DRI-310 for week of 9-15-13: What is Wrong with President Obama’s Claim that the Government Rescued the American Economy?

An Access Advertising EconBrief:

What is Wrong with President Obama’s Claim that the Government Rescued the American Economy?

This week marked the unofficial five-year anniversary of the 2008 Financial Crisis, inaugurated by the bankruptcy of Lehman Brothers on September 15, 2008. In the world of politics and news media, disasters are celebrated as religiously as triumphs and advances. President Barack Obama delivered a solemn recapitulation of the Crisis and his administration’s actions over the ensuing five years. The President’s use of rhetoric has built a solid constituency that has swept him into the White House twice. A full understanding of economics allows us to understand why his actions (and his justifications for them) have been so popular, why his explanation of events is wrong and what the true nature of the Crisis was (and is).

The ICU Metaphor: Government as Emergency Physician, the Economy as Critically Ill Patient

President Obama described his primary duty as “making sure we recover from the worst economic crisis of our lifetimes.” By implying a crisis from which recovery is problematic, the President draws a clear analogy with emergency medicine. A patient faces a medical crisis; the doctor’s overriding goal is recovery; failure will result in death. Although the President mixes this metaphor several times, the basic structure of life-or-death emergency and problematic outcome is preserved.

In a medical emergency, a series of catastrophic events creates a crisis. This is the format in which President Obama recounted the economic history of the past five years. It was “five years ago this week that the financial crisis rocked Wall Street and sent an economy already in recession into a tailspin.” “…Some of the largest investment banks in the world failed; stocks markets plunged; banks stopped lending to families and small businesses.” And, hearkening explicitly to the medical metaphor, “the auto industry – the heart beat of American manufacturing – was flat-lining…By the time I took the oath of office, the economy was shrinking by an annual rate of more than 8 percent. Our businesses were shedding 800,000 jobs each month. It was a perfect storm that would rob millions of Americans of jobs and homes and savings that they had worked a lifetime to build. And it laid bare the long erosion of a middle class that, for more than a decade, has had to work harder and harder to keep up.”

In a hospital ER, a worst-case scenario will compel doctors to invoke the protocol known as “Code Blue,” a crash program to restore vital signs in the face of complete collapse. This was the Obama administration analogue: The federal government had to “…act…quickly through the Recovery Act” to “arrest the downward spiral” and “put a floor under the fall” by “put[ting] people to work…teachers in our classrooms, first responders on the streets.” The government “helped responsible homeowners modify their mortgages” and “jump-start[ed] the flow of credit.” Thanks to these and other measures, the President concluded triumphantly, “we saved the auto industry.”

Once the emergency has been met and the patient is out of immediate danger, doctors can then proceed with the process of rehabilitation. This may involve a hospital stay of short or long duration or possibly a trip to an outpatient facility and extended therapy. President Obama outlines his analogue of the American economy’s recovery after he saved it: The Obama administration “pushed back against the trends that have been battering the middle class… took on the broken health-care system…invested in new technologies… put in place new rules that we need to finalize before the end of the year, by the way, to make sure the job is done… and …locked in tax cuts for 98% of Americans.” All this was accomplished in exchange for “ask[ing] those at the top to pay a little more.”

How is the patient progressing, five years on? What is the economic prognosis? “So, if you add it all up, our businesses have added 7.5 million new jobs [over the last 3.5 years]” and “the unemployment rate has come down.” The housing market is “healing.” Financial markets are “safer.” Today, we “sell more goods made in America to the rest of the world than ever before… generate more renewable energy than ever before…produce more natural gas than anybody.” Why, “just two weeks from now, Americans [are] finally going to have a chance to buy quality, affordable health care on the private marketplace… we’ve cleared away the rubble from the financial crisis [and] begun to lay the foundation for economic growth and prosperity.”

In true doctorly fashion, the President issued some caveats. It seems that the “top 1% of Americans took home 20% of the nation’s income last year…most of the gains have gone to the top one-tenth of 1%.” Congress should be focused on issues such as “How do we grow the economy faster? How do we create better jobs? How do we increase wages and incomes; how do we increase opportunity… how do we create retirement security….” Government, of course, will have to make “the investments necessary” to achieve all these goals. Government will assume “the critical role in making sure we have an education system …for a global economy.” Congress will enable all this via the budget it passes – provided the quixotic Republicans don’t gum up the works with their monomaniacal insistence on “cuts” to trim the budget deficit. How can they say this when “the deficits are falling faster than at any time since before I was born”?

The Facts are Secondary

It would be easy to get hung up on the facts of President Obama’s “medical report.” Here and there he departs from metaphor to into boldfaced, bald-faced lie. Obama’s bland claim that “we saved the auto industry” doesn’t survive even a fast glance, unless the Ford Motor Company was exiled from the industry by a FISA court in the last five years. Ford didn’t receive any government subsidies, whereas General Motors and Chrysler each got a full-monte bailout makeover. It was telling that the former Big 3 all downsized to broadly similar degrees. In other words, they really underwent a reorganization process even though two of them were spared formal bankruptcy. Now, their lean, mean status has put them back on the front pages of business sections and spawned banner headlines reporting land-office sales of new models. The “salvation” of the auto industry can be ascribed to Ford’s refusal to be bailed out and the successful reorganization of the Big 2.

The President’s dire recollection of the imminent doom of investment banking is droll considering his unrelenting class-warfare assaults on Wall Street, the 1% and bankers generally. Ironically, the big banks who received bailouts were doing little investment banking at the time and are doing even less today. Moreover, neither Bear Stearns (whose failure was masked by its sale) nor Lehman Brothers qualify as among the biggest investment banks, so it is not clear which mega-bank failures the President is referring to.

These are mere quibbles, though, compared to the major point at issue, which is the fundamental basis of President Obama’s rhetoric. To what extent is his medical metaphor rooted in analytical reality?

