The Malignity of Capital Gains

By George P. Brockway, originally published September 21, 1992

THE RECURRING wrangle over the fairness or unfairness of capital gains taxation, while certainly not irrelevant, has distracted attention from the malign effects on the economy of the search for capital gains.

We hear on the one side that they are largely the concern of the rich, and of their pursuit by rapacious business executives. On the other side we are told tales of young men enabled to realize a great invention with the help of a timely investment by some capitalist with vision. We learn, too, of family farms and family businesses, of personal art collections, and of great tracts of unspoiled wilderness that would not be put to their best social uses if equitably taxed.

We hear all of these things, and most of them are true, or could be true. But we hear little or nothing about the influence of the search for capital gains on the stock market and, through the stock market, on the efforts of the Federal Reserve Board to stimulate the economy.

It is a source of much puzzlement that the Reserve’s well publicized three-year long assault on short-term interest rates has done, if anything, the opposite of what it was intended to do. Since the summer of 1989 the Reserve has cut short term interest rates more than 20 times. The expectation, of course, has been that lower rates would encourage producers to borrow and invest in plant expansion and modernization. The resulting increased employment, coupled with lower rates on consumers’ loans, would encourage consumers to buy, thus validating the producers’ expansions and setting the economy on a sustainable upward curve.

The plan made sense from almost every economic point of view, yet its failure is manifest. Producers are shutting down plants instead of opening new ones; unemployment has risen painfully; corporate profits and personal savings are both down; retail sales continue to be disappointing.

For most of the economy 1991 was a bad year, and 1992 is worse. But one sector flourished, and continues to flourish. Nearly all brokerage houses are prosperous, some of them more so than ever before. The stock exchanges, despite waffling between their January and July peaks, have been buying and selling at a record rate.

It has been a long time since Wall Street was primarily concerned about the business prospects of the firms whose shares the exchanges trade in the hundreds of millions every business day. Two statistics dominate the thinking of speculators. The first is unemployment, which is a worry because there is supposed to be a trade-off between unemployment and inflation. But in only three of the 46 years since the end of World War II has unemployment been higher than it is today; so regardless of the validity of the supposition, there is little fear of an imminent resurgence of inflation.

The other number that concerns Wall Street is the interest rate, because the capitalized value of any income-earning asset goes up as the interest rate goes down. The reaction of the secondary market for short- term bonds and notes is almost automatic. The long bond market, being congenitally fearful of inflation, follows at a more circumspect pace. As the prices of bonds rise, common stocks become more attractive investments, both for income and for capital gains.

Therefore, as the Federal Reserve Board has lowered the interest rate, the stock market has climbed. Investors especially speculators eager for capital gains-have rushed to take advantage of the quick profits. Money has poured into the stock market.

Now, that money obviously had to come from somewhere, and its ultimate source had to be the producing economy, where things are made and sold and services are performed and paid for. It may be old money from CDs and money market funds and bonds, or it may be new money borrowed at the new interest rates. In either case, it is money that the rising stock market denies to the producing economy. The lower interest rates, instead of stimulating the producing economy, have caused money to be drained away from it. Hence the deplored credit crunch.

Unfortunately, there is nothing the Federal Reserve Board can do about this. A continuation of the policy of lowering the interest rate will lead to a continuation of its consequences. A determination to stand pat will leave us in our present doldrums. A reversal of policy, raising the interest rate, will not only deepen the recession but very likely cause the market to crash. Moreover, when the market crashes the money that is lost simply disappears. It is not returned to the producing economy, nor does it reappear as cash in someone’s pocket.

Gross private domestic investment, as a percentage of GNP, was practically unchanged in 1986, 1987, and 1988 (the year before the crash, the year of the crash and the year after the crash). The percentages were 13.5, 13.1, and 13.8, respectively. As for cash, M1, which includes it, fell in 1987 as the market fell. The lost money was gone forever.

Was the Reserve wrong, then, to reduce the interest rate? Certainly not. Usurious rates are largely responsible for the recession, and still lower rates will be necessary to end it. It is true that the discount rate is now lower than it has been for 30 years. It is also true that it is three times what it was in 1947 and six times what it was on special advances in 1946.

Although the Reserve Board’s recent intentions bay be good, they have been, and will continue to be, overwhelmed by the altogether understandable rapacity of seekers after capital gains. It’s easy to make money on a rising market, but you have to risk a dollar to make a dollar. The dollars that you risk are dollars you might have risked in buying a new machine for your factory or in replenishing the inventory of your store. Your broker will try to tell you that by buying a share of stock you are producing goods just as much as if you were buying a machine for your factory. But of course the stock and the machine don’t both produce goods and it takes time to make money with the machine, while you can do that on the stock exchange very fast. So if you’re smart, you will play the market, and the Federal Reserve Board will be frustrated.

If the Federal Reserve cannot get us out of this mess we are in who can?  Unwittingly, President Bush has pointed the way – even though, characteristically, he was looking in the other direction. He has proposed a low capital gains tax, and a still lower tax on gains on some assets held more than five years. It won’t take you very long to see that his proposal would merely make more attractive the speculation that drains money from the producing economy.

Yet a sliding tax scale could take the profit out of speculating. If I had my druthers, I would have a capital gains tax that went something like this: Gains on some assets held more than five years would be taxed at 95 per cent, gains on assets held more than a year but less than two years would be taxed at 90 per cent, and so on, with the rate falling 5 points a year for 10 years.

Some changes in the tax law should be made regardless of the rates. Gains certainly should be taxed when assets change hands by gift or bequest as well as by sale. Capital gains of otherwise tax-exempt institutions should be taxed, because such institutions are responsible for much of the current market churning. On the other hand, it would be desirable to exempt principal family residences that fall below a certain value, along with small family farms and businesses.

Capital gains are an archaic form of profit. Despite their name, they are typical not of the capitalist system, but of mercantilism and more primitive economic systems. Likewise, the speculation that gives rise to them is an archaic form of economic enterprise. In the Renaissance the merchants of Venice organized each commercial voyage as a separate affair. Their personal experience taught them the sorts of goods most likely to be wanted on the Golden Horn. They stocked their outward bound galleys accordingly, and they brought home the sorts of things they could sell quickly and profitably at the quayside. The system was a series of speculative ventures, making the most of ad hoc opportunities to buy cheap and sell dear. When the selling was ended, the enterprise was ended, too. Capital gains are realized only when an investment is withdrawn and ceases.

In contrast, a modern corporation is a continuing enterprise. The basic concepts of classical and neoclassical economics are irrelevant to it. It could not continue if its market were “cleared.“ Since its market is not cleared, the “law” of diminishing returns is obviously violated. If the law of diminishing returns does not apply, there is no “margin,” and marginal pricing is impossible. If marginal pricing is impossible, “equilibrium” is neither necessary, likely, nor desirable. (And this is a good thing, for as all theorists from Leon Walras to Gerard Debreu acknowledge, economies of scale – the ideal mode of modern business enterprise – are impossible under equilibrium.)

Four years ago it was argued (fallaciously) by candidate George Bush that reducing the capital gains tax would increase tax collections (see “George Bush’s New Trojan Horse,” NL, September 19, 1988). His lips seem to be buttoned shut on that one today. Now we are told that reducing the tax would stimulate business, a notion dear to the far Right, which nevertheless mysteriously mistrusts him. But surely the Federal Reserve Board has had enough experience in the past three years to prove that to encourage capital gains is to encourage speculation, and that to encourage speculation is to induce a credit crunch that throttles productive enterprise.

A low capital gains tax is unfair because it is for the principal benefit of the rich. It is also economically counterproductive.

The New Leader

Where Keynes and Kalecki Went Wrong

By George P. Brockway, originally published April 8, 1991

EVERY NOW AND THEN a learned journal carries an article, or a think tank issues a report, that effects a significant change in academic theory. Once in a blue moon, such an article or report results in a revision of public policy.

Given the volume of material produced every year by the dozens of think tanks and scores of learned journals devoted to economics, it is no wonder that even many of their best offerings bloom to blush unseen. Neither is it surprising that the most open of professions is slow to embrace challenges to established doctrine (and hence, if you want to be mean-minded about it, to established reputations). It is doubtful that learning could proceed in the midst of incessant turmoil.

That said, the fact is that groundbreaking work does appear; moreover, its appearance must be widely discussed if learning is indeed to proceed-and if public policy is to benefit. Accordingly, I rise to salute a recent article and a recent report. The article, by Fred Block, professor of sociology (not economics) at the University of Pennsylvania and the University of California, Davis, is entitled “Bad Data Drive Out Good: the Decline of Personal Savings Revisited.“ It leads off the Fall 1990 issue of the Journal of Post Keynesian Economics. The report, by Robert A. Blecker, assistant professor of economics at American University, is entitled “Are Americans on a Consumption Binge? The Evidence Reconsidered.“ It is available from the Economic Policy Institute, 1730 Rhode Island Avenue, NW, Washington’ DC 20036.

These two papers are careful empirical examinations of two claims or assumptions that have ruled American economic policy for the past 30 or 40 years, and especially for the past 10. Blecker looks at the claim that Americans are irresponsible wastrels who have starved American industry and the American government. Block looks at the related claim that personal savings in this country have fallen so low we can no longer finance our own deficits or maintain a civilized standard of public services.

Together the Blecker and Block papers destroy both claims at their roots and thus cut off the theoretical sustenance that has nourished Reaganomics and Bush Voodoo. If it is not, as a matter of empirical fact, true that Americans have been consuming at an extraordinary rate, or that they have failed to save at some expected rate, then there must be other reasons to explain the misfortunes the American economy has suffered over the past decade.

A couple of months ago I remarked on the irony that the noisy supply-siders of recent years are now noisily complaining that the current recession has been caused by the failure of the demand side to consume (“Our Austerity Recession,” NL, January 14). They can’t have it both ways – the more fools we if we let them. Nor should we continue to hang our heads in shame whenever our saving is compared with that of the Japanese and Germans. As Block shows, we’re saving more today than we did in the early postwar years when our unemployment rate was lower, our inflation rate was also lower, and our after-tax profits were higher. On the record, it is not improbable that we have been saving too much rather than too little.

