Tuesday, May 1, 2018

The Old Deal Strikes Back

The economic situation that we face today in America is not a recent creation, nor one of the twentieth century.  Rather it is an ongoing evolution of events and conditions that started long ago but became dominant at the end of the US Civil War, and then accelerated following the First World War, until they climaxed in the crash of 1929.  This was the time of the "old deal", that dominated in the period of 1875 to 1930.  This period saw a number life changing trends that radically changed life in America including: new technology that dramatically increased productivity, the speed up for the movement of people, goods, and information, a rapidly growing population, and the rise of large corporations.

Expansion of the population and the their sphere of control pushed humans into new frontiers so that new opportunities existed for those seeking them.  In the years from 1875, people pushed west in the US at a rapid rate until in 1900 the Interior Department declared the frontier closed.  Globally, this outward expansion continued until about 1930.  The end result of this was that all land, and the resources contained within them, were now claimed as being owned by some person or group, and if anyone else wanted land or resources he or she would have to negotiate with the owners for it.  Nations began imposing restrictions on trade to manage this new order through tariffs, taxes, and price maintenance programs.  Furthermore, Large corporations, cartels, and combines rather than individuals or families came to control most raw materials from 1875 onward.  Patent rights became a more important form of restriction of ownership as the technology based industrial economy expanded. As a result of these effects wealth became more concentrated, and became known as the "gilded age".  Furthermore, a growing class of un-propertied persons emerged without ties to a family farm or business, who had no assets other than their work skills.  These workers, as we'll see, were vulnerable to any downturn in the economy because they had no family farm or shop to fall back on to sustain them with the basic necessities of life until the economy improved.

The growth of corporations and complex organizations came to dominate the economy during this period.  The complicated methods of production of the growing industries required extensive organization, with a myriad of specialized tasks that needed clock-like coordination to meet the ever increasing demands for more productivity.  A new management class evolved to run these enterprises, while the skilled crafts-person saw a shrinking demand for his skills.  Industrialization was overtaking agriculture as the dominant employment of workers leading people away from their farms and into cities where these new jobs were located.

A complex financial system grew up to fund these extensive and complicated enterprises.  This was the time of "orthodox" economics with the reliance on the gold standard, where a dollar was exchangeable for a dollar's worth of gold.  The rise of central banking and private banker control of money during the lead up to WWI characterized this era, which was achieved though their claims that the government should stay out of business, as only business knows what's best for business and the economy.  But, during WWI the governments of the world borrowed from private banks and inflated money, and afterward the banks continued to speculate in the inflated government and private debt and credit, until the crash of 1929 and the collapse of the banking system that followed.  The result was a nation in Depression and a serious loss of confidence in banks and financial institutions. "If private bankers are ever again to posses and control money and credit, it will have to be on some other authority than the mere assumption of their exclusive wisdom respecting the mysteries of finance." [1]

Concentration of ownership, with the primary business unit being the corporation, grew steadily larger in this period.  A key result of these changes was that "An ever increasing wage and salary class of people emerged and became dependent for a livelihood upon the property ownership of control of a relatively small number of people and the business units through which they operated."[2]  No longer did the family farm and the small craftsman and merchant dominate the economy.  Rather, the corporate, industrial and service economy that continues to this day was the new norm.  This was a dramatic change that took people off their family land and into cities where they owned less property and worked for wages to make their living.  In 1870, 54% of people worked in agriculture, while 22% were in industry, and 24% in services.  By 1930, only 23% were in agriculture, 29% in industry, and 48% in services.[3]  Services had come to dominate the economy, but many of these were not considered necessities for existence that would be important during the coming Depression, such as education, recreation, and medical care, and workers in these fields suffered especially in the Depression as a result.

The growth of large corporations was a key aspect of the overall growth of the corporate business organization in the US.  Not only did corporations come to dominate the organization of enterprise overall, but a few, very large corporations emerged that controlled vast, key areas of the economy.  By 1933,  the 200 largest corporations controlled 20% of the economy. and 60% of the physical assets.[4]  These large companies had great control over their industry segments, with the critical ability to set prices without any meaningful competition.  Thus, these large corporations could tune their production to whatever level was needed to maintain profits, even if this meant laying of large segments of their workforce and idling their plants.  This ability to set both prices and production was a key enabler of the Great Depression, as is evidenced by the fact that during the Depression, from 1930 to 1932, the 960 largest corporations had a profit of $4.6B, while the combination of all other corporations had a loss of $12B.[5]  During almost the same period from 1929 to 1932, agriculture, which lacked the pricing power and ability to reduce production that large industrial corporations had, saw their income drop from $12B to $5.3B, while production stayed almost unchanged.[6]  Thus, small corporations, small businesses, and the farmer took an enormous financial hit during the Depression while large corporations remained largely profitable.

The war that ended in 1918 had brought tremendous change to the American industrial base.  Mass production was invented and expanded before the war, but it was during the war that the methods of mass production were applied in a wide variety of industries and came to dominate the American manufacturing processes.  At war's end, these new, efficient methods were not forgotten, rather they were incorporated into the production of consumer goods to usher in the era of "mass production" and "mass consumption" that characterized the modern era.

At the same time, farmers across American were starting to feel the effects of canceled food contracts for the war and the plunging prices of the resulting oversupply.  Many farmers were unable to meet the costs of servicing the loans they had taken out to provide for the expected war need, and now were paying the price.  In the coming years many would lose their farms, and those who kept them were not able to make any money due to low food prices that would last for decades.  The Great Depression had started for American farmers long before it hit Wall St and main street.

The 1920's roared for those on Wall St and in the business community.  Easy credit and speculation led to booming markets and great increases in wealth for those few who were able to participate.