The Utter Poverty of the ICU Analogy

It is likely that most of the President’s audience did not parse his metaphor as thoroughly as we are about to do. But they instinctively grasped that he was speaking figuratively. They probably experienced a déjà vu feeling of urgency, reminiscent of September, 2008 – a sense that something bad was happening and that something needed to be done quickly to stop it before the world fell apart. How apt was the President’s metaphor; how accurately did it depict the concrete economic reality? Was it true to reality or was it merely the language of political theater, intended to push the emotional buttons of his audience and achieve the desired effect?

The analogy between a modern economy – consisting of hundreds of millions of interacting individuals, and one single patient – suffering a critical illness and facing death – is very bad. There is little or no commonality between the two.

The patient is a single, holistic entity. The economy is an abstraction, made up of many millions of such entities. The patient’s existence is threatened. The economy’s existence is not threatened by a financial crisis, despite the apocalyptic language tossed about indiscriminately by the President. (To be sure, President Obama is only following the example set by Treasury Secretary O’Neill, who spoke darkly of “fac[ing] the abyss” and falsely warned Congress that unthinkable horrors would follow a failure to pass immediate bailout legislation.) The U.S. and every other advanced industrial nation have faced financial crises periodically since the 19th century. No nation has ceased to exist as a result of such a crisis. Indeed, as a first approximation, the individuals within the nation are not threatened with extinction by a financial crisis either, although many people may face a diminution in their standard of living.

A single patient is saved by doctors who utilize resources that originate outside the patient; e.g., outside his or her body. These include medicines, blood for transfusions, glucose and other basic forms of stabilizing fluids and numerous other forms of extraneous assistance ranging from diagnostic tools to organs for transplantation. A government instituting a “recovery program” – whether a Code Blue-type of emergency-bailout plan or intermediate assistance such as Fed Chairman Bernanke’s quantitative-assistance scheme or a longer term program for economic growth – can only use resources that originate inside the economy itself. The resources must come from somewhere and no government has the power to spontaneously generate resources out of thin air. Even money that is borrowed from foreign sources must be paid for by repaying principal and interest and in other ways as well. (A country that enjoys the privilege of “seigniorage” because its money is a “vehicle currency” held for transactions and investment purposes by foreigners may perhaps evade repayment longer than would normally be the case.) Really, “the economy” can be conceived in global terms, since the bailouts were a transnational operation on both sides.

Consider how hampered ER doctors would be if they had to rely on only the patient’s own resources and reserves of strength in fighting emergency illness or injury. Well, that is a fair analogy of the constraints governments face in “rescuing” their citizens from financial crises. Actually, that only begins to describe the limitations of government corrective action. Doctors can learn tremendous amounts about their patients via diagnostic tools like X-rays and cat scans and blood tests. But the information governments would have to know in order to “rescue” an economy is widely dispersed in fragmentary form among hundreds of millions of people. Not only that, much of that information is subjective and wouldn’t be useful to anybody except the particular individuals that possess it.

Doctors can rely on the patient’s help because the patient wants to live. The emergency efforts exerted by the hospital staff often succeed because they are a voluntary cooperative enterprise in which the patient fully cooperates. Governments operate on the basis of coercion and compulsion. This is necessary because governments can acquire resources to help some people only by taking resources away from other people. Coercion is a shaky basis for production and maintenance. If it were a superior form of economic endeavor, the totalitarian dictatorships of the 19th and 20th centuries would have been history’s great success stories. Instead, they were tragic, ghastly failures. The resistance to the bailouts of the big banks is only one of the pushbacks suffered by the federal government’s rescue program. The Fed’s Zero Interest-Rate Program (ZIRP) left millions of elderly Americans adrift without a suitable income-producing vehicle, given the artificially low interest rates imposed on fixed-income investments by the government policy. This population has become highly restive, not to say mutinous. Millions of Americans have left the labor force because the extension of unemployment benefits has made idleness more attractive than work – and because government regulation of the labor market has simply made job creation too costly and dangerous to businesses. These are all cases in which Americans oppose a program ostensibly designed to rescue them from economic emergency and privation.

This highlights the overarching dissonance in the Obama ICU analogy. Treating the economy as a single organic unity fulfills the old socialist dream originally enunciated by the French philosopher Saint-Simon, who declared that a nation should be run as though it were one single huge factory. The pretense that there really is a “nation as a whole” rather than a reality consisting of 312 million individuals allows governments to enact dreadful economic policies like the Economic Recovery Act. Pumping money into an amorphous entity called “the economy” ignores the individual interactions and logical connections that make up a functioning economy. We cannot even draw a useful analogy between the warring organisms within the human body and claim that government is helping the “good” organisms (e.g., people) against the “bad” ones for the good of the “whole body” (e.g., the nation). Doctors know how to separate good from bad organisms for the survival of a single patient; governments have no objective basis for transferring real income from some people to others for the good of the nation.

The Real Nature of Economic Crisis, Financial or Otherwise

Finance differs from non-monetary economic theory in dealing with the allocation of resources over time rather than at a single (hypothetical) point in time.  Thus, complicating topics such as saving, borrowing, interest rates and debt intrude on the analysis. A financial crisis occurs when a gross mismatch between the saving/investing and borrowing/lending desires of the public places financial institutions and mechanisms in jeopardy of failure. The only cure for the crisis is realignment between the value of goods people are willing to commit to future consumption and the value of goods producers commit to make available in the future. Proper alignment implies that the interest rates established in the markets for loanable funds equalize the amounts of borrowing people want to do for each future term to maturity with the amounts of money available for lending in the future. Sooner or later, there is no substitute for this curative process. When values are once again realigned, the resulting pattern of resources will require that businesses wrongly created and jobs formerly occupied due to the crisis will no longer exist. Once again, there is no substitute for this corrective process.

