and if he is dead, why not say so?”

In the same way, Paul Krugman, self-proclaimed spokesman for mainstream economics, writes: “Most of the 5 million or so unemployed are either unskilled or part of the inevitable ‘frictional’ unemployment.” In other words, there are no employable unemployed; hence there is no unemployment problem. Furthermore, says Krugman, “adding 2 million jobs, if we could do it, would drive the U.S. unemployment rate down to about 3 per cent. But that isn’t possible, or at any rate not for very long. At that low unemployment rate, inflation would begin to accelerate rapidly.”

Having grossly underestimated the number of unemployed and having arrogantly dismissed as useless their fellow human beings who make up that number, mainstream economists have embraced the theory of the natural rate of unemployment and simply declared joblessness a non-problem. This has left them free to spend the past quarter century pondering such weighty concerns as “Games with Incomplete Information” (the lead article in the current American Economic Review). Perhaps Greenspan can guide us to a fairer land.

INDEED, the Chairman took another step in that direction as the Humphrey-Hawkins hearings wore on. He was asked if it would be possible to lower interest rates and still have our bonds attractive to German and Japanese investors. Greenspan’s reply was short and to the point: “I’m not aware that we have had very many difficulties selling the debt – the Federal debt – at low interest rates.”

It was very brave of Greenspan to make that statement. Not only does it give the lie to his six-foot- four predecessor – who claimed the budget deficit forced high interest rates that crowded entrepreneurs out of the credit market – it undercuts his own words regarding the deficit. He is for balancing the budget (but no constitutional amendment) because, he said, “there is no doubt, in my judgment, that the net result of moving to budget balance will be a more efficient and more productive U.S. economy.” In forming that judgment he can scarcely have considered what is going on in Washington today or what will happen throughout the nation thanks to these “revolutionary” goings-on.

Nor can he have considered his own power over the deficit. The interest bill on the national debt is at present roughly equal to the budget deficit. A fraction of the debt is rolled over every year. If the new loans were issued in accordance with the “patterns of rates” followed by the Reserve and Treasury during World War II, the reduction in the interest bill alone would practically eliminate the deficit by the mystic year 2002 -and not a single welfare family would have to camp on the public sidewalk while the mother begged for a nonexistent job.

I don’t suppose you are willing to bet anything like that will happen. (It would be a good “derivative” to have the other side of.) You’re right, but it is not some esoteric economic law or some superhuman market that will prevent the happening. The reason, rather, is that we the people of the United States of America care more about money, and individuals with money, than we do about our fellow citizens and ourselves.  We should at least recognize that we are in the deficit mess (if it is a mess) not because too few people are unemployed, but because for the past 40-odd years relatively high interest rates have transferred money from the many who do the work of the world (including the government) to a comparatively few bankers,  rentiers and speculators.

The transfer has not escaped Greenspan’s attention. In response to a question from Congressman Kennedy he said, “Evidence suggests in recent years that income is being dispersed rather than concentrated [that is, the rich are becoming richer, the poor poorer, etc.]. … There has been a regrettable dispersion of incomes that goes back to the later ‘60s…. What’s the major threat to our society? I’d list this as a crucial issue. If it divides the society, I do not think that is good for any democracy of which I am aware.”

Unfortunately, Greenspan did not see that there was anything the Federal Reserve Board could do to change the situation. He did not mention anything anyone else could do either, beyond the new obligatory red herring of higher education for competing in the coming world economy.

Nevertheless Greenspan had a vital three-part message: First and most important, there is no such thing as a natural rate of unemployment, therefore there is work aplenty for economists eager to grapple with real problems of the real world. Second, Federal Reserve policies based on the alleged crowding-out concept can now be forgotten. Third, we should embrace policies that unite us, because policies that divide us may well prove ruinous.

Greenspan’s message permits the gleam I mentioned at the beginning. Put into practice, it would make a better nation, a better world and a better economics. It’s a pity the Times, the Wall Street Journal and the rest missed it.

The New Leader

[1] Ed. – many who knew the author well are reeling, shocked, that he knew how to spell “channel-surfing” much less had a concept of what it was… God forbid he did it!  Oh!  How delicate the façade!