This was still the time of the "old deal" where government played a small part in the economy.  Businesses made most of the decisions about economic and business activities that were undertaken, with little government regulation.  "Orthodox" economics ruled.  The idea that government should take any significant role in the economy was considered heretical. 

But it all came to an end with the crash of 1929, and the Great Depression officially began shortly thereafter.  The negative effects on the economy were quick and severe.  Within a few years real unemployment in America soared above 25%.  Bread lines and men roaming the country looking for work became a common sight.

Businesses could not expand production because of a lack of demand, and instead cut production to maintain profits, which resulted in more unemployed and a further reduction in demand.  This vicious cycle continued into the new administration of Franklin Roosevelt and the beginning of his New Deal policies to thwart the decline and restore the economy to health.

The New Deal was a radical change for the role of the Federal Government in dealing with the economy and finance, and the role government played in the lives of every citizen.  For the first time outside of war, the government played a significant role in the economy.  It hired people directly through its myriad of "alphabet" programs designed to put people back to work immediately and help businesses recover.  It supported and regulated business practices to grow output and reduce unemployment.  It regulated the financial system to prevent the kind of excessive speculation and risk taking that enabled the crash and Depression.  And it provided a system of support, or security, to the population in general to help protect people from events that were outside their control.

Only a few years earlier the programs of the New Deal would have been unthinkable.  But, years of the standard economic "old deal" wisdom: that the economy regulates itself, that business will eventually pick up on its own, and the economy will come back to full strength in the natural course of things, did not have the desired effect of improving the economy, rather the economy kept getting worse year after year.  So, by the time the Roosevelt administration took office the economy was in dire straights, and both businessmen and the general population were willing to let the federal government intervene in the economy in a big way to try to get some kind of improvement going.

By the time the New Deal was fully in place, the economic and financial makeup of the US had been completely transformed.  The federal government was now a major employer both in the direct government business and the multitude of relief programs.  The financial markets were regulated, with the key legislation being the Glass-Steagall act which separated commercial banking from investment banking, brokerage, and insurance.   Labor was strengthened through the National Labor Relations Board, the Fair Labor Standards Act, and empowerment of independent trade unions, which for the first time, gave workers real economic clout to improve their standard of living.  Economic security for workers through unemployment insurance and old-age and disability insurance (Social Security) was implemented.  Extensive spending on infrastructure projects like the TVA and Grand Coulee dam became standard practice.  Some programs were temporary to provide immediate relief and prime the economic pump, including programs such as the CCC and the WPA which would be phased out before WWII.  The income tax, capital gains, and other taxes were used to change the use and distribution of income to favor those who spend and disfavor those who horde.

The depth and length of the Great Depression were a result of the fundamental changes that had happened in the American economy from the end of the Civil War to the start of the Depression.  American had modernized and industrialized with most American working for wages at businesses, and at service occupations in particular, instead of farming the family farm.  Thus, American workers were highly exposed to any downturn in the economy as never before.  When people lived on farms, and a recession hit, they could count on having a roof over their head and food to eat from their own farm, which would allow them to tough it out until the economy recovered.  By 1930, with many workers relying on wages as their only form of income, a recession of any significant magnitude or duration had devastating effects on worker's livelihoods.  Workers lost their homes or were evicted from rentals.  They couldn't feed themselves or their families.  And they also stopped buying other goods and services because they had no money.  This resulted in a further shrinking of demand and further layoff in a vicious cycle the rapidly saw the expansion of the unemployed with no jobs to fill.

The years of depression brought about a new understanding of the modern economy and the place of government, finance, industry, and farms within it.  The fundamental lesson learned was that, given the changes in the economy and the desperation that then ensued during the Great Depression, the federal government must play an active role in the economy to keep it running at its full capacity and moderate the effects of any downturns.  It was also learned that private industry would not risk its profit, or even potential losses, by hiring and spending on capital if no clear demand for goods and services existed, and would layoff workers and close factories if needed to maintain those profits.  Only the federal government had the ability and the authority to make the dramatic incursions into the economy that were required to once again bring it to full capacity.

During the New Deal, the Roosevelt administration experimented with numerous programs to stimulate demand, and hence production and its subsequent hiring, in the economy.  The government even tried something so commonplace today that we hardly think anything novel of it... deficit spending.  But the amounts spent, while sizable, were not sufficient to produce a lasting change on the spending and production levels of industry.  Industry had so much slack capacity, and such a great ability to increase productivity within its existing capacity, that once these stimulus programs had ended, production and employment shrank back to pre-stimulus levels.  What was needed was a huge stimulus that would alter the foundation of production and consumption to a stable, higher level.

The stimulus that brought about this fundamental, foundational change in the economy by the means of government spending was WWII.  The war effort was enormous by any measure and the economy grew and shifted as the country moved the economy to a war footing.  Deficit spending through borrowing was equally enormous, but in the case with war, few objectors could be found to defend fiscal prudence, as was the common objection that impeded similar spending on civilian programs during the Depression.

At war's end the fear of government and business leaders was what would happen to the economy once the war spending subsided and the "boys came home"?  Would the economy slip back into a recession?  These fears turned out to be unfounded as the resulting post-war economy turned out far differently than that predicted by many. Those returning soldiers produced a significant boost to the civilian economy thanks to savings during the war and government programs for vets like education and loan assistance once the war was over when they transitioned back to civilian life.  The home front population had also been saving during the war years, as not much was available to buy anyway due to the shift to war goods production while the federal government was doing most of the buying for the war effort.  All this pent up civilian demand was unleashed at the end of the war, with people eager to buy new homes, cars, clothes, and furnishings that they had gone so long without, and most importantly they had the savings and credit to buy them.  The resulting demand drove production, which of course led to a major hiring boom.

