DRI-172 for week of 7-5-15: How and Why Did ObamaCare Become SCOTUSCare?

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How and Why Did ObamaCare Become SCOTUSCare?

On June 25, 2015, the Supreme Court of the United States delivered its most consequential opinion in recent years in King v. Burwell. King was David King, one of various Plaintiffs opposing Sylvia Burwell, Secretary of Health, Education and Welfare. The case might more colloquially be called “ObamaCare II,” since it dealt with the second major attempt to overturn the Obama administration’s signature legislative achievement.

The Obama administration has been bragging about its success in attracting signups for the program. Not surprisingly, it fails to mention two facts that make this apparent victory Pyrrhic. First, most of the signups are people who lost their previous health insurance due to the law’s provisions, not people who lacked insurance to begin with. Second, a large chunk of enrollees are being subsidized by the federal government in the form of a tax credit for the amount of the insurance.

The point at issue in King v. Burwell is the legality of this subsidy. The original legislation provides for health-care exchanges established by state governments, and proponents have been quick to cite these provisions to pooh-pooh the contention that the Patient Protection and Affordable Care Act (PPACA) ushered in a federally-run, socialist system of health care. The specific language used by PPAACA in Section 1401 is that the IRS can provide tax credits for insurance purchased on “exchanges run by the State.” That phrase appears 14 times in Section 1401 and each time it clearly refers to state governments, not the federal government. But in actual practice, states have found it excruciatingly difficult to establish these exchanges and many states have refused to do so. Thus, people in those states have turned to the federal-government website for health insurance and have nevertheless received a tax credit under the IRS’s interpretation of statute 1401. That interpretation has come to light in various lawsuits heard by lower courts, some of which have ruled for plaintiffs and against attempts by the IRS and the Obama administration to award the tax credits.

Without the tax credits, many people on both sides of the political spectrum agree, PPACA will crash and burn. Not enough healthy people will sign up for the insurance to subsidize those with pre-existing medical conditions for whom PPACA is the only source of external funding for medical treatment.

To a figurative roll of drums, the Supreme Court of the United States (SCOTUS) released its opinion on June 25, 2015. It upheld the legality of the IRS interpretation in a 6-3 decision, finding for the government and the Obama administration for the second time. And for the second time, the opinion for the majority was written by Chief Justice John Roberts.

Roberts’ Rules of Constitutional Disorder

Given that Justice Roberts had previously written the opinion upholding the constitutionality of the law, his vote here cannot be considered a complete shock. As before, the shock was in the reasoning he used to reach his conclusion. In the first case (National Federation of Independent Businesses v. Sebelius, 2012), Roberts interpreted a key provision of the law in a way that its supporters had categorically and angrily rejected during the legislative debate prior to enactment and subsequently. He referred to the “individual mandate” that uninsured citizens must purchase health insurance as a tax. This rescued it from the otherwise untenable status of a coercive consumer directive – something not allowed under the Constitution.

Now Justice Roberts addressed the meaning of the phrase “established by the State.” He did not agree with one interpretation previously made by the government’s Solicitor General, that the term was an undefined term of art. He disdained to apply a precedent established by the Court in a previous case involving interpretation of law by administration agencies, the Chevron case. The precedent said that in cases where a phrase was ambiguous, a reasonable interpretation by the agency charged with administering the law would rule. In this case, though, Roberts claimed that since “the IRS…has no expertise in crafting health-insurance policy of this sort,” Congress could not possibly have intended to grant the agency this kind of discretion.

No, Roberts is prepared to believe that “established by the State” does not mean “established by the federal government,” all right. But he says that the Supreme Court cannot interpret the law this way because it will cause the law to fail to achieve its intended purpose. So, the Court must treat the wording as ambiguous and interpret it in such a way as to advance the goals intended by Congress and the administration. Hence, his decision for defendant and against plaintiffs.

In other words, he rejected the ability of the IRS to interpret the meaning of the phrase “established by the State” because of that agency’s lack of health-care-policy expertise, but is sufficiently confident of his own expertise in that area to interpret its meaning himself; it is his assessment of the market consequences that drives his decision to uphold the tax credits.