The Illogic of Leanness and Meanness

By George P. Brockway, originally published November 2, 1992

                EDITORIALWRITERS and speech makers are fond of the expression “lean and mean” (or, sometimes, “mean and lean”). I suspect it is the rhyme that appeals to them. They can’t possibly be allowing themselves to think about what happens to people who work (or used to work) for lean and mean corporations. They can’t possibly give a satisfactory answer to the question John Kenneth Galbraith asks in Affluent Society: “Why should life be intolerable to make things of little urgency?”

Nor can they possibly be wondering whether lean and mean corporations make this a better world to live in, even for their customers and their stockholders. St. Augustine wrote: “Every disorder of the soul is its own punishment,” and meanness is certainly a disorder of the soul.

Yes, I know: We are told we will have to be lean and mean to compete in the global economy of the 21st century. Some commentators say that the global economy and the competition are already here.  President Bush inclines to this view; President-elect Clinton inclines to this view; and I suspect that Citizen Perot had something similar in mind. At any rate, he had a lean and hungry look.

Fifty years ago another self-made man, Wendell L. Willkie, had a vision of One World in which we would all help each other. Willkie was a lawyer and CEO of a giant utility holding company before he became the 1940 Republican Presidential candidate (Harold Ickes, Franklin D. Roosevelt’s Secretary of Interior, called him the “barefoot boy from Wall Street”); he was no starry starry-eyed innocent. Yet his touchstone was cooperation, not competition. The world seems to be different now, and not as nice. What happened?

It is, I think, a case of Samuel Johnson being right again: “Hell is paved with good intentions.” The economic situation we find ourselves in is mean enough to have at least some of the attributes of hell, and it is paved in part with free trade, a theory whose intentions were the best in the world. I say “were” because I’m not so sure they’re all so good today.

Practically every economist is in favor of free trade, and the fraternity has been joined by a broad range of right-thinking, public-service citizens groups, from the Council on Foreign Relations to the League of Women Voters. The argument for free trade is simple and strong: All of us are consumers, and therefore benefit from cheap consumption goods. Tariffs, subsidies and the like increase the costs of consumption goods, and therefore are bad. A less materialistic reason for open international trade is that it is said to make for peace, although perhaps not in the Middle East.

The foregoing arguments, including Willkie’s, may be classified as general or ideological. There are also technical arguments in support of free trade – for example, the theory that cheap imports are both anti-inflationary in themselves and anti-inflationary in their competitive pressure on domestic prices. This notion was a favorite of former Federal Reserve Board Chairman Paul A. Volcker. The most famous technical argument is David Ricardo‘s so-called law of comparative advantage. Unhappily, there isn’t sufficient space here to discuss this “law,” except to say that it consists mostly of exceptions[1].

For the moment I merely want to register the point that each of the arguments, the ideological and the technical, depends – as does standard economics generally – on three assumptions: that full employment actually obtains here and now, that chronological time does not matter, and that all public questions are, au fond, economic questions (or, as Marx had it, that the state will wither away and need not be taken seriously).

Free trade as an ideal has had a long run on the American political stage, starting at least as early as the Boston Tea Party. What has happened recently is not inconsequential. Even as late as 1950, imports were less than 5 per cent of our GNP (exservices): currently they are running at about 16 per cent. Until 1977, American exports generally exceeded imports; I don’t have to tell you that the situation is different now. Nor do I have to read you a list of American industries that have been decimated by foreign competition. Those who say that the global economy is upon us are not far wrong. I am persuaded, however, that what they propose to do about it is indeed far wrong.

Essentially, they make two proposals. The first is the lean and mean thing, to which I will return. The second involves empanelling a committee of government officials, bankers, businessmen, economists, engineers, scientists, and the obligatory representatives of the general public (but not including Ralph Nader) to recommend research and development projects to the government, and then to pass judgment on the results of the research and propose ways of implementing the development of approved ideas. The government’s role would be crucial, because of the antitrust laws and because the research is thought likely to cost more than any corporation, regardless of its size, could afford. In addition, it is observed that the largest corporations tend to devote less and less money to research.