The U.S. has suffered recurrent financial crises throughout its history. Each financial crisis had one thing in common with all others. They all ended. The first financial crisis was in 1807. Another one – a big one – followed in 1837.The biggest one of all may have been in 1873. But none of them went on forever and none of them caused the death of the U.S. economy – whatever that might be interpreted to mean.

Keynesian economics was neither a necessary not a sufficient condition for recovery from a financial crisis. It was not necessary because Keynesian economics was not invented until 1936; numerous financial crises had come and gone by that time. It was not sufficient because the U.S. economy suffered financial crises after the invention of Keynesian economics that were unaffected, even worsened, by the implementation of Keynesian policies.

Bailouts of big banks were no more necessary than were the bailouts of GM and Chrysler. (Once again, blame should go primarily to the architects of these measures, Treasury Secretary O’Neill and Fed Chairman Bernanke – but the policies were wholeheartedly supported by President Obama.) These measures are often supported even by many so-called free-marketers, some of whom cite Nobel Laureate Milton Friedman’s claim that widespread bank failures triggered a massive decline in the money supply that caused the Great Depression. As an explanation of the Depression, Friedman’s view is misleading at best, but even if accepted it does not remotely justify bank bailouts. Friedman was famous for insisting that the Fed could, and should, have increased the money supply to counter the reverse-money-multiplier effects of the bank failures. His famous quip that the Fed could even drop money from helicopters if necessary illustrated his view that the Fed had countless ways to get money into the hands of the public. Bailing out banks – the realization of moral hazard under fractional-reserve banking regulation – has nothing to do with increasing the money supply. That is exactly what Ben Bernanke proceeded to prove with his program of quantitative easing. By creating money hand over fist after the banks had already been bailed out, Bernanke was closing the barn door after allowing the animals to escape!

Citations of Milton Friedman as authority for the bank bailouts by Ben Bernanke and other left-wing economists are an example of what the Soviet KGB used to call “disinformation” and what magicians refer to as “misdirection.” They are designed to confuse and mislead an opponent by presenting a false trail of reasoning and evidence.

The Real Threat to Life and Limb Posed by Economic Crisis

The only form of economic crisis that can, and has, threatened life and limb throughout human history is a monetary crisis. Only a monetary crisis can overturn the entire basis for trade or exchange, making it impossible or prohibitively difficult for people to exchange goods and services. This poses an immediate threat to life and limb because almost everybody specializes rather narrowly in their production. Specialization increases productivity and increases real incomes – provided people are able to exchange the fruits of their productive specialty for the consumption goods they love. But if and when they cannot do this, specialization turns into a nightmare. People cannot acquire the goods and services they know and love. At best, this is an incredible nuisance. At worst, it is a clear and present danger to life and limb.

Technically, it is true that an economy – or, more properly, a nation – will eventually recover from a monetary crisis, too. But prior to recovery, famine, pestilence and death may visit the nation beset by crisis. Ancient Rome was one nation felled by monetary crisis; the crisis not only caused havoc but weakened the Republic so much that it could no longer fight off its enemies. In Germany’s WeimarRepublic; the chaos caused by hyperinflation put the public’s sole focus on day-to-day survival. This completely delegitimized the democratic government and paved the way for Hitler. His authoritarian rule was seen as preferable to the ineffectual efforts of socialists who could no longer fulfill the promises of security that had won them election.

More recently, we have witnessed the devastating effects in such places as Zimbabwe, where hyperinflation was the last refuge of the scoundrel, Mugabe. The failure of investment projects financed by foreign loans, coupled with land-redistribution policies that dispossessed capable farming operations, had decimated the productive capacity of Zimbabwe’s economy. Unemployment reportedly approached 80%. To finance his administration’s regional wars and pay the government’s bills, President Mugabe permitted money creation on a scale not seen since the Weimar inflation. As we would expect, the result was the disintegration of trade and a retreat into dictatorship, subsistence, barter.

Thus, monetary collapse – not financial crisis – is the only real economic approximation to the emergency-threat-of-death metaphor rhetorically brandished by President Obama.

This is a sobering thought, since it suggests that America does, after all, face a potentially life-threatening menace in its not-too-distant future. It is the threat of hyperinflation and monetary collapse presented by the $4 trillion in excess reserves sitting on the accounts of American banks. This money is currently receiving interest, thanks to the change in policy allowing interest to be paid on excess reserve accounts. Should that status change, though, the money might be loaned out to businesses and promptly spent. This large volume of money chasing domestic goods would bid up prices with alacrity. The resulting hyperinflation would jeopardize the value of U.S. money. That is a disaster waiting to happen.

The threat is not in our past. It lies ahead of us, in our future. President Obama’s policies did not save us from it. Rather, they now threaten us with it.

Should we temper this conclusion with the reminder that the unprecedented money creation of the last few years is the work of the Federal Reserve and its Chairman, Ben Bernanke? Is the President exempt from criticism owing to the Fed’s independence from political influence and control?

President Obama has not moved to replace Bernanke. The President has not even expressed disapproval of the Fed Chairman’s policies. And the current favorite to succeed Bernanke early next year, Janet Yellen, is widely considered to favor even looser monetary policy than Bernanke, if such a thing can be imagined. Presumably, if President Obama disapproved, he could find another Fed Chairman. So far, there is no indication that he will do that.

Rhetoric Matters

The problem with President Obama’s recounting of events during and since the Financial Crisis of 2008 is not his errors of fact, glaring though they are. His rhetoric is built upon a superficially attractive but utterly wrongheaded metaphor – Obama Administration policies as ICU measures taken to rescue an economy that is likened to a critically ill patient. The metaphor leads directly to the wrong diagnosis of the Crisis and the wrong medicine for the patients, who are 315 million individuals rather than indistinguishable parts of one gigantic whole.

DRI-332 for week of 6-16-13: What Lies Ahead for Us?

An Access Advertising EconBrief:

What Lies Ahead for Us?

