Tag Archives: Volker

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

1991-2-11 Don't Bet On The Banks Title

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 The New Leader

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

1989-11-27 What Happened to Jimmy Carter Title

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 Volckerthe 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 25th 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

By George P. Brockway, originally published January 9, 1989[1]

1989-1-9 Bankers Have The Classic Cola Title

IN “The Fear of Full Employment” (NL, October 31, ’88) we examined some of the fallacies behind the almost universally held doctrine that full employment makes for high inflation. This time we’ll look at another almost universally held doctrine, namely that raising the interest rate is the cure for whatever inflation exists. An astonishing thing about the latter doctrine is that no one bothers to say why it should work. The New York Times, which never mentions the prime interest rate without pedantically explaining that it is the rate banks charge their most credit-worthy borrowers, regularly reports without question that if the Consumer Price Index (CPI) starts to rise, the Federal Reserve Board will have to raise the interest rate.

Economists divide what they call the nominal or “money” interest rate (which is what you pay) into two parts: “real” interest (what they think you’d pay if the economy were in equilibrium) and an allowance for inflation. The allowance for inflation is what in other sectors of the economy is called a Cost of Living Adjustment, or COLA. People with money to spare are said to be enticed into lending by the prospect of getting back their money at a stated time with stated interest. What they want back is not the money, but the money’s purchasing power; and in inflationary times the only way to get back the same purchasing power is to get back more money. Hence the Bankers’ COLA.

Of course, bankers don’t call it a COLA. They have, in fact, been unremitting in propagandizing the notion that COLAS are bad and greedy and inflationary and likely to cause the downfall of the Republic. The COLAS bankers talk about are those that appear (or used to) in labor contracts, where they are manifestly an increased cost of doing business for companies with such contracts, and those that appear in Social Security and other pension payments, where they are manifestly an increased cost of running the government. (Another COLA, seldom mentioned, is the indexing of the income tax.) Since increased costs of doing business increase prices, and increased costs of running the government increase taxes (or the deficit), it is argued with some reason that COLAS are inflationary.

The propaganda against them (coupled with high unemployment and underemployment) has pretty well knocked cost-of-living clauses out of labor contracts. The Social Security COLAS are somewhat more secure because there are more worried senior citizens than alert union members. Even so, the steady cacophony from Peter Peterson and other investment bankers (when they take time off from promoting leveraged buyouts, which they evidently don’t think inflationary) has put the American Association of Retired Persons on the defensive. The Bankers’ COLA, however, is accepted as a natural law and discussed matter-of-factly in the textbooks, while the others are deplored as the work of greedy special interests out to line their own pockets at the expense of the nation and its God-fearing citizens.

One way of stating the Banker’s COLA is that it is the difference between the interest rate now and that of some earlier, less inflationary time. The prime rate at the moment is 10.5 per cent, and may have gone higher by the time this appears. In the 4O-oddyears since the end of WorId War II, there is one stretch, from 1959 through 1965, when the CPI and the prime were both substantially stable. In those seven years the CPI varied from 0.8 per cent to 1.7 per cent, and the prime from 4.48 per cent to 4.82 per cent. (Readers with a political turn of mind will note that the Presidents in this period were a Republican and two Democrats- Dwight D. Eisenhower, John F. Kennedy and Lyndon B. Johnson.). The Bankers’ COLA was evidently no more than 1.7 in those years, and the “real” interest rate was somewhere between 3.5 per cent and 4.5 per cent.

Let’s accept the higher figure, even though it is substantially higher than, for example, the rate in the years when the foundations of the modern economy were laid. Subtracting 4.5 per cent “real” interest from the current prime, we determine that the current Bankers’ COLA is, conservatively, 6 per cent.

But only about a tenth of outstanding loans were written in the past year, and many go back 25-30 years. Over the past 10 years the CPI has increased an average of 6.01 per cent a year. That is remarkably (and coincidentally) close to our estimate of the current Bankers’ COLA.  The average gets higher as we go back 15 and 20 years, and falls slightly if we go back 25 years. Consequently if the Bankers’ COLA has been doing what it’s supposed to do, we are not overstating the case in saying that today it is running at about 6 per cent.