The scheme has both practical and theoretical flaws. The chief practical flaw is that whatever good ideas the committee might come up with would be immediately available worldwide. Just as the American television set industry quickly slipped into the Pacific sunset, so would the new wonder industries.

It is inconceivable, for instance, that giant American corporations would be excluded from the marvelous new industries thought up by the committee. Our giant corporations, however, are not really American; they are multinational. They are motivated by the self-interest of the stockholders (in the conventional theory) or of the managers (in Galbraith’s view); in either case, their devotion is neither to the nation nor to the nation’s workers.

Consequently, upon learning of the miraculous new product along with everybody else, if it is truly miraculous, the responsibility of these corporations to their stockholders or to themselves would require them to start producing it in the least expensive way. And where would they do that? Wherever in the world they found the most stimulating subsidies, the most alluring tax rates and the cheapest labor.

Wherever in the world that might be, it would not be in the United States of America, for the inescapable reason that, at least so far, the American standard of living is higher than that of any other first-rank country. The cheapest labor will not be found here unless we destroy ourselves. On the MacNeill Lehrer Newshour a few months ago, U.S. Trade Representative Carla Hills seemed to believe the Mexican poverty rate was only about 11 per cent (ours was 13.5 per cent two years ago and has undoubtedly risen since). She must have been thinking of some Mexico other than the one I’ve visited.

A MINOR practical flaw in the committee scheme is inherent in the very idea of creating such a group. Schumpeter counted the mature corporation’s addiction to committee decisions a prime reason for decline, and we all know the absurdity that would result if a committee tried to design an animal. Perhaps more important, we know from experience that a committee is quickly co-opted by those with the liveliest immediate interest in the outcome of its deliberations.

In the proposed body the industry and banking representatives may not be the smartest or the best informed, but they surely will have their minds concentrated on the fate of their sector of the economy, and they will certainly wield the direct and indirect power that comes with enormous wealth. In Japan, captains of industry respect the authority of even minor bureaucrats; in the United States, money talks.

Beyond this, the committee approach has a serious theoretical flaw in that it contradicts the very reasons for its formulation. These, it should be kept in mind, are (1) the decline of American industry because of foreign competition, and (2) the presumed impossibility or unacceptability of self-protection in any form.

The conventional charge against self protection is that it interferes with and distorts the natural course of trade, thus making for inefficient if not altogether wasteful use of resources. Publicists reinforce the charge with the cliché that a man knows better what to do with his money than does some bureaucrat in Washington. Yet if the charge and the cliché were valid, there would be nothing to be done about the decline of American industry. It would be natural and inexorable. Further, it would assure the “efficient” use of resources and be a necessary contribution to the wealth and happiness of mankind. Some people would no doubt be hurt by it, but you can’t make an omelet without breaking eggs.

On the premises, there is no more place for a reindustrializing committee than there is for self-protection. If the committee wouldn’t interfere with the natural marketplace, what would it do? Its whole purpose is to interfere in a large and comprehensive way. The logic of the scheme is absurd. Major premise: American industry is being ravaged by foreign competition. Minor premise: Self-protection is unacceptable because it interferes with the free market. Conclusion: A committee should be empaneled to interfere with the free market. What kind of logic is that?

The lean-and-mean logic is similar. Major premise: The American standard of living will be ravaged by foreign competition. Minor premise: Self-protection is unacceptable because it interferes with the free market. Conclusion: We should make corporations lean by firing people, make them mean by working the surviving employees harder for less pay, and thereby make ourselves miserable without help from anyone else.

I find it odd that standard economics, based as it is on self-interest, should find self-protection invariably reprehensible.

The New Leader

[1] This link includes references to the Law of Comparative Advantage in other Dismal Science articles

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

What Color is Your Recession?

By George P. Brockway, originally published October 1, 1990

EVERYBODY SEEMS to have a theory about the when or what or how of a recession. The official or customary theory (I’m not sure what office decrees the custom) is that you have a recession if you have two back-to-back quarters of falling real GNP. Some journalists, apparently trying to avoid monotony, say you need to have six months of falling real GNP-which is a little bit harder to do. Federal Reserve Board Chairman Alan Greenspan has a different approach. A business downturn has to feed on itself for him to call it a recession.