Besides the empirical facts about saving, there are a couple of theories. The one you hear in urban bars, on commuter trains and within the Washington Beltway argues that if you want to make anything (the supply side), you have to have proper raw materials and tools, and you have to have enough food, clothing and shelter to keep you and your colleagues going while you’re making it. Saving all these things, in short, is necessary to production. After all, you can’t grow corn unless you’ve saved seed.

But no so fast. You can’t save seed unless you’ve already harvested it. Your ancestors had to gather seed before they could plant their first crop. That’s not a quibble, but since it sounds like one lets turn to high theory.

In college classrooms, saving equals investment, or S = I. This neat little equation, arrived at independently about 60 years ago by John Maynard Keynes and MichaI Kalecki, is fatally flawed yet has been fatefully influential. Kalecki published his work three or four years before Keynes; but because he wrote in Polish, only his countrymen and only a handful of them-knew about it until much later (minority-language advocates, please note).

Kalecki s proof, though not difficult, is too complicated to retail in this space. Approaching the problem more directly, Keynes constructed and solved a pair of simultaneous equations that go as follows: (1) National output equals consumption plus investment; (2) national output equals consumption plus saving; therefore (3) saving equals investment.

As mathematical proofs both the Keynes and the Kalecki equations are perfectly valid. The conclusion S = I, however, is flawed in a way that is particularly characteristic of mathematical reasoning.

My great teacher, John William Miller (author of The Paradox of Cause and four other books I recommend to you), was fond of quoting Touchstone: “Much virtue in if.” Keynes’ first and second propositions would be clearer reading: (1) If national output equals consumption plus investment, and (2) if national output equals consumption plus saving….

Keynes was well aware of the virtue in if and devoted many pages of his great book to defining his terms so that his propositions made sense. But no more than Homer was he exempt from nodding, and here he did nod, with dire consequences. In these instances he is correct only in “real” terms, that is, only if he is talking about goods and services and is specifically excluding money and any of the legal instruments possible in a money economy. But we do live in a money economy (as Keynes knew more profoundly than his predecessors and most of his successors), and our society would collapse if we tried to live without money.

In another passage Keynes gives “investment” a portmanteau definition that is misleading in a different respect. He writes, “In popular usage it is common to mean by [investment] the purchase of an asset, old or new, by an individual or a corporation. Occasionally, the term might be restricted to the purchase of an asset on the Stock Exchange ….” Again Keynes nods. A share of stock or a bond is not an investment in the same way that a machine purchased with the proceeds of that share or bond is an investment. The machine is a producer’s good; it makes other goods. The share or bond makes nothing; it is not an economic good at all, it is a legal asset.

Keynes had some fun writing about stock speculators who made (or lost) money guessing what other speculators were going to do, and he implied that the New York Stock Exchange is a casino (which it isn’t). Still, he had little trouble believing that the exchanges were reasonably efficient ways of evaluating business enterprises. Although he was pre-eminently the analyst of a money economy, he did not quite see that a bull market continues to rise only with continuing infusions of money that is thereby denied to the producing economy (or what he called the industrial circulation).

In short, the conclusion of his (and Kalecki’s) exercise should have been: Saving equals investment plus speculation.

THE CORRECTION is clearly necessary if the elements of the equation are to be quantified in terms of money. Once one has money, it is obvious that one can hide it under one’s mattress. Hidden money is certainly saved, and just as certainly it is not invested. Hoarding (which Keynes called liquidity preference) may be done for a great variety of reasons, but all of them amount to speculating that the future will be more propitious for investing or consuming than is the present.

More important than hoarding is the money that flows into a bull market. While that influx of money may be said to be “invested” in the market, it has only tangential effects on the enterprises whose shares are traded. Practically all the activity on every exchange is speculation, and most of it is in search of capital gains (see “Why Speculation Will Undo Reaganomics,” NL, September 7, 1981). Similarly, investing in land is frequently speculation. The saving for which the Japanese are famous is sunk in real estate to such an extent that you could buy all the land in the 50 United States for less than you would have to pay for the land of Japan (even though it is smaller than Montana).

The high price of real estate does not make Japan a better place to live, of course, or even a richer country. But it needs to be said that speculating doesn’t make any country a better place to live. And it is crucial to insist that saving equals investment plus speculation. Policies that are supposed to encourage saving, such as many advanced in the U.S. this past half century, are worse than useless when what is encouraged is speculation rather than investment.

The Block and Blecker papers underscore this point. They prove that we have not been on a consumption binge, and that we have not imprudently failed to save. Since our interest rate has unquestionably been too high for our industries, since we have unquestionably used money borrowed abroad to finance a large part of our deficits, since those deficits are unquestionably used to excuse our failures in education and medical care and the general welfare, we must now look beyond the false answers of high consumption and low saving to find the explanation not only for the current recession but for the shameful general performance of our economy.

I’ll give you a couple of hints. Try looking at (1) the increasing share of our income that is diverted to speculation, and (2) at the increasing polarization of our society.

 The New Leader

What Happened to Jimmy Carter?

By George P. Brockway, originally published November 27, 1989

James Mac Gregor Burns, Pulitzer Prize-winning biographer, historian, and political scientist, recently published The Crosswinds of Freedom, the third and final volume of his history of The American Experiment. The book confirms Burns’s standing as one of the foremost observers of the modern American scene.  It also carries forward the foreboding analysis he initiated in The Deadlock of Democracy: that American law, by creating a stalemate in politics, makes an almost impossible demand on-and for-leadership.

Jimmy Carter of course figures in Crosswinds, and reading about him makes you want to cry.  He was (and is) a decent man who apparently thought decency was enough, who had a talent for offbeat public relations, and who also had a propensity for shooting himself in the foot.  The prime example was the Iran hostage affair.  As Burns points out, it was Carter who kept that in the news, and it helped defeat him.  On the other hand, if not for Iran, Ted Kennedy might have been able to grab the Democratic nomination.  The economic situation was probably enough to finish Carter, no matter what.  In that connection I offer a footnote to Burns’s magisterial book.

During the last two years of Carter’s presidency we had double-digit jumps in the Consumer Price Index.  It is not clear why this happened.  The usual explanation blames OPEC.  What is generally forgotten is that OPEC blamed the strong dollar for its price increases.  For almost three decades – long before the advent of Paul Volcker – the Federal Reserve Board and other First World central banks had been steadily pushing interest rates higher, thus overhauling their currencies and raising the cost of the goods the OPEC members (which generally had few resources aside from their oil) bought from us.  Before raising their prices, OPEC tried for several years to persuade us to change our policies; but the Reserve plowed ahead, increasing the federal-funds rate from 4.69 percent in March 1977 to 6.79 percent in March 1978 and 10.09 percent in March 1979.

Finally, on March 27, 1979, OPEC oil went up 9 percent, to $14.54 a barrel, and three months later there was another jump of 24 percent.  In December OPEC was unable to agree on a uniform price, but individual hikes were made across the board. By July 1, 1980, the barrel price ranged from $26.00 in Venezuela to $34.72 in Libya.  Thus, in a little over a year, the cost of oil had more than doubled.

Yet petroleum accounted for less than 3 percentage points of the inflation. Moreover, in every OPEC year (and, indeed, in every year on record), the nation’s interest bill has been substantially greater than the national oil bill (including domestic oil and North Seas oil as well as OPEC oil).  If OPEC is to blame for the inflation of 1979-81, the Federal Reserve Board is even more to blame.

A major cause of the rest of it was hoarding, which resembles speculation yet differs from it in that real things are involved. During this period the stock market was quiescent:  The price/earnings ratio was lower than it had been at any time since 1950, and less than half what it would be in 1987 or is today [1989]. But hoarding, probably prompted by memories of the gas lines following the 1974 OPEC embargo, was heavy.

And not merely in petroleum; it extended to all sorts of commodities.  Manufacturers, wholesalers, retailers, and private citizens tried frenziedly to protect themselves against expected shortages. As often happens in such situations, the expectations were immediately self-fulfilled.  Confident that shortages would allow them to raise prices, manufacturers eagerly offered high prices themselves for raw materials they needed.  Maintenance of market share became an almost obsessive objective of business management.

In the book business, for example, “defensive buying” became common.  Bookstores and book wholesalers increased their prepublication orders for promising titles so that they would have stock if a runaway best-seller developed.  Publishers consequently increased their print orders to cover the burgeoning advance sales.  It soon became difficult to get press time in printing plants, and publishers increased press runs for this reason, too.  Naturally, everyone also stockpiled paper, overwhelming the capacity of the mills.  For all I know, the demand for pulpwood boosted prices of chain saws and of the Band-Aides needed by inexperienced sawyers.

Unlike speculation, hoarding has physical limits.  After a while, there’s no place to put the stuff.  And after a while, the realization dawns that a possible shortage of oil and gasoline doesn’t necessarily translate into an actual shortage of historical romances.  Moreover, the shortage of oil and gasoline, once the tanks were topped off, disappeared.  There was plenty of oil and gasoline; you just needed more money to buy it.  Hoarding-or most of it-slowed down and stopped.  Business inventories declined $8.3 billion in 1980.  But prices didn’t come down.

All this time Jimmy Carter was not idle, for he prided himself on being what we’ve come to call a hands-on manager.  As early as July 17, 1979, he got resignations from his Cabinet members and accepted several, including that of Treasury Secretary W. Michael Blumenthal. To fill the Treasury slot, he chose G. William Miller, chairman of the Federal Reserve, and that opened the spot for Paul A. Volcker, who was nominated on the 25^th amid cheers on Wall Street.  At his confirmation hearings on September 7, Volcker revealed the conventional wisdom to the House Budget Committee.  “The Federal Reserve,” he testified, “intends to continue its efforts to restrain the growth of money and credit, growth that in recent monhts has been excessive.”