Now, the present outstanding debt of domestic  non-financial sectors is about $8,300 billion. This figure includes everything from the Federal debt to the charge you got hit with when you didn’t pay your bank’s credit card on time; excluded are the debts banks owe each other and, for some reason, charges on your nonbank credit card. The cost of the Bankers’ COLA for this year therefore comes to about $498 billion (6 per cent of $8,300 billion).

As the late Senator Everett McKinley Dirksen would have said, we’re talking about real money. Let’s try to put it in perspective. At the moment the CPI is said to be about 4.5 per cent (less, you will have noticed, than the Bankers’ COLA, because bankers expect inflation to get worse). Since the GNP is currently about $4,500 billion, inflation is currently costing us 4.5 per cent of that, or $202.5 billion. The Bankers’ COLA is thus costing us almost two and a half times as much as the inflation it is claimed to offset.

So we come to Brockway’s Law No. 1: Given the fact that outstanding indebtedness is greater than GNP (as is always the case, in good years and bad), the Bankers’ COLA costs more than the total cost of inflation, at whatever rate.

Another comparison: The Bankers’ COLA costs close to three times as much as the Federal deficit the bankers moan about. (If there were no Bankers’ COLA, we’d be running a surplus, not a deficit.)

Also: The Bankers’ COLA costs many times more than all the other COLAS put together, and about 50 times – repeat 50 times – more than the Social Security COLA that so exercises investment banker Peter Peterson. (If there were no Bankers’ COLA, none of the other COLAS would exist, because the cost of living would not be going up.)

Also: The Bankers’ COLA costs more than giving every working man and woman in the land, from part-time office boy to CEO, a 10 per cent raise. (So much for the fear of full employment.)

SINCE THE Bankers’ COLA costs the economy more than inflation does, without it there would in effect be no inflation. Other things being equal, there would actually be deflation. And of course very great changes would follow if so large a factor as the Bankers’ COLA were eliminated. Reducing the interest rate to its “real” level would quickly and powerfully stimulate investment in productive enterprise, with a consequent growth in employment. It would trigger a one-time surge in the stock and bond markets, followed by a gradual tapering off of speculation.

1989-1-9 Bankers Have The Classic Cola Factory

As matters stand now, the Bankers’ COLA is an incubus of terrible weight depressing the economy. That this is so is revealed by the statistics whose subject is people rather than things. The standard of living of the median family is falling, even with two earners per family much more common than formerly. The number of people living in poverty is growing, and within that group the number of those who work full time yet are poverty stricken is growing still faster. The rate of unemployment – even counting part-timers as fully employed, and not counting at all those too discouraged to keep looking for work – would have been shocking a few years ago. These are signs of recession, of bad times.

The interest cost is the only one that has a general effect on the economy. We used to hear a lot about the wage price spiral, but a wage increase in the automobile industry (for many years the pundits’ whipping boy) works its way through the economy slowly and uncertainly. Initially it affects only the price of automobiles, and it never brings about a uniform wage scale. Wages of grocery clerks remain low, and all wages in Mississippi remain low. A boost in the prime rate of a prominent bank, on the other hand, immediately affects the rates charged by every bank in the country; and while it is possible for borrowers to shop around a bit for a loan, they find that rates vary within a very narrow range.

More important, interest costs affect all prices, because all businesses must have money, even if they don’t have to borrow it, and the cost of money is interest.

Vastly more important, the Bankers’ COLA is a forecast, a prediction, a prophecy. The figures we have been working with are from the past, but bankers – including, especially, those who make up the Federal Reserve Board – set rates that will have to be paid decades into the future. Well into the 21st century, for instance, we will be paying up to 15.75 per cent interest on a trillion dollars’ worth of Treasury bonds sold in the wonder-working days of former Fed Chairman Paul A. Volcker.

So we come to Brockway’s Law No. 2: Raising the interest rate doesn’t cure inflation; it causes it.

The New Leader

[1] Editor’s Note:  For those who are too young or forget the Coca Cola company came out with the “New Coke” in 1985, and it bombed.  Under-duress they kept the New Coke on the market, for a while, and re-issued the product people wanted to buy as Coca-Cola Classic, or the “Classic Cola.” Thus the gentle wit of the title of this article.