Before Greenspan will sit up and pay attention, inventories have to rise, causing orders for more goods to fall, causing workers who might make more goods to be fired, causing stores that might have sold goods to those ex-workers to lose business, causing them to cancel orders from their suppliers, causing more factory closings, and so on and on and on. The trouble with this is that if such a self-cannibalistic process should get started, Greenspan is not likely to be able to do much about it. The Federal Reserve Board was not conspicuously effective when it realized (some months after the event) that the Great Depression was upon us. Anyway, Milton Friedman, the monetary guru, says it takes two years for monetary policies to take effect.

In short, most economists feel they have done their job if they just say No to recession. But whether what we are now going through is a recession or not, it seems like one to honest proprietors of S&Ls (there used to be many), to automobile dealers, to building contractors, to all the earnest Willy Lomans desperately trying to meet their Christmas-line quotas, and to all their regular customers trying desperately to emulate the Japanese and place their orders “just in time.”

My poet friend has what she calls the Taxicab Theory. As late as the middle of August, she says, you could not get a cab in New York even if there wasn’t a cloud in the sky. It took a half hour or more to sweat out the line at the Vanderbilt Avenue side of Grand Central. Now, she points out, you can get a cab anywhere, rain or shine, night or day. She concludes that if people don’t have money for taxis, we are in a recession. “If you don’t believe me,” she says, “you can ask the cabbies. They’ll tell you.”

No doubt there are other recession theories. What difference do the different theories make?  Suppose all those who are saying we’re in a recession, whatever their degree of technical sophistication, are right. So what? To be able to refer to “The Recession of1990-91” will no doubt be convenient for future historians, but how does it butter our parsnips today?

The answer, of course, is that if somehow someone could convince the Federal Reserve Board that we are in a recession, they might bring themselves to do something about it. And (this is what Samuel Johnson would call the triumph of hope over experience) they might even do the right thing. That’s why Chairman

Greenspan’s definition of a recession is so ominous. If, as he says, a recession is a disaster feeding on itself, there is not much that the monetary authorities can do; and if we are not in a recession, there is no need to do anything. His formulation is an ideal excuse for inaction.

Rather, it is an excuse for no change of action, for what former Chairman Paul A. Volcker liked to call “staying the course.” He was probably brought up (like me) on Iron Men and Wooden Ships and Howard Pyle’s Book of the American Spirit; so he couldn’t help it if others of our generation had visions of him as David Farragut standing in the rigging, shouting, “Damn the torpedoes! Captain Drayton, go ahead!” or as Ulysses S. Grant, lounging on a rough bench during the Wilderness campaign, calmly proposing to “fight it out on this line if it takes all summer.”

The “two quarters” approach to recession is only slightly less lethargic than Greenspan’s. According to this view, the last recession ended in 1982. It follows that we have had prosperity ever since-in fact, we are told, the longest sustained prosperity in our history. Thus the definition of recession is also important because when you say what you mean by recession, you ipso facto reveal what you mean by prosperity. The meaning of bad times implies the meaning of good times. How good are the good times we have been enjoying from the end of 1982 to the present? Let me count the ways. The national debt has increased from $1.137 trillion in 1982 to $3.319 trillion today. The annual trade deficit has gone from $7 billion in 1982 to $136.5 billion today (with two higher years in between). The nation’s atomic plants have so deteriorated that it will cost $200 billion to repair them. Likewise, at a similar cost, the interstate highway system. The United States of America, the world’s largest creditor nation at the start of the period, is now the world’s largest debtor nation.

To be sure, we have been staying the course in order to conquer inflation. So what has happened? The Consumer Index has risen 34.7 per cent. Perhaps you are politically inclined and want to compare these eight Reagan-Bush years with the eight Kennedy-Johnson years. During the latter (which included the Vietnam War), the CPI went up only 22.7 per cent.

The foregoing is not the worst that can be said of our allegedly prosperous era. The worst is what was done to people directly.