Last month, Federal Reserve Chairman Ben Bernanke announced that the Fed Open Market Committee is contemplating an end to the $85 billion program of bond purchases that has been dubbed “Quantitative Easing (QE).” The announcement was hedged over with assurances that the denouement would come only gradually, when the Fed was satisfied that general economic conditions had improved sufficiently to make QE unnecessary. Nonetheless, the announcement produced a flurry of speculation about the eventual date and timing of the Fed’s exit.

The Fed’s monetary policy since the financial crisis of 2008 and the stimulus package of 2009 is unique in U.S. economic history. Indeed, its repercussions have resounded throughout the world. Its motives and means are both poorly understood and hotly debated. Shedding light on these matters will help us face the future. A question-and-answer format seems appropriate to reflect the mood of uncertainty, anxiety and fear that pervades today’s climate.

What was the motivation for QE, anyway?

The stated motivation was to provide economic stimulus. The nature of the stimulus was ambiguously defined. Sometimes it was to increase the rate of inflation, which was supposedly too low. Sometimes it was to stimulate investment by holding interest rates low. The idea here was that, since the Fed was buying bonds issued by the Treasury, the Fed could take advantage of the inverse relationship between a bond’s price and its yield to maturity by bidding up T-bond prices, which automatically has the effect of bidding down their yields. Because $85 billion worth of Treasury bonds comprise such a large quarterly chunk of the overall bond market, this will depress bond yields for quite a while after the T-bond auction. Finally, the last stimulative feature of the policy was ostensibly to indirectly stimulate purchase of stocks by driving down the yields on fixed-income assets like bonds. With nowhere to go except stocks, investors would bid up stock prices, thus increasing the net worth of equity investors, who comprise some 40-50% of the population.

How was driving up stock prices supposed to stimulate the economy?

The ostensible idea was to make a large segment of Americans feel wealthier. This should cause them to spend more money. This sizable increase in overall expenditures should cause secondary increases in income and employment through the economic process known as the “multiplier effect.” This would end the recession by reducing unemployment and luring Americans back into the labor force.

How did the plan work out?

Inflation didn’t increase much, if at all. Neither did investment, particularly when viewed in net terms that exclude investments to replace deteriorated capital stock. Stock prices certainly rose, although the consumption increases that followed have remained modest.

So the plan was a failure?

That would be a reasonable assessment if, and only if, the stated goal(s) of QE was (were) the real goal(s). But that wasn’t true; the real goal QE was to reinforce and magnify the Fed’s overall “zero interest-rate policy,” called ZIRP for short. As long as it accomplished that goal, any economic stimulus produced was a bonus. And on that score, QE succeeded very well indeed. That is why it was extended and why the Fed is stretching it out as long as it can.

Wait a minute – I thought you just said that even though interest rates have remained low, investment has not increased. Why, then, is the Fed so hot to keep interest rates low? I always heard that the whole idea behind Fed policies to peg interest rates at low levels was to stimulate investment. Why is the Fed busting our chops to follow this policy when it isn’t working?

You heard right. That was, and still is, the simple Keynesian model taught to freshman and sophomore economics students in college. The problem is that it never did work particularly well and now works worse than ever. In fact, that policy is actually the proximate cause of the business cycle as we have traditionally known it.

But even though the Fed gives lip service to this outdated textbook concept, the real reason it wants to keep interest rates low is financial. If the Fed allowed interest rates to rise – as they would certainly do if allowed to find their own level in a free capital market – the rise in market interest rates would force the federal government to finance its gargantuan current and future budget deficits by selling bonds that paid much higher interest rates to bondholders. And that would drive the percentage of the federal government budget devoted to interest payments through the roof. Little would be left for the other spending that funds big government as we know it – the many cabinet departments and myriad regulatory and welfare agencies.

Even if you don’t find this argument compelling – and you can bet it compels anybody who gets a paycheck from the federal government – it should be obvious to everybody that the Fed isn’t really trying that hard to apply traditional stimulative monetary policy. After all, stimulative monetary policy works by putting money in public hands – allowing banks to make loans and consumer spending to magnify the multiplier effects of the loan expenditures. But Bernanke lobbied for a change in the law that allowed the Fed to pay interest to banks on their excess reserves.  When the Fed enforces ZIRP by buying bonds in the secondary market, it pays banks for them by crediting the banks’ reserve accounts at the Fed. The interest payments mean that the banks don’t have to risk making loans with that money; they can just hold it in excess reserves and earn easy profits. This is the reason why the Fed’s money creation has not caused runaway inflation, as government money creation always did in the past. You can’t have all or most prices rising at once unless the newly created money is actually chasing goods and services, which is not happening here.

But the mere fact that hyperinflation hasn’t struck doesn’t mean that the all-clear has been sounded. And it doesn’t mean that we’re not being gored by the horns of a debt dilemma. We certainly are.

Being gored in the bowels of a storm cellar is a pretty uncomfortable metaphor. You make it sound as though we have reached a critical economic crisis point.

We have. Every well-known civilizational collapse and revolution, from ancient Rome to the present day, has experienced a financial crisis resembling ours. The formula is familiar. The government has overspent and resorted to money creation as a desperate expedient to finance itself. This has papered over the problem but ended up making things even worse. For example, the French support for the American colonies against Great Britain was the straw that broke the bank of their monarchy, fomenting the French Revolution. The Romanovs downfall occurred despite Russia’s increasing rate of economic growth in the late 1800s and because of financial profligacy and war – two causes that should be familiar to us.

It sounds as though government can no longer use the tools of fiscal and monetary policy to stimulate the economy.

It never could. After all, the advent of Keynesian economics after 1950 did not usher in unprecedented, uninterrupted world prosperity. We had recessions and depressions before Keynes wrote his General Theory in 1936 and have had them since then, too. And Keynes’s conclusions were anticipated by other economists, such as the American economists Foster and Catchings in the late 1920s. F.A. Hayek wrote a lengthy article refuting their arguments in 1927 and he later opposed Keynes throughout the 1930s and thereafter. The principles of his business-cycle theory were never better illustrated than by real-world events during the run-up to the recession and financial crisis in 2007-2008 and the later stimulus, ZIRP and QE.