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

1988-9-9 George Bush's New Trojan Horse title

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

[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.

By George P. Brockway, originally published July 11, 1988

1988-7-11 Taking Stock of the Stock Markets title

1988-7-11 Taking Stock of the Stock Markets Greenspan

IT LOOKS as though they’re going to try putting “circuit breakers” on the securities and futures markets. I’m not sure it will make much difference. The question, after all, is not whether stopping trading for an hour or so after a fall of 250 points would stop or accelerate the plunge. (It might very well do one thing one day and the opposite the next; there are plausible reasons either way.) No, the question is: What is the use of a market that can crash and lose 30 per cent of its value in a single hectic day, and that can routinely lose or gain 2-3 per cent in a couple of hours? What do we have securities markets for anyhow?

The reasons ordinarily advanced are two: (1) to provide financing for productive business and industry, and (2) to encourage people with a little money (or a lot) to participate in the financing. As to the first point, the New York Stock Exchange won’t even bother answering your letter if you ask them how much of their trading is in new securities issued to finance growing business. Probably they don’t know, and certainly they don’t care. As to the second point, today’s lament on Wall Street is that the small individual investor (that is, anyone having less than, say, $10 million to play with) has stayed, as the current metaphor has it, on the sidelines since the 1987 Crash. They’ve stayed out of the game, not for lack of coaches eager to send them in, but because of a prudent aversion to a playing field that sometimes resembles a mud slide.

In short, the pretended justification of the New York Stock Exchange is a sham – and the same goes for all the others, foreign and domestic. They do not in fact provide much financing for new enterprise; they do not in fact significantly facilitate individuals’ participation in such financing; and whatever they do could be easily and far less expensively organized otherwise. If there is no justification for the stock exchanges, there is certainly none for the futures exchanges that are based on them. Federal Reserve Board Chairman Alan Greenspan thinks these things are justified because people use them; the same argument can be made (and I’ve heard of some who have made it) in support of astrology.

Ironically, the exchanges’ own supporters make an air-tight case against them. Look, they say, the Crash didn’t hurt anyone, except for a few foolish widows and orphans. Milton Friedman understands us when he says, “Easy come, easy go.” Six months after the Crash, they say, the markets were about where they had been six months before it. The Great Reagan Recovery is jogging along as if nothing happened: GNP up about the same, inflation about the same, the deficit about the same. Lots of banks may be in trouble, but not because they were involved, directly or indirectly, in the market. A trillion dollars, more or less, disappeared overnight, they say, yet it was only paper profits anyhow. Now that the hysteria has subsided, you can see that the whole uproar didn’t make any real difference.

Since it didn’t make any real difference, they say, there’s no need to do anything. I say that since it didn’t make any difference, there would be no harm in trying to prevent a plunge from happening again, if only to protect the widows and orphans.

The Crash (the biggest ever) had no substantial effect on the producing economy because the damage had already been done. The trillion dollars was really lost and it is a lot of money almost as much as the Reagan increase in the public debt (or, to put it another way, almost as much as the Reagan tax cuts). The enormous loss didn’t matter to the producing economy only because the producing economy never had the use of it. The money went directly from the happy beneficiaries of the Kemp-Roth tax bill into Wall Street and then down the drain.

Of course, some of the tax cuts went into consumption, and some into government investment (bonds to pay for the deficit), and even some into private enterprise. On balance, though, it was the long bull market that started in 1982 that was created by the tax cuts. To be sure, there were other unfortunate things going on simultaneously (mainly former Fed Chairman Paul A. Volcker‘s love affair with double-digit interest rates); but if there had been no tax cuts, there would have been no bull market.

You can see why most people who lost money in the Crash (other than the few widows and orphans) have shrugged it off. What they lost was tax money. So they’re no worse off than they would have been if Ronald Reagan hadn’t been elected; and it sure was fun while it lasted. Yet these people are citizens, too.