After the war, the international financial system was reorganized by putting into place the Bretton Woods system of currency exchange and settlement.  Under this system all currencies were pegged to the only remaining strong currency, the US dollar.  Critically, for the success of this system, the US dollar was itself pegged to gold, so that the effect was that all currencies were transitively pegged to gold, and gold was used to settle international trade among nations.  The critical nature of gold to this system was that all currencies were tied to a real, physical commodity that had generally recognized value everywhere in the world, and could not be conjured out of thin air.  No country could inflate its currency without suffering a decline in gold reserves to settle the trade deficits that typically resulted from extra currency being available for purchases.  All trade then was equivalent to the offset of values of goods from one nation going out, and from the counterpart nation coming in, plus the settlement of any deficit by transfer of gold.  Thus, goods were effectively bought with gold if no export good could be exchanged in kind.  The result was the happy situation where currencies were closely tied to the real economy of goods and services, and served to facilitate business in the economy, rather than exist as entities unto themselves.

Another key piece of legislation that proved critical to providing stability and soundness to the financial system were the Glass-Steagall rules that separated commercial banking from investment banking, insurance, and real estate.  Commercial banks have the unique and awesome power of creating the nation's money supply through the means of fractional reserve lending.  In fractional reserve banking, loans are produced at an amount of approximately ten times the amount of the reserves, thus expanding the money supply by that same amount.  This ability to create money is a powerful, and potentially disastrous one if mismanaged, that needs to be carefully regulated to prevent any instability in the money system and unethical actions from occurring. Commercial banks were bastions of propriety during the post war period, and only lent against sound collateral like land, buildings, and machinery. Furthermore, the government insurance of deposits through the FDIC and related programs, encouraged people to keep their money in the bank, thus providing for the expanded action of money creating loans.  Investment banks did not have access to the government backed credit and loan created money of the commercial banks under these rules, so they had to actually get investors to risk their own money to make investments, which is what investment banks are for after all.  The result was that the financial system was predominantly sound, and bank failures almost nonexistent during the reign of Glass-Steagall.  The exception was the Savings and Loan crisis period of the 1980s when the Federal Reserve raised the discount rate to stem the rise of inflation, effectively making the S&Ls no longer going concerns, as the interest they had to pay exceeded the interest they could bring in as profits.  We will see that the inflation the Fed was fighting was caused by the undoing of the Bretton-Woods agreement.

The systems of the New Deal now firmly in place, the economy grew at a robust rate for the years from the end of WWII until the early 1970's.  It was a time of immense affluence for a majority of Americans who years earlier could only dream of such comfort and opportunity.  These were the "good old days" that people remember today where the middle class expanded dramatically and poverty dropped year after year.  Where well-paying jobs were available for those who sought them.

A less welcome activity also expanded during these boom years...balance of payments deficits.  At war's end the US was the only major economy left unscarred by the war.  The Axis countries lay in ruin, and only after many years, and with aid from the US, were they able to get their economies back up to a high capacity.  Part of the recovery effort for the Axis, as well as other Allied countries, was to boost trade to quickly regrow their industrial base.  The US was the trade partner for these countries as it had a booming economy with consumers that had large and growing incomes to purchase those trade goods and a large manufacturing base to supply needed goods to the war ravaged economies.  The US ran trade surpluses during these years, but nonetheless ran significant balance of payment deficits due to payments overseas for aid and capital outflows.  The result was that the US balance of payments deficit grew rapidly year after year after the war, but the problem was not immediately acknowledged, as all deficits were settled by covering the deficits with transfers of gold.  In this way the deficits were paid for by exchanging the commodity of gold for the excess expenditures.  For example, in 1960 the government exported $1.689B of gold to cover the balance of payments deficit. [8]

By the early 1970s the US started to run trade deficits as well as other payments, and the balance of payments deficits had become a serious problem for the US, as it was exporting a significant amount of its gold stock each year to cover the deficits and this stock was running low, or at least lower than the US wanted it to be. [9]

The response of the US government to the growing trade deficits and increasing outflow of gold, was... not to deal with it.  Denial is a common government reaction to problems, particularly with ones that are extremely difficult or unpleasant to resolve.  All trade deficits eventually come into balance, as countries want tangible goods or services in exchange for its goods and services, rather than to hold another country's currency.  The only thing that surplus export countries can do with the accumulated foreign currency is spend it in the country from where it came, which in the process of doing, should eliminate the deficits and bring trade back into balance.  But, the deficits were being balanced by the transfer of gold, so this accumulation of currency in surplus countries never happened.  Instead the surplus countries accumulated gold reserves, which they may not really have wanted, but accepted as a form of real value payment anyway as specified under Bretton-Woods.

When the US government finally did respond to what was becoming a crisis, it made a crucial and fundamental mistake. Instead of acknowledging the trade deficit as the problem issue, and taking corrective actions such as imposing the traditional government trade mechanisms of tariffs and quotas, the US government instead decided in August 1971 to remove the US dollar from the Bretton Woods exchange mechanism and let the US dollar float against other currencies.  International currency traders would now be in charge of the value of the US dollar.

The decision to float the dollar had multiple harmful effects.  Some were immediate, and some took place over many years and decades.  Furthermore, the action of withdrawing from the Bretton Woods gold trade settlement system was effectively a default by the US on the exchange of the dollar.  Under Bretton Woods the US would give trade partner countries gold for its dollars, and after it simply didn't.  International demand for dollars dropped and US inflation immediately shot up, with workers feeling the pinch in higher prices but stagnant incomes.  The OPEC oil embargo started shortly thereafter, and many economists and pundits erroneously blamed it for the economic problems.  In reality, the effects of the oil embargo were related only in that the oil exporting countries didn't want to be paid in dollars that were being inflated away.  This marked the high point of American workers participation in the rewards of the growing economy, and since this time wages and incomes of most Americans have been flat, while the economy continues to grow at the brisk pace, if not as fast as during the boom years.