It seems amazing, but Keynesian economists today justify government policies by claiming that the alternative would have been worse and by claiming responsibility for anything good that happens. Actually, the real force at work was described by the Chairman of Great Britain’s Bank of England, Mervyn King, in the central bank’s February Inflation Report:

“We must recognize [sic], however, that there are limits to what can be achieved via general monetary stimulus – in any form – on its own. Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required.”

King’s characterization of transferring spending or borrowing from the future accurately describes the effects of textbook Keynesian economics and the new variant spawned by the Bernanke Fed. Keynesians themselves advertised the advantage of fiscal policy as the fact that government spending spends 100% of every available dollar, while private consumers allow part of the same dollar to leak into savings. This dovetails exactly with King’s account. The artificially low interest rates created by monetary policy have the same effect of turning saving into current consumption.

Today, we are experiencing a grotesque, nightmarish version of Keynesian economics. Ordinarily, artificially low interest rates would stimulate excessive investment – or rather, would drive investment capital into longer-maturing projects that later prove unprofitable, like the flood of money directed toward housing and real-estate investment in the first decade of this century. But our current interest rates are so absurdly low, so palpably phony, that businesses are not about to be suckered by them. After all, nobody can predict when rates might shoot up and squelch the profitability of their investment. So corporations have pulled up their financial drawbridges behind balance sheets heavy with cash. Consumers have pulled consumption forward from the future, since that is the only attractive alternative to the stock investments that only recently wrecked their net worth. This, too, validates King’s conclusions. Whether “successful” or not, Keynesian economics cannot last because the policy of borrowing from the future is self-limiting and self-defeating.

Didn’t I just read that our budget deficit is headed lower? Doesn’t this mean that we’ve turned the corner of both our budget crisis and our flagging recovery?

If you read carefully, you discovered that the improvement in the federal government’s fiscal posture is temporary, mostly an accounting artifact that occurs every April. Another contributing factor is the income corporations distributed at year-end 2012 to avoid taxation at this year’s higher rates, which is now being taxed at the individual level. Most of this constitutes a one-time increase in revenue that will not carry over into subsequent quarters. Even though the real economic benefits of this are illusory, it does serve to explain why Fed Chairman Bernanke has picked this moment to announce an impending “tapering off” of the QE program of Fed bond purchases.

How so?

The fact that federal deficits will be temporarily lower means that the federal government will be selling fewer bonds to finance its deficit. This, in turn, means that the Fed will perforce be buying fewer bonds whether it wants to or not. Even if there might technically be enough bonds sold for the Fed to continue buying at its current $85 billion level, it would be inadvisable for the federal government to buy all, or virtually all, of an entire issue while leaving nothing for private investors. After all, U.S. government bonds are still the world’s leading fixed-income financial instrument.

Since the Fed is going to be forced to reduce QE anyway, this gives Bernanke and company the chance to gauge public reaction to their announcement and to the actual reduction. Eventually, the Fed is going to have to end QE, and the more accurately they can predict the reaction to this, the better they can judge when to do that. So the Fed is simply making a virtue out of necessity.

You said something awhile back that I can’t forget. You referred to the Keynesian policy of artificially lowering interest rates to stimulate investment as the “proximate” cause of the business cycle. Why is that true and what is the qualifier doing there?

To illustrate the meaning, consider the Great Recession that began in 2007. There were many “causes,” if one defines a cause as an event or sequence of events that initiated, reinforced or accelerated the course of the recession. The housing bubble and ensuing collapse in housing prices was prominent among these. That bubble itself had various causes, including the adoption of restrictive land-use policies by many state and local jurisdictions across America, imprudent federal-government policies promoting home-ownership by relaxing credit standards, bank-regulation standards that positioned mortgage-related securities as essentially riskless and the creation and subsidy of government-sponsored agencies like Fannie Mae and Freddie Mac that implemented unwise policies and distorted longstanding principles of home purchase and finance. Another contributor to recession was the decline in the exchange-value of the U.S. dollar that led to a sharp upward spike in (dollar-denominated) crude oil prices.

But the reign of artificially low interest rates that allowed widespread access to housing-related capital and distorted investment incentives on both the demand and production side of the market were the proximate cause of both the housing bubble and the recession. The interest rates were the most closely linked causal agent to the bubble and the recession would not have happened without the bubble. Not only that, the artificially low interest rates would have triggered a recession even without the other independent influences – albeit a much milder one. Another way to characterize the link between interest rates and the recession would be to say that the artificially low interest rates were both necessary and sufficient to produce the recession. The question is: Why?

For several centuries, an artificial lowering of interest rates accompanied an increase in the supply of money and/or credit. Prior to the 20th century, this was usually owing to increases in stocks of mined gold and/or silver, coupled with the metallic monetary standards then in use. Modern central banks have created credit while severing its linkage with government holdings of stocks of precious metals, thus imposing a regime of fiat money operating under the principles of fractional-reserve banking.

In both these institutional settings, the immediate reaction to the monetary change was lower interest rates. The effect was the same as if consumers had decided to save more money in order to consume less today and more in the future. The lower interest rates had complex effects on the total volume of investment because they affect investment through three different channels. The lower rate of discount and increased value of future investment flows greatly increase the attractiveness of some investments – namely, those in long-lived production processes where cash flows are realized in the relatively distant future. Housing is a classic example of one such process. Thus, a boom is created in the sector(s) to which resources are drawn by the low interest rates, like the one the U.S. enjoyed in the early 2000s.