They are not merely private atomistic profit maximizers and utility maximizers. As they complain to each other at bars and over bridge tables, they’re weighed down by their share of the public debt. Considering that upwards of 35 million people are living in poverty and that many millions more make so little they pay practically no income taxes, each family of the sort of citizens we’re talking about can actually claim liability for close to $100,000 of the public debt, and perhaps more. Besides, the pundits tell us the debt is to blame for all our troubles.

Thus if Milton Friedman was right when he said, “Easy come, easy go,” he was also right when he said, “There’s no such thing as a free lunch.” The excitement of the bull market and the titillation of the Crash were not free; they were paid for by doubling the public debt. If our tax system were fair, we might say that, in general, the people who had fun in the market are also the people who assume the debt burden, and therefore, again, the whole roller coaster didn’t make any difference.

Aside from fairness, the trouble with such a conclusion is that those tax dollars, like all dollars, come ultimately from the producing economy. No economy can run on securities alone, because stock certificates are not good to eat or wear; and while they’ve sometimes been used to paper walls, they don’t provide much shelter. Wealth is the result of the work of producing, for which people are paid in the form of wages, salaries, interest, rents or profit. The government, too, is a prolific and necessary producer, mainly of services, for which it is paid in the form of taxes.

The way conventional economics has it, as soon as people get paid for something, they buy something with their pay. The people they buy from do the same, and so on and on. Except for a little friction, this producing and buying and selling goes on steadily, to everyone’s benefit. The economic system is in perpetual motion, and also in perpetual equilibrium. There is really no way for anything to go seriously wrong.

Yes, so long as people are buying and selling goods and services- that is, trading in commodities. But when they are buying and selling claims on capital (in the stock markets), or money or options to buy or sell money or capital (in the futures markets), they are not dealing in commodities; they are speculating in the conditions that make commodities possible.

The money absorbed by the speculating economy is money earned by the producing economy that is no longer available to participate in the production of goods and services. The more money goes into speculating, the less is available for producing. Consequently fewer things are produced, and fewer people have jobs producing them. The conventional economists’ happy cycle of buying and selling is shrunk and bent out of shape and may be fractured. Since the speculating markets not only  fail to assist the producing economy but actually hurt it, you might think it would make sense to go beyond regulating them and shut them down altogether.

IN HIS MOST informative new book, Markets: Who Plays, Who Risks, Who Gains, Who Loses, Martin Mayer shows repeatedly how the exchanges have been able to make a mockery of the relatively innocuous rules we tend to think are in force. The Federal Reserve Board, for example, is said to set the margin rate (that is, the amount you can borrow to buy stock) at 50 per cent. If you ask me, it ought to be zero; but it doesn’t matter, because only the littlest millionaires are affected, and all the really big operators have easy ways to get around it.

Given the radically reactionary interests now ruling the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, there is no real possibility of rational control of the speculators for years-or until the next crash. So why not consider abolition?

Naturally, there would be a great debate, or at least, a lot of talk. One of the points that would be made is that shutting down the exchanges would simply send them scuttling abroad. (The same threat will be made whenever rational control is proposed.) New York City is sadly aware that even trying to get the exchanges to carry their share of the tax load is immediately smothered by threats to move to the New Jersey meadows. The wonders of the computer age being what they are, it would not be much harder to set the whole thing up on Grand Cayman Island or Singapore.

Beyond the damage to our pride (equivalent to losing the Winter Olympics), would not the flight of the exchanges be accompanied by a flight of capital, and would not that be our ruin? It is said that the flight could not be prevented. Complete prevention would no doubt be impossible, just as perfect income tax collections are impossible; but perfect flight wouldn’t be possible, either. In any case, the fleeing capital would merely be money. It wouldn’t be factories or warehouses of goods for sale or goods in the process of consumption. And since the money that would flee isn’t doing anything in our producing economy, its loss wouldn’t change anything that matters.

There is, however, a much simpler and fairer way to control the markets. As we’ve said here before, speculative binges occur only because some people have more money than they know what to do with. When we had steeply progressive income taxes, there were many fewer such people (as well as many fewer living in poverty). The markets then were too viscous for wheeler dealers but certainly liquid enough for ordinary purposes. We could do worse than learn from our past success.