In the years since 1982, the number of our unemployed fellow citizens has never fallen below 6.5 million and has generally been much higher. The number of those too discouraged or demoralized to look for work has hovered around 1 million. The number of those working part time has not fallen below 35 million. The number of men, women and children living in poverty has not fallen below 31.5 million. The number of the homeless can only be guessed at. Our infant mortality rate has become the worst of any industrialized nation. We have the most expensive and the least satisfactory medical care system. And the gap between the rich and the poor has steadily widened, reaching its widest in the figures just released by the Census Bureau.

I submit that the economy sketchily described above is not prosperous. Nor is it “fundamentally sound,” although that meaningless phrase will be trotted out if anything more goes wrong. Certainly the current state of affairs is not so wonderful that it justifies “staying the course.” Every sane citizen must want America to do better. Therefore the customary definition of recession and the Greenspan definition are both mischievously misleading.

We want to be alerted to any weakness in our society, and we want especially to be alerted to faltering in our striving to build and maintain a fair and free economy. We don’t have an economy simply to put chickens in our pots and automobiles in our garages. Communism in the Western world has collapsed because its objectives narrowed to just such trivia. When capitalism judges itself on the basis of its GNP, it risks succumbing to the same fate.

We have economics so that we all can be free and responsible providers of our own sustenance, thinkers of our own thoughts, and definers of our own relationships with our fellows. By “all” I mean all. We have come a long way, and obviously we have a long way to go.

HOW CAN WE measure our progress more precisely? We now have two statistical series that will serve at least for the time being. The first gives us the number and percentage of families living in poverty.

To no one’s surprise, the proper way of determining poverty is in dispute. On one side are those who say that the reported numbers of the poor are too high because the definition of poverty is limited to cash income only and excludes the value of public housing, food stamps, Medicaid, and so on.

On the other side are those who say that the reported numbers are too low because the definition of poverty is based on an estimate of the cost of necessary food, which is assumed to be one-third of the minimum budget. It is argued the estimate of the cost of necessary food is too low, and that other essential expenditures come to more than double the cost of food.

We may eventually reach that happy day when we have reduced the number of poor to the point where it is vital to settle this dispute. In the meantime our performance is so disgraceful that almost any definition of poverty will serve to mark our progress (or lack thereof) from year to year. Whether the number is 31 million or 16 million or 40 million, it is shameful and should spur decent people to action.

The other relevant statistical series shows the share of the national income that goes to the different quintiles or deciles of the population. Again there are disputes over details, and again the trend is a good-enough measure for now. Surprisingly, many people (among them Friedrich Engels) have fretted that perfect equality is either impossible or bad or both, but they really need not worry.

The two statistical series-the number or percentage of fellow citizens living in poverty, and the distribution of the national income-are both socially revealing and economically crucial. A free economy not only produces goods, it consumes them. If significant numbers of the citizens are unable-for whatever reason-to produce goods, the economy is weakened. If significant numbers are unable-for whatever reason-to consume what is or might be produced, the economy is weakened. The supply side must be balanced by the demand side, or the whole thing grinds to a halt.

The grinding to a halt is very like Greenspan’s self-cannibalism. It is not quite so bloodthirsty, but it is no less deadly. Real GNP may be increasing from quarter to quarter, yet increasing numbers of men, women and children are excluded. It may take decades or centuries, but the resulting stagnation and rot could destroy the society (see “The Evils of Economic Man,” NL, July 9- 23).

We are not fated to destroy ourselves. To avoid destruction, however, we must first understand what can go wrong what is going wrong. The current popular tests of recession hinder-they do not help-our understanding.

 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

How We Can Control Inflation

By George P. Brockway, originally published March 6, 1989

IN THREE recent contributions to this space[1] I have argued that the conventional theories of inflation are wrong-that it is not caused by full or almost-full employment, and that it is not cured by raising the interest rate. I have gone further: I have maintained that raising the interest rate (which I call the Bankers’ COLA) is precisely what produces inflation in the first place. A legitimate question now is: What do I propose we do?