The increase in employment and income in those sectors causes an increase in the demand for current consumption goods. This bids up prices of labor and raw materials, provided either that full employment has been reached or that those resources are specialized to their particular sectors. This tends to reduce investment in shorter-term production processes, including those that produce goods and services for current consumption. Moreover, the original investments are starting to run into trouble for three reasons: first, because their costs are unexpectedly increasing; second, because the consumer demand that would ordinarily have accompanied an increase in saving is absent because it was monetary expansion, not saving, that produced the fall in interest rates; and third, because interest rates return to their (higher) natural level, making it difficult to complete or support the original investments.

Only an increase in the rate of monetary expansion will allow original investments to be refinanced or validated by an artificial shot of consumer demand. That is what often happened throughout the 20th century – central banks frantically doubled down on their original monetary policy when its results started to go sour. Of course, this merely repeated the whole process over again and increased the size and number of failed investments. The eventual outcome was widespread unemployment and recession. That is the story of the recent housing bubble. This mushrooming disaster couldn’t happen without central banking, which explains why 19th century business cycles were less severe than many modern ones.

I don’t recall reading this rather complicated explanation before or hearing it discussed on television or radio. Why not?

The preceding theory of business cycles was developed by F. A. Hayek in the late 1920s, based on monetary theory developed by his mentor, Ludwig von Mises, and the interest-rate theory of the Swedish economist, Knut Wicksell. Hayek used it to predict the onset of what became the Great Depression in 1929. (Von Mises was even more emphatic, foreseeing a “great crash” in a letter to his wife and refusing a prestigious appointment in his native Vienna to avoid being tarred by exposure to events.) Hayek’s theory earned him an appointment to the London School of Economics in 1931. It was cited by the Nobel committee that awarded him the prize for economic science in 1974.

But after 1931, Hayek engaged several theoretical controversies with his fellow economists. The most famous of these was his long-running debate with John Maynard Keynes. One long-term consequence of that debate was the economics profession’s exile of capital theory from macroeconomics. They refused to contemplate the distinction between long-term and short-term production processes and capital goods. They treated capital as a homogeneous lump or mass rather than a delicate fabric of heterogeneous goods valued by an intricate structure of interest rates.

That is why Keynesian macroeconomics textbooks pretend that government can increase investment by creating money that lowers “the” interest rate. If government could really do this, of course, our lives would all be radically different than they actually are. We would not experience recessions and depressions.

Public-service radio and television advertisements warn consumers to beware of investment scams that promise returns that are “too good to be true.” “If it sounds too good to be true,” the ad declares sententiously, “it probably is.” What we really need is a commercial warning us to apply this principle to the claims of government and government policymakers – and, for that matter, university professors who are dependent upon government for their livelihood.

It turns out to be surprisingly difficult to refute the claims of Keynesian economics without resorting to the annoyingly complicated precepts of capital theory. Ten years before Keynes published his theory, the American economists Foster and Catchings developed a theory of government intervention that embodied most of Keynes’ ideas. They published their ideas in two books and challenged the world to refute them, even offering a sizable cash prize to any successful challenger. Many prominent economists tried and failed to win the prize. What is more, as Hayek himself acknowledged, their failure was deserved, for their analysis did not reveal the fallacies inherent in the authors’ work.

Hayek wrote a lengthy refutation that was later published under the title of “The ‘Paradox’ of Saving.” Today, over 80 years later, it remains probably the most meticulous explanation of why government cannot artificially create and preserve prosperity merely by manipulating monetary variables like the quantity of money and interest rates.

There is nothing wrong with Hayek’s analysis. The main problem with his work is that it is not fashionable. The public has been lied to so long and so convincingly that it can hardly grasp the truth. The idea that government can and should create wealth out of thin air is so alluring and so reassuring – and the idea of its impossibility so painful and troubling – that fantasy seems preferable to reality. Besides, large numbers of people now make their living by pretending that government can do the impossible. Nothing short of social collapse will force them to believe otherwise.

The economics profession obsessively studied and research Keynesian economics for over 40 years, so it has less excuse for its behavior nowadays. Keynes’ main contentions were refuted. Keynesianism was rejected by macroeconomists throughout the world. Even the head of the British Labor Party, James Callaghan, bitter denounced it in a famous speech in 1976. The Labor Party had used Keynesian economics as its key economic-policy tool during its installation of post-World War II socialism and nationalization in Great Britain, so Callaghan’s words should have driven a stake through Keynes’ heart forevermore.

Yet economists still found excuses to keep his doctrines alive. Instead of embracing Hayek, they developed “New Keynesian Economics” – which has nothing to do with the policies of Bernanke and Obama today. The advent of the financial crisis and the Great Recession brought the “return of the Master” (e.g., Keynes). This was apparently a default response by the economics profession. The Recession was not caused by free markets nor was it solved by Keynesian economics. Keynesian economics hadn’t got any better or wiser since its demise. so there was no reason for it to reemerge like a zombie in a George Romero movie. Apparently, economists were reacting viscerally in “we can’t just sit here doing nothing” mode – even though that’s exactly what they should have done.

If QE and ZIRP are not the answer to our current economic malaise, what is?

In order to solve a problem, you first have to stop making it worse. That means ending the monetary madness embodied in QE and ZIRP. Don’t try to keep interest rates as low as possible; let them find their natural level. This means allowing interest rates to be determined by the savings supplied by the private sector and the investment demand generated by private businesses.

In turn, this means that housing prices will be determined by markets, not by the artificial actions of the Fed. This will undoubtedly reverse recent price increases recorded in some markets. As the example of Japan shows only too well, there is no substitute for free-market prices in housing. Keeping a massive economy in a state of suspended animation for two decades is no substitute for a functioning price system.

The course taken by U.S. economic history in the 20th century shows that there is no living with a central bank. Sooner or later, even a central bank that starts out small and innocuous turns into a raging tiger with taxpayers riding its back and looking for a way to get off. (The Wall Street Journal‘s recent editorial “Bernanke Rides the Bull” seems to have misdirected the metaphor, since we are the ones riding the bull.) Instead of a Fed, we need free-market banks incapable of wangling bailouts from the government and a free market for money in which there are no compulsory requirements to accept government money and no barriers to entry by private firms anxious to supply reliable forms of money. Bit Coin is a promising development in this area.