True to Volcker’s promise, on September 18 the Reserve raised the discount rate from 10.5 to 11 percent; and then, less than three weeks later, from 11 to 12 percent.  An additional reserve requirement of 8 percent was imposed on the banks.  More important, a fateful shift to monetarism was announced.  The Reserve, Volcker said, would be “placing greater emphasis on day-to-day operations of the supply of bank reserves, and less emphasis on confining short-term fluctuations in the Federal funds rate.”  On February 15, 1980, the discount rate was set at 13 percent.

Despite this conventionally approved strategy, prices kept going up.  In January and February, the inflation rate was 1.4 percent a month, or about 17 percent a year.

Again President Carter took action.  On March 14, 1980, using his authority under the Credit Control Act of 1969, he empowered the Federal Reserve Board to impose restraints on consumer credit.  It immediately ordered lenders to hold their total credits to the amount outstanding on that day.  If they exceeded that amount, 15 percent of the increase would have to be deposited in a non-interest bearing account in a Federal Reserve Bank. The banks and credit-card companies, adopting various procedures, hastened to comply.

All that was good standard economics.  If inflation is caused by too much money, the obvious cure is to reduce the amount of money.  President Carter and Chairman Volcker were in complete agreement.

The new policy had an immediate effect that, surprisingly, surprised the president and the Chairman.  Not only did sales slow down, as expected, but profits did, too-as should have been expected.  The automotive industry cried hurt almost at once.  General Motors reported an 87 percent drop in profits, and Ford and Chrysler reported losses.  The housing industry saw trouble coming as well.  It even appeared that consumers were taking seriously their leaders’ pleas to cut down consumption:  Some credit-card companies found their cardholders responding to restrictions by borrowing less than now permitted.

Alarmed by these and other complaints, the Reserve relaxed the new regulations after two and a half weeks, cut the reserve requirements on May 22, lowered the discount rate on May 28, and abolished the credit controls on July 3, whereupon the president rescinded the Board’s authority to act.  It was all over in three and a half months, in plenty of time for the nominating conventions.  Everyone pretended to be pleased with the result, and in fact the inflation rate did fall, but not below the double-digit range.  Still, Carter had shown that he could “kick ass” (his phrase), so he won renomination.  His hope of reelection, though, was dashed.

As Jimmy Carter moved back to Plains, Georgia, he must have wondered why inflation remained high.  The OPEC turbulence had subsided.  Hoarding had largely stopped.  Cutting consumer purchasing power had brought on instant recession.

Conventional theory has taught us to look at the money supply, or the budget deficit, or the trade deficit in seeking an explanation for inflation, since it is supposed to follow when these are high and going up.  Well, M1, the measure of the money supply the Federal Reserve claimed to control, went from 16.8 percent of GNP at the start of Carter’s term down to 15.3 percent at the end.  Carter’s reputation as a spendthrift notwithstanding, the budget deficit, again as a percentage of GNP, was lower in every one of his years than in any one of Ronald Reagan’s.  As for international trade, the deficit on current account was four and a half times greater in Reagan’s first term than it was under Carter, and of course in the second term it pierced the stratosphere- where on a clear day it can still be seen.

Carter’s mistake- and the mistake of the American people-was the common one of simply accepting what someone says he or she is doing.  Everybody, including the Federal Reserve Board itself, believed its contention that it was fighting inflation by encouraging the interest rate to soar.  Meanwhile, in the last two years of Carter’s term the nation’s interest bill went up 51 percent, although the outstanding indebtedness increased only 23 percent.  In addition to the fall in M1 that we’ve noted, the board increased the federal-funds rate 68 percent and the New York discount rate 59 percent.  In 1951 (when the Reserve started its well-publicized wrestle with inflation) it took only 4.59 percent of GNP to pay all domestic nonfinancial interest charges.  The Reserve pushed the rate up, in good years and bad, until it stood at 15.04 percent at the end of Carter’s term. (It’s much higher now [in 1989].)

It is generally recognized that Volcker slowed inflation (he obviously didn’t stop it) by inducing a serious recession, (if not depression) in 1981-83. Putting aside the question of whether causing so much grief was a noble idea, we may ask how pushing the interest rate up caused the recession.  The answer, of course, is that it made goods too expensive for most consumers.  Standard economics, though it pretends the consumer is supreme in the marketplace, perversely believes that consumption is a bad thing.

Goods became unaffordable for two reasons.  On the supply side, interest is a cost of doing business; so the prices businesses charged had to cover all the usual costs, plus the cost of usurious interest.  On the demand side, interest is a cost of living; so the prices consumers could afford were reduced by the interest they had to pay.  Usurious interest pushes prices up and the ability to pay down.

Had the interest rate not risen, wages would probably have risen.  Unemployment would certainly have fallen.  More people could have bought more things.  More producers could have sold more things.  Prices might have gone up until could no longer afford to buy; but if so, that stage would not have been reached so quickly or so inexorably as with usurious interest.  And those who had money to lend would have been worse off, unless they were wise enough to invest their money in productive enterprise or spend it on consumption.

Would instant Utopia have been achieved?  Of course not.  The point is that the conventional policies of Jimmy Carter and Paul Volcker were good for lenders but bad for everyone else

The tests of a “sound” economy that people still chatter about-a stable money supply. A balanced budget, and a favorable trade balance-all were worse under Reagan than under Carter.  Inflation was worse under Carter-and defeated him-because the interest rate was higher.  Professor Burns rightly fears that we will not find leaders able to organize power to handle the usual social and international problems.  I fear that we are even less likely to find leaders capable of understanding and leading us out of the slough of conventional economics.

The New Leader

George Bush’s New Trojan Horse

By George P. Brockway, originally published September 9, 1988

GEORGE [H.W.] BUSH has the distinction of introducing the only tax issue into this fall’s Presidential campaign.

For anyone whose interest in government or economics goes beyond personalities, taxes are endlessly fascinating. The power to tax is the power to destroy – and also the power to create. It is a sign of the shallowness of our society that the eyes of so many people of all ages and both sexes glaze over when the subject comes up. It is a sign of the shallowness of Bush’s understanding – or the deviousness of his intentions – that he wants to upset one of the best features of the 1986 tax law, which treats capital gains as ordinary income. He wants to tax them at 15 per cent – the lowest rate since the grand Depression days of Herbert Hoover.

A tax – the StampTax – crystallized the colonists’ dissatisfaction with England and led to the American Revolution. Another tax – the so-called Tariff of Abominations – led to the nullification crisis of 1832, and ultimately to the American Civil War. In both cases much more than taxes was involved; yet taxes were central issues in the great wars that made and preserved our nation.

Taxation can serve one or both of two purposes: It can raise revenue to pay the costs of government, and it can encourage or discourage various activities. The Revolution was fought (in part) because the Stamp Tax did the former, the Civil War (in part) because the tariff did the latter. In 1767, John Dickinson wrote in the second of his Letters from a Farmer in Pennsylvania that before the Stamp Tax, taxes “were always imposed with design to restrain the commerce of one part that was injurious to another, and thus promote the general welfare. The raising of a revenue thereby was never intended.” In contast, in 1832, South Carolina passed its Ordinance of Secession that denounced the tariff because of “bounties to classes and individuals … at the expense of other classes and individuals,” and espoused the theory of taxation for revenue only.

A more general theory appears in Alexander Hamilton‘s classic Report on Manufactures (1791): “[T]he power to raise money is plenary[1] and indefinite, and the objects to which it may be appropriated are no less comprehensive than the payment of the public debt, and the providing for the common defense and general welfare.”

All three of these theories are involved in Bush’s tender concern for capital gains. Of the three, he has pushed most strongly the one dealing with revenue. In this he is supported by Treasury Department Research Paper No. 8801, “The Direct Revenue Effects of Capital Gains Taxation,“ which argues that a lower rate brings in higher revenues. There are opposing views, specifically those of the Joint Committee on Taxation and the Congressional Budget Office. And much private ink has been spilt on both sides.

On one level, the question is an extreme case of that raised by the Laffer Curve, and of Peter Peterson‘s claim that the rich pay more taxes when the rate is lower (see “In for a Penny, In for a Pound,” NL, June 13). The case is extreme because Bush’s proposal would cut the capital gains rate roughly in half, requiring capital gains “realizations” to double just to keep revenues running in the same place.

The latest figures the Treasury research paper gives us to work with are those of 1985, when the marginal rate was 20 per cent, capital gains realizations were about $169 billion, and the revenue raised was about $24 billion. Since 20 per cent of$169 billion would be almost $34 billion instead of $24 billion, it is obvious that the capital gains tax, even though admittedly mostly falling on the superrich, was paid by many whose Adjusted Gross Income was less than the $175,251 then needed to boost a married couple into the top bracket. Obviously, too, once the new tax law settles down and a married couple with an Adjusted Gross Income of $29,751 finds themselves in the top bracket (28 per cent), practically everyone with any capital gains will be paying the top rate.

Neither you nor I nor even George Bush knows what the future will bring. It is probable that realizations were up in 1986 and down in 1987. A large part of what was realized in 1986 (including everything I cashed in) was in anticipation of 1987’s higher rates, while a large part of what was realized in 1987 was losses in the stock market’s Oktoberfest (me, too). It is likely that realizations this year will be greater. No matter: For Bush’s scheme to work, they must more than double what they otherwise would be. The question I ask is: Do we want that to happen?

To answer that question we have to look at where capital gains come from. They come about in two ways: (1) a company retains and reinvests its income instead of paying it out in dividends, thus increasing its net worth and, presumably, the market value of its shares; or (2) goods (especially real estate and works of art) increase in value because of market shifts or inflation, thus tending to lock holders into property they might otherwise have wanted to sell. It is received doctrine that the first method should be encouraged, and that adverse personal consequences of the second should be mitigated; hence the special treatment of capital gains. In Britain, and generally on the Continent, they are not taxed at all, making George Bush more moderate than he may find congenial.