The second harmful and ongoing effect of abandoning Bretton Woods was that the dollar, and other major currencies, were no longer tied to the real economy.  The US dollar became a true fiat currency that could be issued at will.  Or, in the case of the fractional reserve system, borrowed into existence at any opportunity to lend, with any collateral that suited the need, whether actually sound or not.

Lastly, the issue of the trade deficits was swept under the rug.  As stated before, all trade deficits eventually come into balance, either by controlled means like Bretton Woods and government action, or through potentially disruptive means such as a fickle and irrational international market system.  The longer the deficits exist, the more trade debt builds up, and the more likely an uncontrolled and devastating correction will result.  Indeed, the fact that a correction has not happened in the forty plus years since the withdrawal indicates strongly that the market mechanism is inadequate for maintaining a balance of trade over reasonable time periods.

The US government did recognize the threat to the dollar as a result of its conversion to a floating, fiat currency. But, again, instead of dealing with the problem directly to implement a permanent solution, the government once again turned to a trick to keep the demand for the dollar high.  In 1974 the US made a deal with the Saudis to have all purchases of oil priced in dollars.  In exchange, the US would ensure the security of the Saudi regime.  The de-facto effect of this deal was that all oil was priced in dollars and became known as the petro-dollar.   This action had the effect of propping up the dollar as anyone who wanted to buy oil needed to first obtain the necessary amount of dollars to execute the purchase.  The oil producing countries meanwhile started to accrue large amounts of dollars, which they then invested in the US in government bonds and other assets.  The trade deficit and dollar settlement issue were not solved by this trick.  Rather the issues were merely kicked down the road to a future point where the balance of payments and trade debt with the oil producers would become untenable either because they had too accumulated too many dollars to spend or will start to accept other currencies in payment for oil. [18]

The 1980s brought deregulation and "free trade" ideas that dismissed the notion of national industrial and trade policies as being counterproductive.  The effect was that manufactures saw it profitable to export jobs instead of goods, with millions of production jobs and thousands of factories moved overseas.  Any time workers wanted a real raise, their jobs likely went overseas instead, and they were left unemployed.  Incredibly, the US government did nothing to prevent this destruction of the industrial base.  Indeed, the government did all it could to aid and abet this outsourcing of the US economy, as the pundits and economists explained that this is the new economy and all is good, while the notions of the New Deal were quickly becoming a fading memory.  The "old deal" factions were quite pleased with this turn of events as their share of the national income grew faster than it had since before the crash of 1929.  Equally odd, was the lack of a correction of the US dollar exchange rate as all these dollars piled up overseas, the dollar should have dropped in value, making imports more expensive and exports cheaper.  But, somehow this never came to pass, perhaps purely due to the peculiar state of the petrodollar?

The last nail in the coffin for the US economy was the repeal of Glass-Steagall in 1999.  Investment banks wanted to merge with commercial banks and insurers to create "one stop shopping" for financial products. In particular, in 1998 Citicorp, a commercial bank holding company executed a merger with Travelers insurance company to form Citigroup.  The merger was a clear violation of Glass-Steagall, so the Fed issued Citigroup a temporary wavier to allow the company to continue operations.  They promised to keep investment banking from influencing commercial bank operations, but this was soon shown to be not the case.  Inevitably, the government insured deposits and fractionally reserve created currency found its way to less than sound investments.  Even completely speculative financial elements such as novel derivative securities were used as collateral for loans, something that was seen before the crash of 1929.  The leveraged trade and buyout business boomed as "cheap money" abounded on Wall St. where traders and brokers made millions in this new found unregulated, cash rich environment.  On main st. the story was starkly different as more middle class jobs disappeared overseas and put downward pressure on incomes.

Speculation became the driving force in the economy in the 1990s, but a harbinger of future financial catastrophe occurred in the collapse of LTCM, a hedge fund that was highly leveraged to the point where its default would have harmed the entire financial system.  Only a late night bailout organized by the Federal Reserve warded off catastrophe, but no new regulations resulted from this event.

However, some real progress was being made in the economy at this time in the tech sector, where the telecom boom was happening due to deregulation and the Internet economy was being created, but a bubble of irrational exuberance was building in the tech stocks as well.  Outside of Wall St. and the tech sector, the economy was not doing well at all for people.  The federal government budget was also doing well.  So much so, that Fed chairman Alan Greenspan worried that the US would actually pay down the entirety of the national debt and run a surplus [19]. His suggestion was for a tax cut to prevent this from happening with the reason that it may affect the Fed's ability to conduct monetary policy. President G.W. Bush did just that in a series of "Bush tax cuts" that will add $3T to the national debt by 2019 [20].  Paying down the national debt never happened as events intervend as they usually do to cause a increase in the budget deficit and the run up a massive national debt that only increased during the financial crisis of the Great Recession.

The goal of tax cuts at all cost and rationalizations has become a core principle of the "old deal" faction.  Federal programs for the middle class cost money and if the government can be shown to be running massive deficits then an argument is put forth by that faction that the government can't afford these programs as they add to the deficit.  They even go so far as to claim that the federal government will go bankrupt.  A technically impossible feat as all debts are denominated in US dollars and the government controls the supply of dollars.  The worst case scenario is one of hyperinflation as the government prints money to pay debts as did Germany in the 1920s.

The inevitable collapse of the tech sector market in 2001 led the Federal Reserve to take aggressive action to prop up the markets.  Too aggressive we now see, as they pumped hundreds of billions into the financial system by lowering interest rates well below their previous levels.  The result was to inflate another bubble and boom in the housing industry as home prices soared in response to cheap credit.  People don't buy houses, they by monthly payments, so as interest rates fall the principal portion of the monthly payment goes up and with it the home price.  Add to this the mortgage loan fraud called sub-prime "liar loans", and the stage was set for the next  financial crisis.  During the housing boom people were using their homes as ATMs to extract the growing cash value to maintain the life styles that their jobs would no longer support.  During these years the US government also started to run up ever growing perpetual budget deficits because "deficits don't matter" we had been told.  So, now everyone was in hock to the investing class. This, of course, suited this "old deal" factions quite nicely.