The New Leader

By George P. Brockway, originally published February 8, 1988

1988-2-8 Catch a Falling Dollar Title

I SEE BY the papers that many a pundit, from the President on down, thinks the dollar should fall a bit more-but not too much more. How much is too much? Two answers are given: (1) We don’t want to scare foreign investors into pulling their marks .and yen out of our economy, and/or (2) we don’t want to do anything to start inflation again. Quick rejoinders are: (1) There are dollars but no marks and yen in our economy, and (2) no one who has had occasion to buy anything thinks inflation has ever stopped. Let’s take a look at the problem in a little more detail.

Those foreign investors were a big concern of former Federal Reserve Board Chairman Paul A. Volcker (see “Vale, Volcker,” NL, June 1-15, 1987). The story was that we needed them to finance the budget deficit because, as pundits keep telling us, we don’t save enough to finance it ourselves. And the foreigners, being strangers in a strange land, had to be offered bait in the form of high interest rates. It is possible to argue that our maneuver was self-defeating, since the annual interest on the Federal debt is now close to double the annual deficit. Yet mistake or not, the bonds have been sold, some with coupons as high as 15.75 per cent, and there is nothing that can be done about it; so we should (as the President plaintively pleads about a great many things) put it behind us.

At this point we are supposed to worry that foreigners will pull out if the dollar falls much lower, and it is certainly understandable that the Great Crash of 1987 may have made them skittish. Getting their money out could, however, be a bit more complicated than it appears.

Say Mr. Togo has some of those nice 15.75 per cent 20-year bonds (payable November 15, 2001) and so does Ms. Falck[1], and they want to sell them. No problem. The quote this morning is 153 bid, 153 6/32 asked. Although the price may shift a bit one way or the other by the time our foreign friends contact a bank or a broker, they can be confident of selling the bonds at 153, give or take a few cents. Cents? Well, yes, and naturally the 153 is dollars. They’ll get $15,300 for each $10,000 bond they own – a nice capital gain on top of the 15.75 per cent interest they’ve been receiving since purchasing the bonds in 1981.

But Mr. Togo and Ms. Falck don’t want dollars and cents. The whole idea is to pull their money out of the United States, because the financial tipsters they read tell them Washington isn’t going to put its house in order (whatever that means). They want good old yen and marks, respectively.  Again, no problem. This morning the yen is quoted at 127.90 to the dollar, and the West German mark at 1.6805 to the dollar. There may be a slight fluctuation before the exchange is made; still, Mr. Togo and Ms. Falck will have their familiar currency back.

Now, when Mr. Togo and Ms. Falck are given yen and marks for their dollars, it is because someone buys their dollars for yen and marks. Obviously. But look you: The numbers of dollars, yen and marks remain the same (this is one place where money has a quantity). Mr. Togo and Ms. Falck can get their money out only if some other foreigners put theirs in.

Should all foreigners try to get their money out simultaneously, the exchange rate of the dollar would surely fall, and fall very fast (this is the one place where the law of supply and demand works). It wouldn’t be a free fall. At some stage Mr. Togo’s compatriots would get so few yen for their dollars that, say, $40 million wouldn’t be worth much to them, and they might just as well use it to buy a painting of flowers that van Gogh never got around to finishing. Or Ms. Falck’s compatriots might think it smart to buy an American publishing house or two[2] with their cheap dollars.

In the end, the only way all foreigners can get their money out of the States is by buying something we have to sell. Of course, this is how they got the dollars in the first place: We bought some of what they had to sell. It is also well to remember that, budget deficit and all, ours is a pretty stable society and therefore not altogether a bad place to keep your money. Moreover, our debts are denominated in dollars (except for some worrisome ventures of our biggest borrowers), which distinguishes us from Third World debtors (see “Becoming a Debtor Nation,” NL, February 24, 1986).

The pressure is not all one-sided. We’re eager to buy Hondas and BMW’ s, and they’re eager to buy American securities, both public and private. They may not be so eager to buy more securities if the Federal Reserve lets the dollar continue to fall, but they’ll have to buy something we have to sell-unless they intend to give us Hondas and BMW’s for free.