A company that reinvests its income grows. The more companies grow, the more the economy grows: more goods, more jobs, more profits. Assuming that for a given company expansion makes sense, the necessary capital can be raised by borrowing, by selling new shares of stock, or by retaining earnings. Interest payments on borrowings are a deductible business expense, while dividends on stock are not. On the other hand, interest payments are a fixed expense, while dividends, again, are not. Balancing the foregoing considerations, a fairly prudent and sanguine management will opt for borrowing, but a company that can satisfy its stockholders with capital gains will enjoy the best of both worlds by relying on its retained earnings.

In addition, it is said that the possibility of capital gains attracts both entrepreneurs and investors to new businesses, which are the economy’s hope for the future.

Since retained earnings are rarely enough to do the job for a rapidly growing concern, its real choice is between issuing new stock and shouldering new loans. There would be no problem at all if interest payments were not a deductible business expense. The 1986 tax law has partially eliminated it as a personal deduction. I’ve made the case for eliminating it for business, too (see, “A Tax Increase by Any Other Name,” NL, November 24, 1984[2]) and shall only outline it here. In brief, the deduction, although it seems to subsidize the borrower, in fact subsidizes the lender. Without the subsidy, interest rates would have to fall, because few could afford the raw rate.

Moreover, the subsidy is meaningful only to an already profitable company, given that a new enterprise typically operates at a loss for some time and can’t afford to borrow at all. It has no net income from which to deduct the interest expense, and therefore has to pay the usurious raw rate on whatever it borrows. In sum, if you want to encourage new enterprise, you will eliminate the deduction for interest expense and will consider the treatment of capital gains more important for personal than for business finance.

DOES IT, then, make sense to encourage individuals to seek capital gains twice as eagerly as they seek earned income? What is actually encouraged, of course, is wheeling and dealing. It is not impossible that some good enterprises are thus sponsored that would not have been undertaken otherwise; but it is quite certain that wheeling and dealing raises the cost of capital for all enterprises, new and old, good, bad and indifferent. It is also certain that, whatever the ills we have recently been suffering, they were not caused by a lack of wheeling and dealing.

Finally, it is urged that capital gains are, for most individuals, an unexpected and even unwanted consequence of inflation. The house you bought for $100,000 five years ago can be sold for $200,000 today, which is dandy. But you have to have some place to live, and an equivalent new place will cost an equivalent number of dollars, or $200,000. An ordinary tax on your capital gain (28 per cent under the new law) would leave you $28,000 poorer than you’d have been if you hadn’t moved. Bush would leave you $15,000 poorer, and that is better, but not great. (There are, to be sure, special ways to handle this special problem, and some of them are embodied in the present law.)

Any attempt to offset the general effects of inflation, however, winds up by encouraging it. Conservatives of Bush’s school colors are quick to see that wage increases tied to the cost of living are inflationary. The same is true of capital increases. As a matter of fact, capital increases are even more inflationary for reasons we’ve previously discussed (see “Vale, Volcker,” NL, June 1-15, 1987). The very possibility of capital gains stimulates the frenetic search for more of them; it’s easier than working.

Indeed, it is precisely this frenzy that Bush wants to stimulate. As the Treasury has told us, capital gains realizations in 1985 were $169 billion. On the same realizations, the present rate of 28 per cent would yield $47 billion, and Bush’s rate of 15 per cent would yield $25 billion. For Bush to bring in more revenues than the present rate, he would have to push realizations beyond $340 billion, or more than twice the highest they’ve ever been before.

Since 1966, capital gains realizations have steadily increased, from $31 billion ($67 billion in 1985 dollars) to the present. It happens that, as Professor Hyman P. Minsky points out in his recent book Stabilizing an Unstable Economy, since 1966 “the American economy has intermittently exhibited pervasive instability.” While not necessarily conclusive, the association of these facts is at least suggestive, especially when you remember that instability is another name for the volatility that comes with wheeling and dealing.

Bush deserves a good mark for daring to talk about taxes. But he has offered us another Trojan Horse to make the rich richer. Let’s suppose he succeeds and manages to boost capital gains realizations to $340 billion. Then the after-tax income from capital gains would leap to $289 billion-more than double that of any previous year. As we said in discussing Peter Peterson’s ideas of taxation, this is the way multimillionaires are made.

The New Leader

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[1]complete in every respect:  absolute, unqualified

[2] Editor’s note:  The name of this article in print is “The Bottom Line on Tax Reform.” From time-to-time the New Leader replaced the author’s title with another.  This is one case.

Bursting the Supply-side Bubble

By George P. Brockway, originally published November 30, 1987

ONE LISTENS with astonishment to the explanations of the Great Crash of 1987. With unprecedented unanimity, pundits and brokers and bankers and public officials call the budget deficit and the foreign trade deficit to blame.

In his post-crash press conference, President Reagan seemed not to understand. He was being pushed into what the press called a summit conference with Congressional leaders to see about reducing the budget deficit, but his heart plainly wasn’t in it. Look, he protested, the budget has been Gramm-Rudmaning down and will go down some more, even without a conference. He couldn’t see what is so bad about that trend, although he was ready to blame the Democrats for anything anyone happened to think bad about it.

It’s not hard to share the President’s bewilderment. If the budget deficit is a problem, it is in fact being reduced. A few hardliners may be upset that the reductions are not greater and faster; yet most people (including Ronald Reagan) have absorbed enough from Keynes (whom the President gracelessly and ignorantly disparaged) to know that doing too much too fast with the deficit would be a pretty sure prescription for a recession. Keynes himself might well have thought the reductions an utter mistake at this time. But he is dead (as we all are in the long run), and what is actually being done is what the pundits say Wall Street wants. If Wall Street is really upset by the deficit, it should have broken two years ago, when the deficit was higher, or five years ago, when the deficits (and the market itself) started their dramatic climb.

No, the deficit story is a fairy tale. It is implausible on its face, and its implausibility can readily be tested. We had a pretty good market crash in 1929. What happened then? Well, one thing is sure: The 1929 crash wasn’t caused by a budget deficit, for the budget was in surplus that year to the tune of $700 million, which was a lot of money back then. Either the crashes of 1929 and 1987 are totally different breeds of animal, or deficits had nothing to do with either of them.

The two crashes did, without question, have one thing in common. Both were preceded by prolonged and steep run-ups of the stock markets. That in itself is no surprise, since you have to have attained a certain height to be able to make an attention-getting fall. But what it signifies is that both climbs were speculative: Business didn’t improve all that much. Though in both years all persons of prominence assured us that the economy was fundamentally sound (there seem to be no other words to express this meaningless thought), in neither year was there a justification for the heights the market reached.

Speculation, however, doesn’t need a justification; it merely needs an occasion. The necessary occasion is a very simple one: Some people have to have more money than they know what to do with.  Literally.

We have been satisfying this requirement. As the recently announced figures from the Census Bureau show, the number of people with large incomes has increased in the decade and a half from Richard M. Nixon through Ronald Reagan. The top 20 per cent of American families had an average income of $126,415 last year and together engrossed 46.1 per cent of all personal income. More important, they have improved and are improving their position at the expense of the middle class and the poor.

Now, it is practically impossible to spend a million a year on living well (although some 57 professional baseball players are having a go at it), and it is perfectly possible to be pretty comfortable, even in a high-priced city like New York, on as little as a hundred thousand. You can, of course, spend pots of money collecting lead soldiers or used postage stamps or post impressionist masters. The trouble with such collections is that, even at a moderate rate of inflation, they increase in value very rapidly and so add to rather than deplete your wealth. So lots of people-and not merely ball players have lots of money.

The supply-side theory, to which the President pledged continued devotion the other night, contemplates that the rich, thwarted in their struggle to consume their income, will invest it. But when 20 per cent or more of the economy’s productive capacity is lying unused, the possibilities of prudent new investment are severely limited. What to do? Nothing for it but to take a flyer in the market. At the same time, the rich of the rest of the world have the same problem-and the same solution. Add to all this the mutual funds, the pension plans, the educational and charitable endowments, the insurance reserves, and the unabashed speculations, and you have a lot of money chasing a limited number of shares of stock.

Ingenious men have worked very hard to increase the number and kinds of paper to buy and sell. Two ways have especially recommended themselves: the development of the stock futures markets, and the computerization of Wall Street. The first created new products (as the brokers call them) out of nothing but the eagerness to speculate; the second, by enabling an increased velocity of trading, increased the opportunities to speculate, just as an increase in the velocity of money in effect increases the money supply.

There was also a partially contrary movement. Takeovers and buyouts, which generally substituted debt for equity, reduced the number of shares of some stocks available for speculation while simultaneously greatly enhancing the taste for speculating.

THE MOST elementary fact about a bull market is that it absolutely and unceasingly depends on sucking more money into it. If there are 100 shares of stock, and $100 available for investment, the price of each share will fluctuate narrowly around a dollar, no matter what incantations are uttered by market analysts and government officials. If the number of available shares is reduced, or the number of available dollars increased, the price will rise proportionately. But all who anticipate a further increase in available funds will become more eager in their bids, in the expectation of quickly and profitably selling what they buy to the holders of the new money. Thus Holland’s Tulipmania was sustained, and thus the Great Bull Market of the ’20s, and thus the Reagan-Thatcher-Nakasone market that has now crashed.

Because one way or another the number of pieces of paper to speculate in has greatly increased, the number of dollars to sustain the recent bull market had to be increased still more, and this has been done in two ways: the shift of trust and endowment funds out of the bond market and into the stock market, and the supply-side tax cuts for the wealthy. The former was substantially effected a couple of years ago, and the latter has gone about as far as it can go with the new tax law’s reduction of the top rate to 28 per cent. There is still a fantastic amount of money around, but it is no longer being increased rapidly. The kissing had to stop.

The trade deficit is said to have joined with the budget deficit in scaring foreigners out of our market. This explanation of the crash overlooks what is ordinarily insisted on: the global interdependence of financial markets. It wasn’t Wall Street alone that laid an egg. Eggs were laid in Tokyo and Hong Kong and Sydney and London before the New York market opened on Black Monday. You might say that all over the world bull markets that had known no boundaries were suddenly fenced in.