Eventually, the housing bubble did burst in 2007, and with it the economy went into recession.  The "Great Recession" had begun. Home prices plunged.  The inflated securities based on home loans also tanked as the underlying value of homes decreased and the realization sunk in that the securities had been insincerely overrated by the private securities rating agencies when they were created.  The banks holding these securities and related leveraged securities were now technically insolvent, including all of the largest Wall St. banks.  The first to go was Lehmann Brothers, which set off a panic on Wall St. not seen since the Great Depression.  Bear Stearns was next.  It couldn't be saved, but a shotgun buyout by JP Morgan Chase was arrange at only pennies on the dollar of its value it had just weeks earlier.  Soon after the Federal government stepped in to bail out the big banks.  The Emergency Economic Stabilization Act of 2008 was rushed through Congress as the first measure to bail out the big banks by providing $700B to acquire preferred stock and troubled mortgages from the ailing banks.  A multitude of other programs by the Federal government and the Federal reserve followed that put the US government on the hook for potentially tens of trillions of dollars of debt risk and raise the Feds balance sheet to a record $4.5 trillion.

Meanwhile, unemployment surged to the highest level since the Great Depression.  Labor force participation rate dropped from over 66% to less than 63% of the population [21], which equates to about 10 million people losing their jobs.  Fortunately, Depression era unemployment insurance helped to ease this blow.  But many never found new jobs and sunk further into other Federal relief programs.  People who had bought homes near the peak of the bubble found themselves underwater with homes worth less than the mortgages owed, causing many to just walk away from the houses.  Many rationalizations for bailing out the banks were floated including that they would start lending again or restructure loans.  None of this came to pass, leading many to ask "where's my bailout?"

The members of the "old deal" did just fine as their stock holding were propped up by cheap Fed money and their bank holdings were bailed out.  For these people, the Great Recession became a once-in-a-lifetime buying opportunity to snap up depressed assets.

Once again, the federal government did little to nothing to correct the policies that led to the crisis.  Indeed, it appears that the federal government has become incapable of addressing events head on and providing the needed regulatory remedies. Instead, the government provides bailouts to the investor class and platitudes the the majority of citizens who see the future for their children as having less than they had.

The government of the New Deal is no more. Will the government return to the lessons of the New Deal to create once again an economy and society that benefits everyone?  That allows all to share in the prosperity and growth of the economy?  Or will the deficits and debts of all kinds continue to climb until while the benefits of these excesses accumulate to the financial sector and continue to leave Main Street behind?



References:
[1] "The old deal and the new", Beard, Charles A., Smith, George H. MacMillian, 1940, p29
[2] "The old deal and the new", Beard, Charles A., Smith, George H. MacMillian, 1940, p36
[3] President's research committee on social trends: "Recent Social Trends in the United States, 1933, Table 6, p.281
[4] National resources committee:"The structure of the American economy", 1939, p.107
[5] Standard Statistics, Co publications for this period
[6] National resources committee:"The structure of the American economy", 1939, p.371 Table III
[7] https://www5.fdic.gov/hsob/HSOBSummaryRpt.asp?BegYear=1934&EndYear=2017&State=1&Header=0
[8] https://fraser.stlouisfed.org/files/docs/publications/frbslreview/rev_stls_196103.pdf 
[9] https://www.census.gov/foreign-trade/statistics/historical/gands.pdf 
[18] https://www.investopedia.com/articles/forex/072915/how-petrodollars-affect-us-dollar.asp 
[19] https://www.federalreserve.gov/boarddocs/testimony/2001/20010125/ 
[20] https://www.cbo.gov/sites/default/files/111th-congress-2009-2010/reports/01-07-outlook.pdf 
[21] https://fred.stlouisfed.org/series/CIVPART



Tuesday, December 6, 2016

Tariffs to Fund Infrastructure, a plan for President-Elect Trump

Donald Trump has made fixing trade a centerpiece of his agenda.  He has repeatedly called to end the practice of outsourcing American jobs to other countries.  He has also repeatedly threatened high tariffs to those companies that do outsource jobs.  Numbers quoted have included a blanket 35% tariff.   A second piece near the center of his agenda is rebuilding American infrastructure, where he has called for $1T investment over the next 10 years.  That infrastructure in the US is badly in need of repair and upgrade is not in question.  He has often spoken of how other countries have shinny new airports, roads, damns, bridges, etc. while those in the US look dilapidated comparison, and few could argue with that. 

Information about how Mr. Trump plans to implement this infrastructure plan have slowly trickled out in the forms of various quotes, briefings, reports, etc.  One of the features appears to be a form of privatizing infrastructure where private companies will pay for the work and then collect a toll or fee for its use.  This is probably not feasible for the majority of infrastructure projects, nor is it advisable in general.  The American people will not likely be in favor of selling off the US Interstate system, all the bridges and tunnels, the water systems in towns, etc.  Doing so is just another short term fix that puts the public in hoc in the future to endless user fee increases.  The problems with the initial idea appear to be so pronounced that Mr. Trump is now said to be reducing the amount to spend on infrastructure to only $550B to appease those in his party who would rebel against any significant deficit spending on infrastructure.

A better solution is to combine these two pieces of the agenda into a single, self-funding package.  Use the funds generated from tariffs on imports to fund the infrastructure projects.  This would provide for the $1T of spending on infrastructure and much more. 