Let it be admitted – nay, insisted – at the outset that there aren’t any easy answers. No matter how ingenious the laws we enact, we can be certain that ingenious ways of avoiding them will be discovered. Legal avoidance happens with even the most uncomplicated statutes. There is a book out on how to defend against a drunk-driving charge by a trial lawyer who has had thousands of such cases and never lost a one. The unremitting search for loopholes in the income tax laws is sporadically countered by searches for ways to close them. It will be the same with whatever we propose. Perfection is impossible, because perfection cannot act.

To control the interest rate – to eliminate the Bankers’ COLA – one must be able to control the money supply. The Federal Reserve Board tries to do that now (for reasons different from those I’ve advanced) by fiddling with the reserve requirements it imposes on the banks and with the interest it charges them for temporary loans. Using these levers, the Fed can control the supply pretty well; but the interest rate – the cost of money – depends also on demand, and there is one demand for money that the Fed has so far refused to do much more than talk about. Seven and a half years ago (“Why Speculation Will Undo Reaganomics,” NL, September 7, 1981), I wrote in these pages: “Unless one is ready to run the printing presses flat out, the only way to get money into productive hands is to see to it that little or none of it falls into speculative hands.”

Although there is probably no way of keeping speculators from getting their hands on money if they want to, it would be quite easy to keep them from wanting to. All one has to do (as Felix Rohatyn and others have suggested in order to inhibit leveraged buyouts) is tax capital gains at 100 per cent on property held less than a year or two, then at 95 per cent on property held less than two or three years, and so on until the rate got down to the level of ordinary income.  (This, it will be noticed, is exactly contrary to the proposal of our new President, but he has never been quite clear in his mind what was and what was not Voodoo Economics.)

The foregoing, however, earth shaking as it is, would not be enough. For the archetypical speculators of our day are not beefy gents in flashy suits on the order of Betcha-million Gates or even aristocratic gentlemen with narrow ties on the order of J.P. Morgan or even indescribables like Ivan Boesky. No, the big-time wheeler-dealers are “institutions,” and institutions are churches and colleges and foundations and pension funds and insurance companies and mutual funds. We might almost say with Pogo that we’ve met the enemy and they is us, for most of us are beneficial owners of pieces of one or more of the nameless, faceless institutions the market gossips gossip about.

These institutions, our surrogates, write the computer programs that run the market, and they do it for capital gains. Unless that candy is taken away from them, it will do little good to take it away from the old-time speculators who still exist. Consequently, we’ll have to take a deep breath and tax the capital gains even of charitable institutions. (I said it wasn’t going to be easy.) The demand of nonproducing speculators for money would thus be greatly reduced, if not altogether stopped, and the Reserve Board, by increasing the money supply, could lower the interest rate for everyone else and take a step toward eliminating the Bankers’ COLA.

But it would be only a step. The bankers would resist, and their line of argument would be practically identical with the one they used in freeing themselves from most of the New Deal regulation. They were, in fact, remarkably successful in getting Democrats to make their arguments for them, as William Greider documents at excellent length in Secrets of the Temple. For example, Wisconsin’s recently retired Senator William Proxmire “delivered a short lecture on inflation and interest rates. At 15 per cent inflation, an investor lending $1 million at 10 per cent ‘loses’ $50,000 a year. ‘You cannot count on the lender being a complete idiot,’ Proxmire said. Sooner or later, he will stop lending at the low interest rate and invest the money himself in commodities or real estate.”

Our capital gains tax would cancel the commodities option and could be made to cancel the real estate option, but suppose the Senator’s million-dollar lender is smart and doesn’t lend at all, thus saving that $50,000 “loss.” He would be like the unfaithful servant in the parable, for at the end of a year he would have only his million dollars, while his neighbor, who wasn’t so smart and lent his million at 10 per cent interest, would have $1,100,000. What happened to the $50,000 loss Senator Proxmire talked about? If there was anything more to it than fancy rhetoric, the 15 per cent inflation affected both investors. The one who refused to lend wound up with $850,000 worth of purchasing power, while his neighbor wound up with $950,000. A negative “real” interest rate, in apparent defiance of the laws of mathematics, proves to be greater than zero. Perhaps we can count on the lender not being a complete idiot.