Just as the reason for the crash is grievously misunderstood, the policies proposed for dealing with it are grievously misconceived. Since what happened was caused by a large number of people having more money than they knew what to do with, it follows that it is counterproductive to resist taxing some of that money and applying it to public purposes, not excluding deficit reduction. The supply-side tax cuts were a disaster. Since the wealthy couldn’t find enough new productive investments for their surplus funds, it follows that there hasn’t been enough effectual demand (as Adam Smith would have said) to keep our existing productive capacity busy; so the enthusiasm devoted to union busting, entitlement shaving, welfare restricting, and real-wage reducing-all of which reduce effectual demand-has been disastrously misdirected.

Our pundits seem able to behold the mote in German and Japanese eyes but not to consider the beam that is in ours. If the world economy would be strengthened by increased consumption in those lands (and it would), it can scarcely make sense to decrease consumption in ours. Over the past 15 years the income share of the poorest 20 per cent of our families- those who have to spend their incomes-has fallen 10.8 per cent. An economy that reduces its aggregate demand in that way-and seems determined to do more-is not fundamentally sound.

The New Leader

The Big Bang in London

Originally published November 3, 1986

WITH ITS characteristic penchant for triviality the daily press’ stories out the deregulation of British financial institutions (a.k.a. the Big Bang) have concentrated on the consequences, or lack thereof, for the traditional City of London man with his bowler and his tightly rolled umbrella. Will he be able to compete with Yahoos in shirtsleeves? Perhaps this is as it should be, since the consequences for the rest of the world are only as great as it allows them to be, and the rest of the world has already made its decision evident in Tokyo and Zurich and the Bahamas and New York and even in Chicago.

For a variety of reasons – some doctrinaire and some pragmatic – the world has already decided that international finance should not or cannot be regulated. Computers are too fast, and their ways too mysterious. While it would take you six months, together with fees to two teams of lawyers, premium to at least one title company and a half inch pile of paperwork, to induce your friendly banker to spring for a $50,000 mortgage, that same banker will transfer $50 million to an arbitrager in Hong Kong in the twinkling of an eye. He will have your notarized signature many times on all that paper to show for his deal with you; the Hong Kong deal will be recorded only as an electrical impulse in a computer.

The money may come back, via another blip, as the earth turns. In these circumstances, the pragmatic may well lie back and enjoy it. Margaret Thatcher’s Britain, which has now done this, and Ronald Reagan’s America, which would dearly like to do this, both also have doctrine to sustain them. Untrammeled finance, they believe, makes for liquidity, and liquidity encourages investment, and investment means production, and production means prosperity. They’re right on the first and last points.

The liquidity part of the story is limpidly clear. Give bankers and brokers and insurance companies their heads, and they’ll make your head swim. It is not, however, clear exactly what is liquid. A Singapore computer chatting up one in London doesn’t make it noticeably easier to sell a shirtwaist factory in Katmandu or a spare forklift truck in Trondheim. These things are as solid and stolid as they ever were, and are correspondingly unattractive to speculators; consequently, the new liquidity doesn’t stimulate the production of more of them.

International liquidity may make it somewhat easier to sell a large company, but this does not mean the sale stimulates the creation of anything new. There is no need to create a company in order to sell it; it is much easier to play with what is at hand.

International finance may make it somewhat easier for a large company to borrow large sums. Eurodollars are available, because of the lack of regulation, at a slightly lower rate of interest than domestic dollars. If the Reagan Administration gets its way, this differential will disappear (and if I had my way, it would not be available).

So what is left for international liquidity to do? It comes down to speculation in existing securities or in securities issued for the purpose of speculation. Back in THE NEW LEADER for April 19, 1982, Henry C. Wallich, a governor of the Federal Reserve Board, took me to task for not recognizing that liquid securities make everything liquid. “Eventually,” he wrote, “the money [resulting from a speculative coup] will find an outlet in directly productive new investment, unless it is consumed or hoarded.” I replied that there is a fourth possibility, which is by far the most likely – namely increased speculation. You have only to read the Wall Street gossip columns to know this is so. The economy may be essentially flat, yet day after day investors run from one takeover rumor to another; and if T. Boone Pickens squints his eyes, feverish attempts are made to discover the meaning.

The difference between Governor Wallich and me is by no means an idle one. If I am right, speculation will tend to pre-empt whatever money the banking system makes available, and productive industry will be starved. In addition, the very existence of a speculative market introduces a Catch 22. Because speculation encourages and thrives on running up the prices of securities, it will tend to reduce the earnings ratio of companies that attract its attention. A company that earns $5 a share has a price earnings ratio of 5 per cent if its stock sells for $100 a share; once the stock takes a modest run up to $125, its PE ratio will naturally fall to 4 per cent.

There are repercussions on Main Street and Commercial Street, too. When the company’s financial officer needs the usual line of credit to tide the firm over from the start of a production run to the time, a few or several months away, when income will start flowing from production, he has his regular lunch with the company’s friendly banker. The latter is unexpectedly cool and murmurs that in view of the falling PE ratio he’ll have to ask another half a point for the credit. The next day the principal stockholder, speaking for his sisters and his cousins and his aunts (their grandfather started the company), phones the company president all the way from his yacht in English Harbor, Antigua. He notes that many other stocks have a better PE ratio and wonders what can be done. Should he and the ladies mortify their family pride and sell out, or can the president somehow improve the picture?

Now, it is obvious that, in what are called real terms, the company is as good as it’s ever been and earns as much in dollars and cents as it ever did. The banker and the stockholder (who have contrary concerns) may even be bright enough to understand this, but they are also bight enough to see that they might make more money or safer money by lending or investing elsewhere. They have other options.

The company’s management has options, too, except they are more limited. They can try to increase income, a reduce expenses, or both. Increasing income isn’t the easiest thing to do. Sales can be improved by introducing new products, but that takes time and money, neither of which the company has enough of. Sales also can be improved, at least in theory, by cutting prices; but if the company has been reasonably well managed, its prices are already at the most profitable level.

That leaves the option of reducing expenses. This can certainly be done, and done quickly. Advertising campaigns can be trimmed or aborted; all it takes is a phone call to the agency. Production runs can be cut back and inventory allowed to run down. And of course people can be fired. In the long run-and in the situation we’re imagining, six months can be a long run-these cost-cutting measures may prove counterproductive. You have to spend a dollar to make a dollar; the absolutely perfect way to cut costs is to go out of business.

We don’t have to carry our story any further to see that, no matter how it comes out, bankers and stockholders have more options than do corporation managers and workers. The money that bankers and stockholders invest is more liquid than the sweat and tears the active people invest. Securities are more liquid than people. Workers and managers have personal commitments and can’t easily relocate even when jobs are available.

EVERY KIND of activity is risky, but the liquidity of securities reduces the risk involved in investing them. Liquidity also makes volatile trading possible, with sudden shifts of position to pick up a fraction of a point. Fortunes can be made very fast that way (see “New Ways to Get Rich,” NL, September 8). In contrast, it generally takes a lifetime to accumulate a modest retirement nest egg merely by working hard at producing something.

Traditional economists have built their theories on the notion that people are inherently or rationally or necessarily profit maximizers. I don’t myself hold with the notion, but I’m going to accept it here to meet the traditionalists on their own ground. On this ground, it is clear that a speculator who makes a killing in one speculation will look around for more of the same. Only a foolish profit maximizer would ever commit himself (or herself) to a “directly productive new investment,” especially one that required any hands-on productive work of him (or her). That is why the money growth the Federal Reserve Board has allowed since 1982 has gone into the run-ups of the securities and commodities markets, and not into what Governor Wallich called “brick and mortar.” Speculation is a problem, and it is not one that cures itself.

There are, to be sure, some economists who believe that speculation is actually beneficial. They base their arguments on Ludwig von Mises‘ dictum, “Action is always speculation.” To the extent that Mises meant what’s to come is still unsure, he was of course perfectly correct. Moreover, every business tries, within limits, to buy its inputs as cheaply as it can and to sell its outputs as dearly as it can, and so sometimes makes (or loses) a dollar on inventory. But this is not all that a business does. It adds value to what it takes in, and what it puts out increases the goods the rest of us can enjoy. Speculators or financial institutions attempt to increase price, but add no value. They avoid taking physical possession of and physically working with the things denominated in their bonds.

These are the people and institutions who will benefit from the Big Bang. Internationalizing Britain’s financial markets may give employment to a few hundred Yahoos in shirtsleeves, but it will do nothing for productive industry, either in Britain or anywhere else in the world. If we had any sense, we’d keep ourselves and our money out of it.

The New Leader

Junk Bonds and Watered Stock

Originally published March 24, 1986

INTHE 1920s, bond salesmen were admired and envied. Later, when Wall Street laid its egg, they became butts of bitter jests (“Where are the customers’ yachts?” asked a book by Fred Schwed Jr.). In the end, they were objects of opprobrium and scorn. Today’s bond salesmen seem to be following in their grandfathers’ footsteps.

Salesmanship is now marvelously subtle, combining an ancient rhetorical device with an even more ancient childhood game. Long before Aristotle wrote his Rhetoric, Greek sophists found that an appearance of frankness could help them win a bad case; openly admitting a superficial weakness or two could get them good marks for sincerity. And since long before the sophists, children have known how to tempt their peers with the challenge, “I dare you.”

The device and the game are joined in the term “junk bonds.” The immediate connotation is of shoddy goods or a tangle of broken machinery, old plumbing fixtures and wrecked automobiles, partly hidden by a tumbled-down board fence as unsightly as what it pretends to hide. A secondary connotation is of junk mail, which almost everyone hates. The junk bonds metaphor boldly accepts both connotations and thus disarms criticism. No one, it winks, is trying to fool anyone.