In 2015 the US imported $2.25T of goods (census figures) [1].  If even a 5% average tariff were applied to the import of these goods that would more than cover the suggested spending on infrastructure.  The 5% figure is an average.  Specific tariffs would depend on the particular goods and the source country as the balance of trade with that country will be the main determinant if tariffs are an appropriate mechanism to use in trade policy. 

The US ran up a total deficit of $745B in that year.  With nearly half, $365B, coming from China [2].  No wonder China is Mr. Trump's favorite target in regards to trade agreements.  The US also had a trade deficit of $60.6B with Mexico [3], another of Mr. Trumps trade targets.

As described in previous postings the main purpose of tariffs should be twofold.  First, to balance trade so that long term imbalances don't cause the kinds of dislocations in the economy like we have experienced here in the US for the last few decades causing the kinds of job loss and consequent stagnation or loss of standard of living for many Americans.  The second is to protect high-tech, high-value, and high-wage industries as these yield the highest prosperity for the country.  High-tech industries in particular tend to also be high-value and high-wage industries.  Further, future technology grows on current technology.  So, creating and maintaining a cutting edge, technology environment is key to sustaining and growing a modern economy.

Given the high level of the trade deficit with China a high tariff may be needed to bring this figure into balance.  Indeed, more than balance a trade surplus with China is needed to offset the many years of trade deficit that have accrued.  Perhaps a tariff as high at the 35% tossed around by the Trump team is in order after all with regards to China?  The US imported $483B from China in 2015 and if a 35% tariff was applied that would have yielded $169B from that country alone.

Tariffs could provide a meaningful and ongoing source of funds for the infrastructure projects that the incoming Trump administration proposes.  He should consider linking the two to create a revenue neutral plan that his Republican colleagues can live with.  Perhaps even delaying the implementation of the proposed corporate tax cuts until the tariff and infrastructure issues are settled.


[1] http://www.census.gov/foreign-trade/statistics/historical/goods.pdf
[2] http://www.census.gov/foreign-trade/balance/c5700.html 
[3] http://www.census.gov/foreign-trade/balance/c2010.html

Wednesday, March 9, 2016

A quick thought on a Paul Krugman article

Paul Krugman writes lots of interesting articles and blog posts on economics.  He recently commented on the trade policies of Donald Trump and his critic Mitt Romney.

See: http://www.nytimes.com/2016/03/07/opinion/when-fallacies-collide.html?partner=rss&emc=rss

Dr. Krugman says : "In fact, a worldwide trade war would, by definition, reduce imports by exactly the same amount that it reduces exports."

This property of trade is a bit short on its completeness.  This is simply stating that an export from one country is imported to another country.  Such a tautology is necessary, but hardly helpful in understanding trade.  Unfortunately, this leaves out the balance of trade of a single country, which is what is really important to that country.  The problem is with what is advertised as “trade” actually is is not trade.  Rather, it is a multi-currency purchase and sale system where each country buys from another in its own currency which is then exchanged for a global reserve currency, such as USD, and then exchanged to the seller’s currency.

By this mechanism imports and exports of a country are decoupled.  A country can choose to import and not export by simply making foreign purchases with currency.  Or, in the opposite extreme, a country can choose to export and not import by simply taking foreign currency for its goods.  More likely the trade is nearly balanced, or goes off to one side for a period of time as with the US where it imports more than it exports and has done so for decades.

But, what’s the long term effect of a trade imbalance?  Don’t imports have to equal exports over the long term?  Why would a country continue to sell to another for long periods of time, i.e. many decades, if it only gets foreign currency for its products?  What would happen to a country that maintains a balance of trade deficit for decades?  Wouldn’t trading partner nations simply stop selling to it after some time?  Well, the US may soon be able to answer this question.

So, what is wrong with moving toward a balance of trade by imposing tariffs when trade imbalances exist for long periods of time?  Wouldn’t that have the needed effect of reducing imports to be more in line with exports?


Saturday, February 20, 2016

Increasing inequity impeeds growth and causes deflation

Much has been written and commented on about inequity in recent years.  From the Occupy movement to the current campaign of Bernie Sanders.  Inequity has become a rallying call for many Americans who see the system as not benefiting them, while a few appear to reap all the gains of a growing economy.  Interestingly, no one that I've seen seems to have connected the growth in inequity to slow growth and deflation.  I would be interested in finding others that have examined this issue.

First a few definitions so we agree on what we're discussing.  Growth is the total change rate in real value of production in the economy, and is usually expressed as the change in GDP.  The measure of growth is thus truly economic as the effect of inflation (or deflation) is removed from the value.  Inflation (or deflation) is the change rate in the nominal price of a set basket of goods and services.  So, that the actual goods and services received are the same and the change in the total price is measured.

The increasing nature of inequity that is a driver of slow growth and deflation.  This is tied to long term debt that people have incurred over the previous decades.  This primarily includes mortgages and student loans, but some other debt like auto loans may also contribute.  When these debts were incurred decades ago the distribution of incomes was skewed more toward what we call the middle-class.  Workers in the economy brought home a greater percentage of the GDP compared to the highest earners in the economy.  These are the so called "1%" who's share of GDP has grown significantly over the last few decades as has been documented in many places.

The effect of a higher relative income in past decades is that people took on long term debts with the expectation that their incomes would continue to grow as they had for the previous decades.  When incomes failed to keep rising as they had in the past, i.e. inequity increased, people thought is temporary and took on yet more debt to maintain the life styles to which they had become accustomed.  Eventually, the lack of rising incomes and growing inequity led to an inability to pay the monthly payments on those large debts, and crisis ensued. 

This phenomena of growing inequity continues today with wages growing slowly relative to the economy and long terms debts slowly being paid down to levels that can be supported by the new expectation of future incomes.  These effects are deflationary for two reasons: first, the basket of goods and services that is used to measure inflation are mainly comprised of the very items that these middle-class members consume.  So, perhaps at better label would be "middle-class inflation" for what is measured.  Second, people are paying down their long term debt and have little additional money to spend on these goods and services, so their is little demand pricing pressure to push prices up.  Perhaps if the measures of inflation included more high luxury goods then the reported inflation would be rising at a faster rate that is more inline with the desires of policy makers.  In this case goods such as trendy art, super yachts, and mega-mansions would need to be included in the rate.