They may buy goods we produce, and that will certainly be fine with us. On the other hand, they may buy or build factories to make a Stateside version of the Honda. Or they may put their excess dollars into real estate. Large chunks of our major cities are already Japanese owned, just as large chunks of London are Arab owned (and substantial pieces of Manhattan are British and Canadian owned). Patriotic sentiment aside, should we be upset by foreign investment in American industry and real estate?

From the standpoint of American working men and women, it makes no difference who their employers are (unless they’re self-employed) so long as the employers are fair and decent. From the standpoint of American consumers, it makes no difference who produces the merchandise they buy so long as the quality is good and the price is fair. From the standpoint of American investors- well, they’ve shown themselves more interested in speculating on the stock market, anyhow. From the standpoint of the American government, taxes on foreign-owned income could be as good as taxes on domestic-owned income (I say “could be” because the Administration has wimpishly restored breaks for foreigners that we’ve canceled for ourselves).

There remains the problem of the profits earned by these foreign-owned factories and buildings. Our payments to foreigners are already in the tens of billions of dollars annually. If they go even higher, won’t they drain the lifeblood out of the economy? Hardly. These profits are in dollars and thus only exacerbate the foreigners’ difficulty in converting dollars to yen or marks or whatever. The profits will have to be spent on American goods or invested in American industries or exchanged for yen or marks at increasingly unattractive rates.

Mr. Togo’s and Ms. Falck’s last option is worth a moment’s notice. It is their ultimate option; and if the dollar continues to fall, it won’t be worth much. In an unexpected way it will fulfill Keynes‘ prophecy of the “euthanasia of the functionless  investor.” As Keynes explained in the closing chapter of The General Theory:

“Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.”

Unfortunately for Mr. Togo and Ms. Falck, capital denominated in dollars is overabundant and will accordingly be ill paid. (It happens to be overabundant in their homelands, too, but that’s not our worry.) Of course, Mr. Togo and Ms. Falck still have the penultimate option of leaving their money where it is, in which case there is no need for the Federal Reserve Board to “defend the dollar.”

BECAUSE DOLLARS will mean so little to them, our Japanese and German friends will be increasingly able to outbid us for paintings and publishing houses and such that come on the market. That will be a blessing for those of us who have things for sale, but it brings us to the second problem of the falling dollar-inflation.

Conventionally, this is seen to result from the rising dollar cost of imports. The effects are both direct and indirect. Directly, to the extent that the price of a Mercedes is a factor in the Consumer Price Index, an increase in the number of dollars it takes to buy a Mercedes tends to increase the CPI. Indirectly, if it becomes necessary to put up $85,000 worth of marks to import a Mercedes, General Motors might feel safe in bumping the price of a Seville to $75,000. There is little in the history of General Motors to suggest a reluctance to do the bumping, nor can I think of any likely reason for them to hang back.

Potentially more serious are increases in the costs of raw materials, principally oil. The effect here is somewhat mitigated by the fact that OPEC quotes its prices in dollars. It is also mitigated by the fact that sluggish economies around the world have made oil a glut on the market. It could be further mitigated, if not eliminated, by the pursuit of rational conservation policies-but that’s probably too much to expect us to undertake.

The inflationary effect I call your attention to is the bidding up of the prices of American industries. That happens when companies are bought outright and also when shares are bought on the exchanges. The Great Crash of 1987 is one sort of consequence. A much more dangerous consequence is the compulsive reaction of American managements to increased valuation of their companies. They feel obligated-and indeed are obligated by their investment bankers- to try to raise profits to match the increased valuations. They can do this in two ways, neither of them desirable -by raising prices, which is inflationary, and by holding down wages, which is stagnatory.

In the space remaining I can only suggest that the conventional solution of protecting the dollar by raising interest rates is precisely wrong-headed: It is merely another prescription for stagflation. The hopeful solution would combine a monetary policy of low interest rates (that would tend to encourage industry) with a fiscal policy of steeply progressive taxation (that would tend to discourage speculation by foreigners as well as by Americans).