At the same time, these negative connotations are modified by some that are at least ambiguous.  Those who send out junk mail presumably think well of it. Paraphrasing Abraham Lincoln, one might conclude that God must love churches and charities that raise money by mail, since He made so many of them. For another example, junk food is eaten by an awful lot of people, who apparently have a tolerance, if not taste, for it; and purveyors of junk food make an awful lot of money, something the purveyors and buyers of junk bonds hope to do, too.

In addition, the term admits risk and so suggests sport. I dare you to run the risks that may lead to a big killing. Are you big enough to afford such risks? You say that the capitalist system depends on risk taking: Do you dare put your money where your mouth is?

Yet just as a paranoiac may have real enemies, junk bonds may be really bad. They may not necessarily be bad for the new owners of the corporations that issue them or for the purchasers or for the underwriters, but they are almost invariably bad for the corporations themselves; they are also undeniably bad for the morale of our society (see “The Faith of Fiduciaries,” NL, December 24, 1984) and for the tax collections that support our society.

In spite of all the present hype, junk bonds are not new. Practically every railroad issued bonds at usurious rates – and ultimately paid the penalty. Neither are junk bonds the first securities of “less than investment grade” to be widely marketed in the United States. Most of our giant corporations – including many of those now being raided – were originally papered together with such securities. The chosen instrument was different, and the metaphor was different, but the results were similar. Stock was issued instead of bonds, and the stock was said to be watered like cheap whiskey.

In Other People’s Money, Louis D. Brandeis, later a Supreme Court justice, told how the United States Steel Corporation was formed in 1901: “The steel trust combines in one huge holding company the trusts previously formed in the different branches of the steel business. Thus the tube trust combined 17 tube mills, located in 16 different cities, scattered over 5 states, and owned by 13 different companies. The wire trust combined 19 mills; the sheet steel trust 26; the bridge and structural trust 27; and the plate trust 36 …. Finally, these and other companies were formed into the United States Steel Corporation, combining 228 companies in all …. ”

The tube trust, when it was put together a few years earlier, had been capitalized at $80 million. Half of that was common stock, and half of the common “was taken by J.P. Morgan & Co. and their associates for promotion services; and the $20 million stock so taken later became exchangeable for $25 million of Steel Common.” The tubes plainly held a lot of water, as did the other trusts that went into United States Steel. Nor was this all. The rest of Steel Common was watered in its turn, with nearly one-seventh issued directly or indirectly to the promoters.

Although Brandeis doesn’t give all the gory details, I would wager that at least half of the original 228 companies were enticed to sell out at greatly inflated (or pumped up) prices. Some of the others may have been squeezed a bit, but the total paid for the 228 was almost certainly far greater than their entire net worth. Once you add it together you have United States Steel, the first corporation capitalized at a billion dollars, and pretty close to half of it was water.

In Morgan’s time, high-flying corporations were overcapitalized. Currently they are undercapitalized, a.k.a. leveraged. The shift is a function of the tax laws, though you may read many an analysis of takeovers without coming across a mention of the part played by taxes.

When U.S. Steel was floated, there was no corporation tax. Since earnings were not taxed, interest paid on bonds was obviously not deductible. Interest was a fixed expense. Dividends, on the other hand, were not fixed (except for some on preferred stock). You paid dividends when you were flush; otherwise not.  Therefore a prudent company got its money from stock, rather than bonds. Today, with the corporation tax at 46 per cent (assuming a corporation pays any taxes at all), and with interest payments deductible, a clever company will issue bonds instead of stock, and a clever raider will happily issue junk bonds paying 14-15 per cent in order to buy up stock earning 5-6 per cent. (For reasons why no interest should be deductible, see “The Bottom Line of Tax Reform,” NL, November 26, 1984) After the deduction, the new load on the company is only about 6-8 per cent, and before it becomes oppressive, the raiders will be long gone.

That the debt will eventually become oppressive, there is usually little doubt. The interest payments will have to continue in bad times as well as in good. As profits fall or disappear, so will the benefit from deductibility. The corporation’s cash flow will be soaked up by the high interest. Even a sluggish cash flow can quickly lead to bankruptcy. Of course, bankruptcy may now be sought to break a labor contract, whereupon the company may become solvent again. Guess who’s left with the short end of the stick?

This result of undercapitalization is, you may be astonished to learn, not substantially different from the result of overcapitalization. How was the water in Big Steel paid for? As the man might say, there’s no such thing as a free drink. If the capitalization was half water, Steel’s earnings on its real assets would have had to be twice “normal.” Without a research assistant, I can only suggest the outline: First, the owners of the original 228 companies were well paid. Second, J.P. Morgan and his fellow underwriters were very well paid. Third, those who bought the watered stock received “normal” dividends. Fourth, the price of steel was not grossly exploitative (steel rails stayed at $28 per long ton for more than 10 years).

Here someone is sure to cut in with the claim that U.S. Steel was more efficient than its 228 components had been. Evidence for this is the fact that most of the 228 were shut down, while the surviving units were expanded. But if those shut down were inefficient, why were they bought in the first place? The competitive system is supposed to let inefficient companies die.

The case for technological efficiency is, if anything, worse. In 1911, 10 years after the emergence of U.S. Steel, Engineering News reported: “We are today something like five years behind Germany in iron and steel metallurgy, and such innovations as are being introduced  by our iron and steel manufacturers are most of them following the lead set by foreigners years ago.” (That might have been written yesterday.)

The question remains: Who paid for the water? Those who didn’t immediately answer “Labor!” will stay after class and be given a quick review of the effects of mass immigration, Taylor System management, and courts that issued injunctions against labor unions as conspiracies in restraint of trade.

THE Federal Reserve Board’s new rule limiting the use of junk bonds to 50 per cent of the price of a takeover may put a momentary hitch in a few raiders’ plans. And some say the present run-up of the stock market will put an end to takeovers by increasing the amount of money needed. The run-up, however, has been caused by the drop in interest rates, which increases the capitalized value of every income-earning asset. (An asset that earns $10 is worth $100 when the interest rate is 10 per cent, and jumps in value to $200 if the rate falls to 5 per cent.) For this reason, the bond market has been rising, too; the interest that investment-grade bonds must pay is falling-and so are the requirements for junk bonds.

Should President Reagan be successful in cutting corporation tax rates (as seems likely), the deductibility of interest payments will become less important and watered stock will tend to displace junk bonds in takeover schemes. In other words, look for an upsurge in new blue-sky issues. R.R. Palmer tells us in A History of the Modern World of an 18th-century promoter who issued shares in “a company ‘for an undertaking which in due time shall be revealed.” Does anyone doubt that if Carl Icahn made such an offering today it would be oversubscribed tomorrow? Whatever happens, the financing of the American economy will still be largely an incidental function of speculation, or as Keynes said, of running a casino.

My first “Dismal Science” column (NL, September 7, 1981) was entitled “Speculation Will Undo Reaganomics.” The title displays an innocence on my part. I did not imagine that the Reaganauts’ intention was to make paupers and millionaires. Speculation continues to have the effects I discussed; I still find it hard to believe that decent people think it’s grand.

Since the Civil War days of “Betcha Million” Gates and Jay Gould, speculation has resulted in American enterprises paying too much for capital. Andrew Carnegie observed in The Empire of Business (1902) that “railway managers today are … directed to obtain a return on more capital than would be required to duplicate their respective properties.” It matters little whether the capital is paid for with dividends on watered stock or with interest on junk bonds. Either way, it is the working man and woman-the people who put that capital to work – who do the ultimate paying.

The New Leader

Big is Ugly

Originally published September 3, 1984

THE Continental Illinois and the Financial Corporation of America bailouts, although different in nature, have one glaringly obvious lesson that everyone sees and even talks about endlessly yet refuses to think about. The lesson is that this bank and this thrift institution were too big to be allowed to fail, just as Chrysler and Lockheed were before them.

Everyone knows and says that. Everyone has enough mathematics to know as well that if Financial Corporation of America, the nation’s 12th-largest organization of its kind (counting both commercial banks and thrifts) is too big to be allowed to go under, there must be at the very least 11 others in the same category. Clearly, Citibank and Chase and the rest did what they did in South and Central America because they were confident that no matter what happened, they would not be allowed to fail, and in the meantime they could make a lot of very big loans at very high interest. Still, only a few people – like William Wolman, editor of Business Week – dare to say that in the end many, if not most, of these loans will be repudiated, and that Uncle Sam will, in one way or another, pick up the tab.

This may not be so bad in the event as it looms in contemplation. You have probably been struck by the fact that an awful lot of money is involved, and that no one seems to be certain exactly how much; yet whatever the amount, it is not overwhelming in relation to our national debt or even to our annual Reaganomic deficit. When Uncle Sam picks up the tab, we won’t be bankrupted. Indeed, we may be sure that the whole operation will be handled in such a discreetly indirect way that we will not notice it. There is a time for flamboyance and a time for discretion, and bankers are very good at telling which is which. Have you heard anything about the Polish loans lately?

More than money is at issue here. There has been talk about having someone – the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, or some private insurance company – look more closely over the bankers’ shoulders. New laws are being proposed, and complaints are being made that old ones are not being enforced. The bankers are not much concerned, though, because they know that not much can come of it.

As long as the big banks are substantially free of regulation on the interest they can pay, they will be free of significant regulation elsewhere. Walter Wriston, the recently retired chairman of Citibank, who may be said to have initiated the current state of affairs with the dictum that countries don’t go bankrupt, now says that bankers are too proud to conduct their business in the expectation that the government will rescue them from their mistakes. He is undoubtedly as reliable one time as the other.

Early last month, the New York banks had a little war to see who could pay the highest interest on certificates of deposit. The war was apparently started by Manufacturers Hanover as a macho gesture, to show that current rumors of its weakness were false. An ad for Citibank, and several others, at one stage quoted an effective annual rate of 13.6 percent on one-year CDs. That sounded dandy (and was) for those with the cash to take advantage of it.