Growth suffers for similar reasons.  The distribution of goods and services planned for production still reflects the demands of the middle-class from years ago.  So, with the inability of this class to consume at a higher level with their constrained incomes growth stagnates.  To remedy this situation manufacturers can shift quicker away from producing middle-class goods and services to those that are consumed by the "1%".  Or we can simply wait for deflation to reduce the price of goods for the middle-class to a level where their incomes will allow them to consume more.  The economy is shifting toward a new steady state of lower relative incomes.  Until that new state is achieved the effects will be observed as low growth and deflation (or low inflation).

In any case, it is the lack of demand from middle-class consumers that is limiting both growth and causing deflation (or low inflation).  A shift in incomes from the "1%" back to the middle-class, as was the condition decades ago, will allow the middle-class to consume more.  This will have the twofold effect of raising prices as consumers compete to buy goods and services, thus eliminating deflation, and increasing growth as the increase in demand and subsequently prices will spur manufactures to increase production to satisfy that increasing demand.  This will contribute to a virtuous cycle of increased employment as manufactures hire to increase production which will in turn increase incomes which will in turn increase demand.

Tackling inequity is central to fixing the economy.  Fixing the economy is central to fixing the financial problems.  Changes to Federal government policies is central to both.




Friday, May 22, 2015

Adam Smith on a Progressive Tax

Adam Smith thought about many things in economics, and taxes were an important area of concern.  He discussed quite extensively the kinds of taxes that governments could raise and what effects each would have on the the economic and financial sectors.  He also had opinions on the proportion of taxes that the various segments of society should pay.  In particular what the wealthy should contribute, and he decidely did not agree with the "flat tax" arguments being bandied about in recent years.  From Wealth of Nations:  "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion."[1]  In this instance, Smith is talking about property tax in particular, but it does not take a great leap to see that this sentiment generalizes to all forms of wealth and income.

Smith clearly understood that the wealthy benefit quite extensively from their situation in society, and that contributing a greater fraction that others to taxes would not harm them in the least.  He also appears to suggest that they should contribute more because they can afford to pay more, while greater taxes on people of more modest means would have an adverse effect on their standard of living.  This also suggests that the wealthy should contribute more because they benefit from the system so greatly that they should be willing to do more than others to support and propagate this system.

So, flat taxers take head, Adam Smith is not a supporter!

[1] http://www.gutenberg.org/files/3300/3300-h/3300-h.htm

Monday, December 22, 2014

Oh, USA regarding China, your sincerity is incredible

We are endlessly barraged by comments from lawmakers, pundits, the press, etc. about the problem of the rise of China's economic and military might.  They seem to think that this happened in a vacuum, and is now just appearing without warning.  One wonders where they have been since Nixon's trip?  Could this be one of the most incredible feats of insincere lamenting in history?  Perhaps these same folks haven't noticed that it has been US policy for decades to build up China's technological might by transferring US education, US advanced technology, and US manufacturing companies to China.  How else do they explain the rise of China?

When Nixon visited China in 1972 the economy was that of a large but an unremarkable undeveloped nation with a second rate military.  But, his visit started the opening of trade for which US companies were clamoring.  The mere thought of a billion new consumers and low cost workers must have driven financiers and corporate managers to a frenzy!  They, of course, wasted no time in taking advantage of this new opportunity.  The following decades saw the transfer of thousands of US manufacturing businesses to China, along with their jobs, and just as importantly their technology.  This has likely been the greatest completely voluntary surrender of economic and sovereign capability in history.

The Chinese played this game for all its worth.  They insisted on the transfer of valuable technology in exchange for the right to open manufacturing operations in China.  They also insisted on the formation of joint ventures with Chinese companies in these transferred operations so that Chinese managers and support professional services would rise with the manufacturing capability.  The Chinese, unlike their US counterparts, were working with the goal of increasing the capabilities of the Chinese nation and people.  China sees a greater, endless China as the goal.  US leaders seem to have forgotten about the US as a sovereign, self sufficient nation as the founders had envisioned.  Indeed, given their manifest lack of concern for the future of the US, one wonders who are they working for?

So, now that China has set up advanced universities to teach the next generation state of the art technology and management, built up a modern infrastructure that is the envy of the world, established a broad industrial base, and secured access to a vast amount of world resources, why would anyone be surprised that they take the next obvious step and enhance their military might and presence in the world?  This certainly was inevitable to anyone who wasn't sleeping.

Perhaps this serves a purpose in itself?  China is the new bogeyman for the US to raise the alarm over.  Thus, the US military must rotate to the Pacific to protect US interests in the region from the US created Chinese military.

Perhaps the folks who press this agenda don't see a powerful China as a problem at all?  In spite of saber rattling over disputed islands, and aircraft incursions and encounters, the Alibaba IPO went off without a hitch on the US stock market.  An amazing occurrence if one thinks about this a bit.  Why would a Chinese company want to list on a US market?  Doesn't China have a market?  Doesn't Alibaba need funds in Chinese Renminbi to pay its Chinese workers and debts?  Currencies are now completely exchangeable and fungible in other currencies.  Its like having one world currency where there are no actual sovereign nations ;)

Apparently, as long as the business continues unimpeded and finananciers and corporate managers are making big profits, the effects of manufacturing and job loss, massive trade deficits, and military adventures are mere annoyances and distractions.  So, leaders and pundits, let's stop the lamenting and congratulate each other on "job well done!"  All goals were accomplished, so shouldn't you be celebrating?