Of course, the millionaires have other choices. They could take their money and invest it directly in productive enterprise, or they could live it up. The former option is what we had hoped they would do, anyhow; that’s why all the editorial writers in the land have been urging them to save. As for the latter option, they might find consuming a million a little difficult, but it would be fun to try, and the economic result would at least be some priming of the pump. Someone has to consume what the economy produces.

The fact remains, though, that both millionaires have taken a loss in purchasing power, and that deliberate, cold-blooded national policy has forced the loss upon them. That’s not nice, and it’s nothing we can be proud of. So what can we do? Well, all that the Fed and other true believers in traditional economics have proposed (and put into practice) is raising the interest rate, usually by restricting the money supply. That’s how former Reserve Board Chairman Paul A. Volcker got the prime interest rate up to 21.5 per cent in December 1980, while the Consumer Price Index was up only 13.5 per cent, leaving Senator Proxmire’s investor with “real” interest of 8 per cent, which should have made him happy. The funny thing was, it didn’t make others eager to become like him. The real interest rate was greater than the prime itself had ever been (with one exception) before 1978; nevertheless, the national savings rate fell, and in spite of the subsequent Reaganomic tax cuts for the wealthy, the savings rate continued to fall. Moderately reflective true believers should have had their beliefs shaken just a bit.

Moderately compassionate believers should have been severely shaken by what else happened. The number of people unemployed went from 6.1 million in 1979 to 10.7 million in 1983. In the same years, 9.2 million more people were impoverished, and the median family income (in constant dollars) fell $2,305. That was not so nice either, and it was brought about by deliberate, coldblooded national policy.

Nor was that the whole story. The Federal deficit soared, our foreign trade was savaged, and Latin America was saddled with loans at un-payable interest rates. And all this was done to keep the real interest rate from falling below zero.

IFTHAT WERE merely a trade-off – suffering a lot of grief and getting back a little stability – it would be bad enough, for what was exchanged was the livelihood and prospects of millions of fellow citizens for the” reality” of usurious interest rates. The economy was deliberately depressed to “save” it from the possibility – the mere possibility – of being depressed later. But the savings rate continued to fall, corporate investment continued to fall, and industry after industry was allowed to fall before the Germans and Japanese, the Koreans and the Taiwanese.

At this point Wall Street-wise types will explain that Volcker was concerned about more than Senator Proxmire’s millionaire; he was concerned about the Japanese. He needed their money to pay for the deficit, which was all of $40.2 billion in 1979 (or about a third of the Gramm-Rudman target President Bush is going to be unable to meet). If Volcker had not given the Japanese what they wanted, they wouldn’t have bought our bonds, and Proxmire’ s millionaire would have sent his money abroad. The argument, in short, is that any attempt to reduce the interest rate will cause a flight from the dollar, and that the flight cannot be stopped because the financial world is international, its denizens are multinational, and they communicate electronically, instantaneously and secretly.

That is almost true. Yet multinational corporations are taxed. Granted, some of them may not be above diddling their books a bit, and very likely the diddling is difficult to detect; but taxes are collected, and where taxes are collected money can be controlled. The fact that financial operatives set up shop in the Cayman Islands to escape inconvenient regulation indicates that a flight from the dollar has to be an actual flight; a pretended flight won’t do.

We could perhaps stop the flight if we wanted to, but it would be much easier to let the money go. It is merely marks on paper; the factories and even the computers remain. The time to do the stopping is when the money wants to come back. Under present law, the Treasury Department is responsible for control of foreign exchange. It could require those who want to bring money into the country to go to the Treasury to buy dollars and to satisfy any taxes and regulations they had been fleeing from. The flight would no longer be so attractive, or serve any purpose.

Would that be the end of the problem? Of course not. Still, the proper direction of policy is, I think, clear. To control inflation, the interest rate has got to be brought down – way down. To do this, money has to be withdrawn from speculation and made available to productive enterprise. Faced with inconvenient regulation, finance will flee the dollar. The flight can be controlled by controlling foreign exchange. Such control will certainly affect foreign trade; but only doctrinaire true believers in laissez faire will blanch at that, and doctrinaire laissez faire is what got us into the mess we’re in.

The New Leader

 

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[1] The Truth About Inflation, Bankers Have The Classic Cola, The Fear of Full Employment