If such a solution incidentally soaked the rich, it’s about time, for it must be acknowledged that they have not performed faithfully as stewards of the inordinate share of the common wealth they have engrossed over the past 15 years, and especially over the past seven. Their wanton misuse of their increased riches mainly to create a bull market and a crash was, and is, a passionless prodigality.

The New Leader

[1] As far as the editor can determine the names Togo and Falck are intended to represent generic Japanese and German investors and do not refer to actual individuals.

[2] Editor’s note, the author had been chairman of “an American publishing house,” at the time, and now, still privately held by the employees

Originally published February 24, 1986







AT SOME POINT recently, the United States crossed a great divide. Rather, we re-crossed the divide and became again a debtor nation, as we were until 70 years ago, owing more to the rest of the world than the rest of the world owes us. We owe so much, as a matter of fact, and our debts are piling up so fast, that very shortly we may become the world’s largest debtor, surpassing Brazil, the present leader.

Mention of South America’s biggest country causes our hearts to miss a beat. Only a decade ago our financial wise men were ecstatic about the Brazilian GNP and jostled each other in their eagerness to press our savings on the Brazilian government, on Brazilian entrepreneurs and on conspicuous Brazilian consumers. There’s no need to detail what happened. Will the same thing happen to us?

Our hearts must miss another beat when we reflect on the British, our creditor until World War I and an overall creditor for another decade. But in World War II they crossed the divide from general creditor to general debtor, and coincidentally entered upon a downward slide whose end is not yet. Does a similar fate await us?

Foreign debts-like national or even personal debts-come about in different ways that can have different effects. Since, as I never tire of saying, economics is not a natural science, the effects are not invariant nor, especially, are they invariably benign (or malign).

The most obvious source of foreign indebtedness is an unfavorable trade balance on current account. This means, merely, that we buy abroad more than we sell there. As a result, we increase our stock of capital goods (machine tools, for example, or knitting machines) and our supply or flow of consumer goods (automobiles or sports shirts). That is good, for it increases our common wealth and has a moderating effect on our inflation.

The moderation is achieved by substituting cheap foreign goods for expensive domestic goods. The domestic goods are expensive because our wages are relatively high. Foreign competition forces our prices down, which forces our wages down or, more usually, forces some of us out of work. That is not so good, though it is remarkable how steadfast our editorialists and economists are in the face of this outcome. (It would not be nice to suggest their steadfastness is strengthened by the fact that neither newspapers nor economics departments face foreign competition.)

Whatever its impact, an unfavorable balance on current account can continue as long as foreign sellers are willing to extend us credit. Of course, we must also be willing to buy. In both cases, the willingness is reinforced by (or is a sign of) the “strength” of the dollar. Our currency is strong (that is, attractive to foreigners) because our interest rates are high and our society is large, open and comparatively stable. Thanks to our size, there are a lot of dollars around, and practically all of our foreign sales and purchases and borrowings are in terms of dollars. Therefore, we are the masters of our fate; we (well, the Federal Reserve Board) set the terms of our trade.

Of course, the dollar can lose its strength, too. Indeed, we had a weak dollar not that long ago. This weakness was not of a piece with President Carter‘s alleged wimpishness; it was deliberately induced by President Nixon‘s alleged machismo. A weaker dollar means lower purchases and higher sales abroad, with both consequences producing higher employment and, probably, higher prices at home. No one really knows the extent of the consequences, but they can be handled, for there is very little we absolutely have to buy abroad: bauxite and a few such things that we don’t have, oil and a few such things that we’re too self-indulgent to manage properly, coffee and a few such things that are enjoyable yet hardly necessary. In short, since our national existence is far from dependent on foreign trade, we are not threatened by that part of our foreign indebtedness that is caused by the imbalance on current account.

The next most visible category of our foreign indebtedness consists of foreign purchases of U.S. government bonds (part of the capital account). Federal Reserve Board Chairman Paul A. Volcker considers he purchases important perhaps vital-in financing the Federal deficit. Without them, he argues, much less money would be available and the interest on government bonds would be much higher than it is. Moreover, the government would crowd private industry out of the money market. Businesses unable to afford the high rates would fail; even successful businesses would have to reduce operations-in other words, fire people. The quantity of money, however, is controlled by the Fed itself (at least the Fed thinks it is), making you wonder who is doing what to whom, and why.