Monday, July 7, 2014

What's changed since the start of the financial crisis?

It's been seven years since the start of the financial crisis (an estimate of course as the actual start dates of these kinds of things are always a bit subjective).  We'll take the start of the crisis as being in August 2007 "when BNP Paribas terminated withdrawals from three hedge funds citing "a complete evaporation of liquidity"[1].

What has changed?  For the better?  For the worse?  Or not at all?

US National Debt:  This certainly has gotten worse.  In August 2007 it stood at:$8.9trillion but by June 2014 it had ballooned to: $17.5trillion [2].  That's almost double the amount in only seven years!  So, what did Uncle Sam spend our money on during that period?  Well, a big part of it turns out to be bailing out the banks.  As of 2011 the total amount of funds disbursed by the government to the banks was: $4.76trillion [3].  Most of the rest was due to continued government spending during a time of economic depression that lowered tax receipts.  In essence the government was hit with a double whammy by the crisis in that it had to keep spending through running deficits and it chose to bail out the major banks which were almost certainly going to otherwise fail.

Labor:  No improvement here.  Participation rate is still headed down, and the employment/population ratio which plunged during the official recession period has hardly budged at all  [4].
So, all those folks who lost their jobs don't appear to be back in the labor force.  Of course, that's only a problem for these folks if they say its a problem.  If they took early retirement or are happy to be out of the labor force then this is OK.  But, I suspect that many in this group are out of work involuntarily and would like to get a good job.  For these folks the depression continues.  In May 2014, 3.4 million were long-term unemployed and 7.3 million were involuntarily part-time employed [9]. Fortunately for the national debt, the wise people in Washington decided to end the long term unemployment benefits for many of these non-workers.  Not so good if you're on the receiving side.

Stock Market:  The S&P 500 was $1433.06 on July 30, 2007 and is trading around $1977 as of this writing on 7/1/2014.  The bailouts certainly helped the markets, particularly since the S&P500 hit a low of $683 after the crisis began.

Regulation: The main government regulatory response to the crisis was the passage of the Dodd-Frank Act which imposed some minor requirements on banks.  In addition, greater capital requirements were imposed on banks, a designation of "systematically important" was created for the biggest banks, and some form of plan for an orderly liquidation was to be created for these banks [5].  But the overall response was quite limited given the enormity of the crisis.  Nothing on the scale of the response to the Great Depression was even under consideration.  No "Pecora Commission" was created to properly investigate the causes of the crisis.  Few were brought to account for their actions.  In other words, other than an increased requirement for reserve capital, banks could pretty much go back to what they were doing before the crisis.  Though their actions will certainly come under greater scrutiny than before, and their apatite for risk is slightly diminished, at least until they can find ways of once again shifting the risk to other parties.

Trade: Once seemingly bright spot in this is that the trade deficit dropped from the pre-crisis level of $-705billion in 2007 to a low of $-383billion in 2009 and was $-476billion in 2013. Interestingly, exports actually grew over this period, with the exception of one year, from $1.65trillion in 2007 to $2.28trillion in 2013.  Total trade has expanded dramatically from $4.0trillion in 2007 to $5.0trillion in 2013[7].  So, the crisis has been good for trade.

Housing: As usual, Bill McBride has collected some great data and created some useful graphs.  The Core Logic Housing Price Index peaked at around 200 in 2006 before the crisis began, or perhaps a better description is that it is part of what tripped the crisis release mechanism, bottomed in 2011 to 2012, but has been moving up for the last several years. 
Is this good or bad?  Well, depends on which side you're on.  If you are a homeowner with a big mortgage or a seller then this is good, if you're a buyer then this is bad.  More importantly is the "rentier" aspect of home prices.  That is, what fraction of the price represents actual construction costs, and what fraction represents aspects of speculation?  That is, the price of the land and price of older buildings?  A market that is good for homeowners is one where the land is essentially free and the price of the house almost entirely represents construction costs.  The fraction of home price that is land rose from 32% in 1984 to 50% in 2006 [10], a clear indication of the speculative boom in housing, and incidentally, evidence that the Fed was quite aware of this.

Once significant improvement in the housing market is the fraction of mortgages that are seriously delinquent has dropped dramatically from the high in early 2010 and continues downward.  A simple extrapolation shows that by the beginning of 2016 this rate should be back to pre-crisis levels.  This is an indication that homeowners are getting their finances back into order.


What does this mean for the future?  What's there to prevent another crisis?  The supporters of current policies believe that the added regulation and reserve requirements are sufficient to prevent another catastrophe like the crisis we're still digging out from.  I'm less sure as many of the same risky behaviors that caused the crisis are now rearing their ugly heads once again [8].  The rules of the game determine the play.  And the rules of this game have shifted dramatically over the last few decades to allow risky financial behavior by banks, businesses, and consumers that previously was considered unacceptable.  The inevitable outcome is the ongoing financial crisis.  A return to the regulations and policies which led to decades of growth and stability is a prudent action for the future of the nation.


[1] https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010
[2] http://www.treasurydirect.gov/NP/debt/current
[3] http://www.sourcewatch.org/index.php?title=Total_Wall_Street_Bailout_Cost
[4] http://data.bls.gov/pdq/SurveyOutputServlet
[5] http://www.ritholtz.com/blog/2012/05/regulatory-reform-since-the-financial-crisis/
[6] https://en.wikipedia.org/wiki/Pecora_Commission
[7] See table on: http://bea.gov/newsreleases/international/trade/tradnewsrelease.htm
[8] http://www.nytimes.com/2013/04/19/business/banks-revive-risky-loans-and-mortgages.html?pagewanted=all&_r=0
[9] http://www.bls.gov/news.release/empsit.nr0.htm
[10] http://www.federalreserve.gov/pubs/feds/2006/200625/200625pap.pdf