What does all the talk about the Fed “unwinding” its actions refer to?

It refers to undoing previous actions; more specifically, to sales that cancel out previous purchases of U.S. Treasury bonds. The Fed has been buying government bonds in both primary and secondary bond markets pursuant to their QE and ZIRP policies, respectively. It now has massive quantities of those bonds on its balance sheet. Technically, that makes the Fed the world’s largest creditor of the U.S. government. (Since the Fed is owned by its member banks, the banks are really the owner/creditors.) That means that the Federal Reserve has monetized vast quantities of U.S. government debt.

There are two courses open to the Fed. One of them is hyperinflation, which is what will happen when the Fed stops buying, interest rates rise to normal levels and banks have no alternative but to use their reserves for normal, profit-oriented purposes that put money into circulation for spending. This has never before happened in peacetime in the U.S. The other is for the Fed to sell the bonds to the public, which will consist mostly of commercial banks. This will withdraw the money from circulation and end the threat of hyperinflation (assuming the Fed sterilizes it). But it will also drive bond prices into the ground, which means that interest rates will shoot skyward. This will create the aforementioned government budget/debt crisis of industrial strength – and the high interest rates won’t do much for the general business climate for awhile, either.

Since it is considered a public-relations sin for government to do anything that makes the general public uncomfortable and which can be directly traced to it, it is easy to see why the Fed doesn’t want to take any action at all. But doing nothing is not an option, either. Eventually, one of the two aforementioned scenarios will unfold, anyway, in spite of efforts to forestall them.

Uhhhh… That doesn’t sound good.

No spit, Spurlock. Yet, paradoxical as it might seem at first, either of these two scenarios will probably make people more receptive to solutions like free banking and free-market money – solutions that most people consider much too radical right now. There are times in life when things have to get worse before they can get better. Regrettably, this looks like one of those times.

DRI-444: And the Beat of the Economic Greek Chorus Goes On

Early in 2012, broad indices of income and employment turned upward. Although not dramatic, the upturn raised hopes that at long last the economic recovery was about to shift out of low gear and into overdrive.

Of course, there were nagging problems with this optimistic scenario. For one thing, the transportation sector did not participate in the upturn. Trucking in particular languished. This seemed odd in view of the fact that roughly two-thirds of all freight travels by truck. While puzzled by this seeming anomaly, commentators like Edward Leamer of UCLA voiced optimism that trucking would soon get with the program. And it seemed unlikely that the pace of trucking activity could long lag that of the general economy.

Well, one quarter later, trucking’s rate of growth has lined up with that of the overall economy. But convergence has not been effected by a growth spurt in trucking. Instead, it is the overall economy that has dropped back into line with the dismal growth rate of the trucking sector.

What might account for the seemingly inexplicable pattern of economic fluctuations that have plagued the Great Recession and its stunted offspring, the Little Recovery? Can we identify the keynotes that distinguish this Great Recession from past business cycles?

The Greek Chorus on the Economy

In ancient, classical drama, the Greek chorus served the function of narrator and commentator on the events depicted. Over the last few years, economic commentators have formed their own Greek chorus. This suits the dramatic quality of world economic history ever since the financial crisis of 2008 – crisis following crisis, the major industrial nations bleakly eyeing a wall of worry. No sooner has one fraught moment passed than another pops up.

The Greek Chorus may be theatrically effective, but they are analytically deficient. They lack the experience and assurance needed to ad lib an explanation for this, the least conventional business cycle of them all.

The traditional model of the business cycle posits wave-like movements of economic activity joined by high (peak) and low (trough) points. The falling portion of the wave is the contraction phase. The rising part is the expansion. This roughly corresponds to the experience of living Americans. But the current Great Recession is new and different.

At the outset, the recession began in December 2007, but few would have made book on its existence until the meltdown came in the fall of 2008 – at which point the economy nosedived like a crooked prizefighter. The official end of the recession in June 2009 came and went without notice; unemployment remained sky-high for months afterward.

Eventually, it became apparent that a recovery was underway. Make that an apparent recovery – two or three months of modest growth was succeeded by a backslide in income and employment. This is hardly a classic business cycle scenario and it’s no way to run a railway to economic growth. You can travel between two points by dancing a box step but it’s not an efficient way to traverse the distance.

But the Greek Chorus could only sing its part from a script. It could moralize about the Greeks and their woes, and how those woes would wound the West if we weren’t careful. It could sing about morality – greed and inequality and protest and such. It could narrate a familiar tale about the business cycle. But it couldn’t analyze. It lacked a theoretical framework in which to look beyond history and tradition to ask why this episode differed from all that had gone before.

The Greek Chorus Sings the Same Song, Different Verse

In the fourth quarter of 2011, the U.S. economy achieved annualized growth of 3.0% and unemployment fell to 8.3%. The Greek Chorus raised its voices in hosannas of praise and thanksgiving. In January, employment jumped further. This was an “unmistakable” sign that we had turned the corner.

Alas, first quarter of 2012 simply repeated the same song heard ever since 2009. This verse featured reduced annualized growth of 2.2% and slightly lower unemployment, culminating in an 8.1% rate in April, 2012.

Unfortunately, even a lower unemployment rate became a mixed message. While the number of unemployed persons fell by 175,000 between March and April, 2012, the number of employed persons also fell, by 165,000. The job gain of 115,000 was well below the 200,000 job gain usually considered necessary to absorb increases in population and labor-force growth in a typical month. Of course, this month was anything but typical – the civilian labor force fell by 342,000. Since the unemployment rate is calculated by dividing the number of unemployed (12,500,000) by the total number of people in the labor force (154,365,000), the resulting 8.1% was only a razor-thin improvement over the previous month (12,675,000 divided by 154,707,000 equals 8.2%). The total number of employed people was 141,865,000 – up from 137,968,000 in December 2009 but well behind the 146,595,000 in 2007, before the recession started.