You may wonder how, with a prime rate that was then 13 per cent, Citibank could pay 13.6 per cent for its money. Mr. Micawber would have said: “Annual income thirteen per cent, annual expenditure thirteen and six-tenths, result misery.” It’s pretty hard to fault Mr. Micawber’s reasoning. Are bankers alchemists after all?

AT LEAST three things are going on behind the scenes. The first is that the bankers are practicing alchemy-up to a point. When they increase their reserves by selling you a CD for $1,000, they are able, very conservatively, to increase their lending by $5,000. A prime rate of 13 per cent on $5,000 earns them $650; so they can easily afford to pay you $136 for your money and are happy to spend a lot on television and newspaper ads to lure you into their shops.

(Incidentally, should similar battles flare up among the banks where you live, you might want to keep in mind that you can be an alchemist, too – assuming you are in the 50 per cent bracket and have some security to offer. It’s easy: You borrow $100,000 from Bank A, paying perhaps 15 per cent interest. You use this money to buy a $100,000 CD from Bank B that will earn $13,600. Since your tax will be reduced by $7,500 because of interest paid, you will have a profit of $6,100. After taxes you will be left with $3,050 net-all for simply signing your name a few times, and having a lot of money to begin with. And if you run part of this through your IRA, your gain will be greater.)

Can the banks continue doing that forever? Well, it isn’t quite like a chain letter, but it can be kept up as long as there are people and businesses clamoring to borrow money. (The private dodge I have outlined for you can be pursued as long as Congress allows a deduction for interest paid.) Should the demand for loans collapse, or should the loans turn “nonperforming,” the party would be over. For this reason, one may presume that a modest shuffling of the feet is also going on behind the scenes as the banks get ready to raise the prime rate again, probably not until after the election.

And why not? It’s as plain as day that their little CD wars will result in a higher cost of funds for all of them. Finally, a playlet is being prepared behind the scenes that will go like this:

Enter Stern Bank Examiner, who says (sternly): “Hey, you’ve got to stop making those crazy loans to Third World countries and oil wildcatters and speculators in California real estate. Even though the United States has figured out how to have what we say is a recovery with eight or 10 million unemployed, the rest of the world is still depressed, and the demand for oil is going down, and there really is a limit to what anyone in his right mind will pay for a piece of the San Andreas Fault.”

To that, Deregulated Big Banker will reply (contritely): “Well, shucks, sir. Then this bank, which I remind you is bigger than you can possibly imagine, will have to go bankrupt, because our cost of funds is so high that we have to make these crazy loans at high rates, or we can’t pay our bills. If you say we have to go bankrupt, why of course, we’ll do as you say. But if we go, I humbly remind you, we’re so big that we’ll pull a whole lot – maybe everything-down with us, and we wouldn’t like to do that. ”

Whereupon Stern Bank Examiner will answer (sternly): “Well, all right. If you can’t be good, be careful.”

The consequences of such unavoidably permissive regulation will extend far beyond the cost of bailing out a superbank every now and then. Most immediately, the rest of the banking system will be strangulated. If the biggest banks are essentially free of regulation, the remaining banks (some of them bigger than I can imagine) will be at a competitive disadvantage unless they can sell out to a super bank or combine with others similarly situated and become superbanks themselves. The merger movement, already possessed of enough momentum to satisfy a sports announcer (including one formerly known as Dutch[1]), will proceed apace. Everybody will become too big to be allowed to fail.

That last sentence is twice as long as it should be. If we are truly to learn the lesson of Continental Illinois and Financial Corporation of America and Lockheed and Chrysler, the sentence should read, “Everybody will be too big.” Period. Put another way, the lesson we should learn is that great size, in and of itself, is an economic evil. For almost a century, since the passage of the Sherman Antitrust Act in 1890, we have said and repeated and contrived to believe that the issue is competition, not size. The Sherman Act has been amended and strengthened, most notably by the Clayton Antitrust Act of 1914 and the Robinson-Patman Act of 1936; the courts have been clogged with cases, some of which dragged on for decades without a decision; and always the effort has been to discover and enforce a judicial definition of competition.

The effort has not succeeded. The power of the “trusts” of 1890 was insignificant in comparison with that of the Fortune 500 or the Forbes 500 of today. Absurdities have multiplied. It is, for example, established antitrust law that a company can engage in what the law defines as unfair business practices when the company has to do so to meet competition. If you think that’s nutty, you’re right.

I’m not saying that we would be better off without Robinson-Patman and the rest. I’m merely saying that the expensive, time-consuming antitrust effort has failed to come close to its promise, and that its failure follows from the apotheosis of competition.

In this space a couple of months ago (“Unthinkable Thoughts on Competition,” NL, April 2), I presented some empirical evidence that competition doesn’t always work for the benefit of the consumer. For evidence that it doesn’t always work for the benefit of the producer or of society, I refer you to a 1921 essay entitled “The Ethics of Competition” by the late Professor Frank H. Knight of the University of Chicago. Knight demonstrates in careful detail what we know in our hearts, namely that the competitive race is seldom fair, and that the effort it stimulates is as likely to result in chicanery as in beneficial innovation. One of Knight’s favorite pupils was Milton Friedman, showing that, happily for mankind, personal relations are thicker than ideology.

If competition doesn’t work, what does? Not cooperation. That is merely the flip side of the coin. Milovan Djilas and a great many others are ready to tell you in convincing detail that cooperative societies, with the best will in the world, tend to degenerate into stultifying dictatorships. I propose that we look a bit more closely at the question of size.

SINCE THERE ARE unquestionably economies of scale, it would seem that we are stymied in that direction, too. As a matter of practical politics, we are undoubtedly stymied now and will be for a long time. But there does exist a workable solution. It is embodied in a 166-page book published in 1947. The title is The Limitist, and the author is Fred I. Raymond.

Raymond was a successful executive in a family business that was sold, against his advice, to Wall Street speculators. Then he was an inventor of successful heart-regulating devices that he had to sell to Minneapolis-Honeywell because he couldn’t get at the market for them. Then he pondered what had happened to him and wrote his book, which I am very proud to have published. It attracted attention from John Chamberlain of the Wall Street Journal on the Right and Senator Paul Douglas of Illinois on the Left, but of course was (and unfortunately still is) long before its time.

Observing the courts’ inability to define competition, Raymond put forward what he called a limitist law. The speed limit is such a law. If you go over 55 miles an hour you are in violation, no matter what arguments you can make about safety or efficiency or the behavior of others. Observing the way business works, Raymond concluded that seeming economies of scale are often (if not generally) results of the favored access great size can command to finance and to markets. The Chevrolet plant in Tarrytown, New York, for instance, achieves (or could achieve) all the engineering economies of scale available in automobile manufacturing. It is not made more efficient by the existence of similar Chevrolet plants elsewhere.

On the basis of these observations, Raymond proposed that a business organization could be as large and as spread out as it wanted to be, provided that it had only one place of shipment to its customers, whether other manufacturers, retailers or the public. If a business had more than one point of delivery, it would be limited to a certain number of employees. Raymond suggested 1,000 as the maximum. He drafted a “Business Limitation Act” that runs to not quite 2,000 words, including definitions of terms.

I doubt that you have heard of a more elegant, simple, effective, and far-reaching proposal. The book never sold many copies and has long been out of print, but I suppose you can find one in some library. If you do, you will be well repaid for the two or three hours it takes you to read it. It is, as Chamberlain said, “a practical way of dealing with the economic ‘sin’ of bigness that doesn’t require cumbersome bureaucratic supervision, insidious taxation of human energy, or incessant effort to prevent government corruption.”

We can, of course, simply give up and turn the country over to the Business Roundtable. Or we can keep muddling through the courts. Or we can make a start at diagnosing and treating our actual ailment. That is, we can face up to the problem of bigness.

The sad fact is that we had a limitist law in banking in the shape of Regulation Q, which limited the interest certain banks could pay. It was not altogether effective because it could not (given the patchwork control of our financial system) cover all it should have covered. In the circumstances it would have been rational to extend the coverage. But overawed by the wealth and wisdom of Walter Wriston and his ilk, we reduced it, instead. The more fools we.

The New Leader

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[1] Reagan

The Savings Bust

Originally published October 17, 1983

CONSTANT readers of this column have foreseen since THE NEW LEADER issue of March 8, 1982, what last month burst like a paper bag full of cold water over the heads of the self-assured enthusiasts for Reaganomics. The New York Times, evidently relying on Federal Reserve Board figures, announced that our national rate of saving has steadily declined in spite of the massive supply-side tax cuts that were supposed to stimulate it.

This development has caused some bewilderment. Norman B. Ture, former undersecretary of the Treasury for tax and economic affairs, who was the “architect” of the 1981 tax cut, said the news was disturbing and surprising. “It’s very difficult to understand,” he added. Other worthies were tempted to dispute the figures, for the mind-boggling reason that “they cannot show tax-evasion income” (the inference being, I suppose, that the so-called recovery has been fueled by illegal savings).

As you know, I am like Adam Smith in that I hold no brief for statistics. (One of the most successful books I ever edited was entitled How to Lie with Statistics.) It does, nevertheless, seem to me fitting that those who live by statistics should die by statistics. In the present instance, I think it as likely that the rate of saving has been overstated as the other way around; but whatever the precise figures may be, they certainly show that the tax cuts didn’t do what President Reagan promised they would do.

Nineteen months ago I told you why they wouldn’t. I wrote that “unless the government is running a surplus, there is no way for tax cuts to be a direct stimulus to productive investment.“ To emphasize the point, I said it in italics, a typographical device I don’t resort to lightly.

My reasoning was as follows: “Try as he will, the supply-sider can’t get money into the hands of producers. This is not because of the conspicuous consumption of the rich or the notorious perversity of Wall Street. Even when everyone is doing his best to cooperate, the scheme can’t work. The supply-sider’s tax cuts go to the rich, all right; but the recipients have to lend the money right back to the government to cover the [increased] deficits. No more money becomes available for productive investment than there was before the game started.” I continued: “You will note that I say ‘available,’ because I don’t for a minute believe that much of that tax windfall would go into productive investment even if it could. Almost all of it is earmarked for speculation. No goods will be produced as a result of it, nor any services rendered. But the rich will be richer.”