In any case, we seem to have some sort of reason to be grateful for foreign purchases of our bonds. It’s pleasant to see that money coming in, but then the interest money has to go out, and the rate has to be high to induce people to buy the bonds. What do foreigners do with the dollars we pay them?

Well, the dollars can be used to buy American goods, whereupon our prices will tend to rise, the dollar will tend to strengthen, and we will have to sell them less for their money. Alternatively, they can use the dollars to buy their own currencies, whereupon the dollar will tend to fall, and we will be able to sell more goods abroad and to import less.

Now, that is very curious: The results are contradictory, yet both are largely favorable. There are two explanations, and I can only hint at them in this space. The first and more obvious one is that very few, if any, economic policies are all good or all bad-an unexampled blessing-and we are here accentuating the positive. The second and more important explanation is that our economy- faulty as it surely is-is more liberal than most of those of the rest of the world. That is to say, in the United States whatever is to the benefit of one class is likely to have some benefit for everybody. It is more nearly true that whatever is good for General Motors is good for America, I am suggesting, than that ours is a zero-sum economy. All workers are consumers and so benefit from low prices, and most consumers are workers and so benefit from high wages. If more American consumers had good jobs it would be better for all of us.

The third most visible category of our foreign debt involves investment in U.S. industries. Foreigners have played our stock exchanges and commodities markets for years. Major chunks of U.S. real estate-New York’s Pan Am building, for example-are foreign owned. Volkswagen had a U.S. assembly plant decades before Toyota and General Motors settled on their new joint venture. Foreign ownership has gone so far in Vermont that the state has now put obstacles in’its way. At first glance all this looks as though we were being colonized by foreigners. Is it really our fate to recapitulate Brazil’s experience?

The significant difference between Brazil and the U.S. is that foreigners invest their own currency in Brazil and take their interest out in their own currency, while their investments and returns in the United States are in United States currency. Foreigners can do with their income from U.S. investments what they do with their interest from U.S. bonds, and the consequences for us are the same. Foreign investment is not bad per se. To the extent that it provides jobs, it is good. To the extent that it produces goods for use in the producing country, it can be good. But to the extent that it is extractive, it is bad (see “The Wages of Exploitation,” NL, August 8-22, 1983).

BRAZIL and the rest of the Third World are choking to death on the rich loans we have fed them because their societies cannot now digest the kinds of investments we have urged on them (see “Starving All the Way from the Bank,” NL, May 6-20, 1985). To dramatize the problem, consider the Democratic Republic of Madagascar, a nation of some 8.7 million souls occupying 226,658 square miles. Suppose the Gallup Poll went into Madagascar and asked the people if they would like to have an automobile. You know they would answer in one voice, “You bet!” Conservatively, there is an abstract Madagascarian demand for 3 million automobiles-enough to support a fully diversified, computerized, robotized industry. Sweden has almost the same population on only 173,665 square miles, and seems to do pretty well in the automobile business. Why shouldn’t Madagascar get cracking?

We could list reasons from here to breakfast, and they would come down to one word (system) and to one fact (a system is not built in a day). The moral is this: Because of our system, international indebtedness does not have the same consequences for us (or for Sweden) as it may have for the Third World.

The heart of our system is us-we the people. I don’t mean that we’re a national resource, as conservatives of good will like Milton Friedman would have it. I mean that we are the nation. We could be a better nation. More of us could participate in the pleasures, the excitements, the excellences that some have discovered or developed. The shame of the Reagan Administration is that it has, at every turn, reinforced exclusion and resisted participation.

When it, too, has passed away, we’ll be left with that mountain of foreign debts. They will still be denominated in dollars and so under our control. This does not assure that we will control them wisely. If the Federal Reserve Board continues to manage the money supply instead of the interest rate (or try to), if our financial markets continue to be absorbed in takeovers and mergers, if our tax laws continue to reward speculation, then it is quite possible that our foreign debts will drain the enterprise out of our system. Britain is only the shell of her former greatness. It could happen here. But the danger is not in our stars, nor is it in indebtedness as such.

The New Leader

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