Once again, the “unmistakable” signs of recovery had become mistakable.

Why the Greek Chorus Sings Off-Key

In its narrative role, the Greek Chorus is not performing but instead “phoning in” its performance by relying on pre-digested Keynesian platitudes and bromides, as if it had substituted a pre-recorded instrumental for live performance. And that instrumental is like an old phonograph needle stuck in a crack, playing the same notes over and over again.

The Greek Chorus excoriated Wall Street for the failures of its “rocket scientists,” who developed complex derivative securities and relied on statistical databases to develop safety ratings for mortgage-backed securities. Rightly so, for radically changed credit standards had made the databases worthless for evaluating creditworthiness in today’s environment. But now the Chorus fails to recognize that the textbook business-cycle model cannot describe today’s reality, in which policymakers manipulate markets in vain efforts to make miracles or buy time in which to maneuver.

The simple business-cycle model only worked when markets were allowed to work. Today, the economy functions like an automobile whose fuel supply is impaired by some flaw such as a clogged filter. The vehicle lurches forward, stutters, stops, and lunges forward again. Something is obviously wrong, even if the source is not quite clear.

Insofar as they have any economic training at all, most people are trained to look to aggregate demand, or total spending, as the key to all mysteries. But that is not the problem.

In a functioning economy, markets tend to reconcile diverse perspectives of different people by providing objective knowledge about reality. People rely on that. Each of us knows that we don’t know everything, so we rely on what markets tell us and we rely on our ability to get information on the future and in the future. We can’t do that today because we all know that today’s economy is not “real.”

The best example is the “zero interest rate” policy (ZIRP) followed by the Federal Reserve. Everybody knows that interest rates do not reflect the actual saving and investing desires of consumers and businesses. We all know that ZIRP cannot go on forever, and when it ends the interest-rate environment will change drastically. We know that all those drastic changes will have tremendous effects on most of the economic choices we make now and in the immediate future.

In effect, most of the country is living with one ear attuned to daily life and the other one keenly listening for the other shoe to drop – that is, for any sign of the change that we know is coming. Obviously, we can’t live in a state of suspended animation. But just as obviously, it’s in our interest to do the minimum necessary to get by until this state of massive uncertainty clarifies.

And guess what? Everybody “doing the minimum necessary” translates into an economy with minimal growth and confused direction. Long-term investment is attractive only when the circumstances are absolutely ideal – or when political corruption or cronyism tips the scales in favor of action. Hiring is analogous to long-term investment because it entails assumption of so many costs and because firing has become correspondingly difficult. It’s no wonder, then, that we’re in the fix we’re in.

Waiting – But Not for Godot

Some other paralysis-inducing factors are related to ZIRP. Current and future projected spending at the federal level is producing unprecedented peacetime accounting deficits. These require federal borrowing. Interest payments on the necessary bonds threaten to eat up the entire federal-government budget before the decade ends. Everybody knows that this process cannot continue. Everybody knows that its termination will require massive dislocations. Some of these might be large spending cuts, huge tax increases, elimination of federal-government agencies and departments, privatization of government functions, and large-scale reductions in federal employment. Nobody can dispute the stunning impact of these measures. Everybody is waiting to see what will happen.

Many state and local governments are in bad financial shape as well. Included among them are some of our largest and most populous states, such as California, Illinois and New York. Most people realize that the promises made to many public-employee unions regarding retirement pension and health-care benefits have placed government finance in an untenable position. Once again, the necessary remedial actions will have dramatic effects on all the affected parties. Everybody is waiting to see what will happen.

In Europe, Americans can watch a preview of coming distractions. The European welfare state is imploding. Whether the implosion becomes an explosion will depend on where the charges are set and on their strength. Greece is facing default on its public debt and withdrawal from the European Monetary Union. In an unprecedented action, Spain is about to bail out its largest bank. Everybody suspects that the stronger European countries are rapidly running out of time to deal with the depredations of the weaker ones. Deep in our hearts and heads, we know that Germans will not work until age 67 so as to pay higher taxes whose revenues will allow Greeks to retire at age 50.

We are waiting to see what happens.

The Federal Reserve has created astounding amounts of money by purchasing both new and existing federal debt. Instead of entering the flow of income and expenditure via the loan process, most of this created money has sat on bank balance sheets in the form of excess reserves, drawing interest paid by the Treasury. This policy was deliberately contrived by the Fed and Chairman Bernanke, presumably because of fears that many banks required bolstering to forestall insolvency and couldn’t be expected to bear the risks of normal operations. Everybody knows that this situation cannot continue indefinitely. Everybody knows that if this flood of money is injected via the usual loan process, hyperinflation will result. Everybody knows that hyperinflation would throw the U.S. economy into chaos. We are waiting to see what happens.

Tune Out the Greek Chorus

All this “waiting to see what happens” is frighteningly real. It cannot be quantified into a simple model like the Keynesian multiplier of income and expenditure, so it is beyond the ken of the Greek Chorus. It requires economic analysis of a kind that went out of fashion at the point when economics became “scientific” by relying exclusively on mathematics and statistics. We are beset by radical uncertainty, a term that is qualitative rather than quantitative. We cannot meaningfully assign probability values to possible outcomes, so the so-called economic theory of uncertainty is mostly useless here.

The solution, counterintuitive though it may be to so many of us, is to step back and allow markets to work. Every single source of radical uncertainty listed above is caused by policymakers either trying to overwhelm the market or trying to buy time to decide what to do next. Only time and markets can lift the fog of uncertainty, because only markets can generate and collate the objective information necessary to dispel the uncertainty that currently paralyzes us. In the meantime, we should ignore the Greek Chorus. If necessary, use earplugs.