Two months after my column appeared, the Times had a roundup of opinion on the economy, in which Professor Arthur Laffer was quoted. He was a big man in those days, with a curve named after him. The Laffer Curve, you will remember, was the principal intellectual underpinning of the Reaganomic tax cuts. Though it first appeared on a cocktail napkin and never was able to find empirical support, it was used to justify giving major tax cuts to the rich (whose incentive would otherwise be sapped). But on May 2, 1982, Laffer was quoted to the effect that the cuts would have “no economic effect” because the government would “give a dollar back and then borrow it right away from you.”

Yes, that is what I had said, and it amuses me to think Laffer might have gotten the idea from my column. That would have been sufficiently astounding. Sensationally astounding was the fact that here was one of the original supply-side gurus confessing that the scheme wouldn’t work. Laffer’s recantation was on a par with David Stockman’s confession that Reaganomics was a Trojan Horse for the rich.

Unfortunately, the Times business reporters are so used to stitching stories together out of mindless handouts, and Times readers are so used to skipping such stories that not even the Times editors noticed the recantation. In an editorial some weeks ago they still didn’t understand what had happened, attributing the fall in savings to the failure of the tax cuts to give individuals any “particular incentive” to save.

Now, in discussions like this, one can easily lose track of what the real issue is. The real issue here is not why savings have fallen but whether it makes any difference, and whether any “particular incentive” should be legislated to change the situation.

Classical economics noted that steam driven looms produced more cloth than hand looms, and were bought by men who had saved some money or could borrow the savings of others. Thus it seemed obvious that savings increased production (and so were virtuous and should be rewarded). That analysis, however, was inside out, as any moderately reflective businessman has known these past two centuries. For regardless of the savings one has accumulated, one is not well advised to buy a power loom if there is no effective demand for cloth or if the demand is already oversupplied. Of course, if there are no investment possibilities in textiles, there may be some elsewhere. But when you have 12 per cent of your labor force and 30 per cent of your industrial plant standing idle, the odds are against finding suitable places to put your savings, no matter how much you have laid by.

In this situation – which is the situation we have been in and are still in –  you can do two things with your savings: you can live it up, or you can speculate. Speculation, I’m ready to admit, is my King Charles’ head; I will therefore confine my remarks on the point to asking where you think all the billions came from that have gone into the stock market in the past 15 months.

Putting speculation aside, let’s look at living it up, otherwise known as consumption or demand. Here again, classical economics has something to say that seems plausible enough until you stop to think about it. The gimmick is Say’s Law. Jean Baptiste Say, a French contemporary of Adam Smith’s, had it figured out that production creates its own demand. He reasoned this way: If you set up a textile mill, you have to pay the people who build the factory and those who make the looms and those who raise and shear the sheep and those who run your looms. All these payments are used by these people to buy things they want or need, and the people who sell them these things use the money they are paid to buy what they want or need, and so on and on. Sooner or later, someone will buy your cloth. Or if no one does, it still happens that a lot of other goods are sold, so that, in the aggregate, production creates demand, and a universal glut is impossible.

MALTHUS, among a handful of others, saw that this is nonsense (because of the time lapses involved, if for no other reason), but he couldn’t convince his friend Ricardo or the followers of Ricardo. It took the Great Depression, when an unsalable glut existed for all to see, to exorcise the ghost of Say. And yet, only a half century later, the ghost of Say is again seen nightly on the battlements and occasionally stalking abroad in full daylight, driving Atari Democrats and self-advertised liberal businessmen mad with schemes to reduce consumption in the hope of increasing production.

A convenient example is at hand in an Op Ed page piece in the very issue of the Times that carried the story about the fall in savings. The author is one Fletcher Byrom, chairman of the Committee for Economic Development, described as “an organization of chief executive officers and university presidents.” Awesome. Byrom proclaims: “The United States needs to move away from a patchwork tax system that penalizes saving and investment toward one with more systematic emphasis on taxing consumption.” Someone should take Byrom aside and tell him about the Economic Recovery Tax Act of 1981.

He might also glance at another story in the same issue of the Times revealing that millionaires have multiplied like fruit flies even as savings have been languishing. There were about 180,000 millionaires in 1976 and 500,000 in 1981. It is not irrelevant that the great leap forward coincides with the introduction of the maxi tax on “earned” income. Goodness knows how many millionaires there are today, but I’ll bet the number has redoubled since the maxitax on unearned income went into effect two years ago. (I’ll bet the number of those below the poverty level has redoubled, too.)

If Byrom and his committee have their way, there will be still more people with millions to throw around. Their fortune-good for them but bad for the country – will be made possible by lowering the personal income tax and the corporation tax, while raising Social Security taxes and sales taxes, and maybe introducing a value-added tax, which is a semi-hidden kind of sales tax.

I am sorry, but I find it difficult to have proper respect for chief executive officers and college presidents who talk this way. The empirical evidence is plain that their policies have not done what they promised, yet they persist in them. The empirical evidence is plain as well that their policies have caused appalling suffering, not only in this country but throughout the world. Nonetheless, they persist. Although I find it hard to have proper respect for these people, I’m scared that they will continue to have their way.

The New Leader

Letter and response re: “Why Deficits Matter”

Originally published April 19, 1982

Dear Editor

Speculation

I feel tempted to say a word about one part of George P. Brockway’s “Why Deficits Matter” (NL, March 8). Brockway draws a distinction between speculation and productive investment that is entirely misleading.

Of course, there is a difference between a purchase of a share of stock on narrow margin and a purchase of the same stock out of savings. The first is speculation, the second you might call investment, depending on the stock. The economic effect, however, is the same. The market does not distinguish where the buyer of a security got his money from. In fact, it has no way of knowing. In either case, the seller of the stock can do three things with the money he gets-consume it, hoard it, or put it into some other investment. Few sellers of stock consume their principal. Not much idle money is held at today’s interest rates. The chances are overwhelming that the seller of the stock, whoever he is, will put his money into another investment.

If that “new investment involves the creation of brick and mortar, it is directly productive. If it just leads to the purchase of an existing security, the same set of choices confronts each successive seller. Eventually, the money will find an outlet in directly productive new investment, unless it is consumed or hoarded. In the process, stronger demand for securities reduces interest rates and stock yields, reduces the cost of capital to investors, and in that way also stimulates investment.

In conclusion, I want to note that while I fully agree with the statement in the title that deficits do matter, I find the entire article so one-sided that in limiting my comments to the point I have made I do not mean to imply agreement with any of the rest of it.

Washington, D. C.                HENRY C. WALLICH

Member of the Board of Governors

Federal Reserve System

 

George P. Brockway replies:

To comment on Governor Wallich’s interesting letter I must try to summarize points I made in “Why Speculation Will Undo Reaganomics” (NL, September 7, 1981). There I proposed definitions of gambling, speculating and productive investing that, I believe, disclose the different economic effects of the three kinds of activity.

In brief, gambling is a zero-sum game that produces nothing but the players’ pleasure or despair. Speculating is not a zero-sum game: Over very long spans of time all who participate can gain, though some will no doubt gain more than others, but speculating is like gambling in that it only rearranges wealth that already exists. Productive investing is like speculating in that it is not a zero-sum game, but it differs in that goods and services are produced. It should be emphasized that all three activities are risky; consequently risk is not a useful criterion for distinguishing among them, though it is the one ordinarily used.

Governor Wallich’s view, which is the standard one, is that such distinctions are idle because ultimately the results of speculating go into consumption, hoarding, or “bricks and mortar.” This, I should contend, is one of those instances in which Keynes’ remark (“In the long run we are all dead“) is appropriate. Holland’s tulip mania increased in virulence from 1615-37-…It took nine years for the South Sea Bubble to burst. The Great Bull Market lasted six or eight years. Some of these speculative frenzies might, in Governor Wallich’s terms, be classified as hoarding or consumption; but they were not productive investments. They absorbed, and ultimately destroyed, vast sums that could have gone into productive investments.

More important than all this is the role of the stock and commodities markets. Governor Wallich says that “Eventually, the money will find an outlet in directly productive new investment unless it is consumed or hoarded.” The imagined event has to be a long time coming. Fewer than 1 per cent of the transactions on the stock and commodities exchanges have anything to do with productive new investment. Professional traders can and do spend their whole lives buying and selling without ever touching a productive new investment. Insurance companies and endowment funds tend to shy away from productive new investments. Investment bankers (so called) are now mainly concerned with mergers and takeovers. A very large nonproductive tail keeps the productive dog off balance.

I’m afraid it simply is not so that “stronger demand for securities reduces interest rates … and … stimulates investment.” This may be what the theory calls for, but it is flatly refuted by the present situation, when both exchange transactions and interest rates are at all-time highs. The “stronger demand” is a speculative demand, and it attracts money away from productive investment.

To cite an example, U.S. Steel abandoned plans to update its mills and borrowed $3 billion to acquire Marathon Oil. It would be fantasy to suppose that the happy Marathon stockholders, having unloaded at the top of the market, have not been encouraged to bid up the shares of other companies thought susceptible to takeover. There is nothing productive about this. Moreover, the $3 billion U.S. Steel borrowed has surely helped to keep the interest rates high. It is the same with margin accounts, which soak up available funds and thus help keep both securities prices and interest rates higher than they would otherwise be.

I agree with Governor Wallich that “The market does not distinguish where the buyer of a security got his money from.” For this reason (among others), I would not try to prevent speculation. But I would shut down margin accounts (as has been done before). I would see what could be done to discourage borrowing to finance mergers. And I would not encourage a hundred speculative transactions (as the low capital gains tax does) in the bumbling hope of stimulating one new productive investment.

As to the fact that the rest of my article on deficits was one sided, I admit the soft impeachment. If you have a reasoned conviction, I’d think it irresponsible to pretend to what is called a “balanced view.”