Roberts’ opinion prompted one of the most scathing, incredulous dissents in the history of the Court, by Justice Antonin Scalia. “This case requires us to decide whether someone who buys insurance on an exchange established by the Secretary gets tax credits,” begins Scalia. “You would think the answer would be obvious – so obvious that there would hardly be a need for the Supreme Court to hear a case about it… Under all the usual rules of interpretation… the government should lose this case. But normal rules of interpretation seem always to yield to the overriding principle of the present Court – the Affordable Care Act must be saved.”

The reader can sense Scalia’s mounting indignation and disbelief. “The Court interprets [Section 1401] to award tax credits on both federal and state exchanges. It accepts that the most natural sense of the phrase ‘an exchange established by the State’ is an exchange established by a state. (Understatement, thy name is an opinion on the Affordable Care Act!) Yet the opinion continues, with no semblance of shame, that ‘it is also possible that the phrase refers to all exchanges.’ (Impossible possibility, thy name is an opinion on the Affordable Care Act!)”

“Perhaps sensing the dismal failure of its efforts to show that ‘established by the State’ means ‘established by the State and the federal government,’ the Court tries to palm off the pertinent statutory phrase as ‘inartful drafting.’ The Court, however, has no free-floating power to rescue Congress from their drafting errors.” In other words, Justice Roberts has rewritten the law to suit himself.

To reinforce his conclusion, Scalia concludes with “…the Court forgets that ours is a government of laws and not of men. That means we are governed by the terms of our laws and not by the unenacted will of our lawmakers. If Congress enacted into law something different from what it intended, then it should amend to law to conform to its intent. In the meantime, Congress has no roving license …to disregard clear language on the view that … ‘Congress must have intended’ something broader.”

“Rather than rewriting the law under the pretense of interpreting it, the Court should have left it to Congress to decide what to do… [the] Court’s two cases on the law will be remembered through the years. And the cases will publish the discouraging truth that the Supreme Court favors some laws over others and is prepared to do whatever it takes to uphold and assist its favorites… We should start calling this law SCOTUSCare.”

Jonathan Adler of the much-respected and quoted law blog Volokh Conspiracy put it this way: “The umpire has decided that it’s okay to pinch-hit to ensure that the right team wins.”

And indeed, what most stands out about Roberts’ opinion is its contravention of ordinary constitutional thought. It is not the product of a mind that began at square one and worked its way methodically to a logical conclusion. The reader senses a reversal of procedure; the Chief Justice started out with a desired conclusion and worked backwards to figure out how to justify reaching it. Justice Scalia says as much in his dissent. But Scalia does not tell us why Roberts is behaving in this manner.

If we are honest with ourselves, we must admit that we do not know why Roberts is saying what he is saying. Beyond question, it is arbitrary and indefensible. Certainly it is inconsistent with his past decisions. There are various reasons why a man might do this.

One obvious motivation might be that Roberts is being blackmailed by political supporters of the PPACA, within or outside of the Obama administration. Since blackmail is not only a crime but also a distasteful allegation to make, nobody will advance it without concrete supporting evidence – not only evidence against the blackmailer but also an indication of his or her ammunition. The opposite side of the blackmail coin is bribery. Once again, nobody will allege this publicly without concrete evidence, such as letters, tapes, e-mails, bank account or bank-transfer information. These possibilities deserve mention because they lie at the head of a short list of motives for betrayal of deeply held principles.

Since nobody has come forward with evidence of malfeasance – or is likely to – suppose we disregard that category of possibility. What else could explain Roberts’ actions? (Note the plural; this is the second time he has sustained PPACA at the cost of his own integrity.)

Lord Acton Revisited

To explain John Roberts’ actions, we must develop a model of political economy. That requires a short side trip into the realm of political philosophy.

Lord Acton’s famous maxim is: “Power corrupts; absolute power corrupts absolutely.” We are used to thinking of it in the context of a dictatorship or of an individual or institution temporarily or unjustly wielding power. But it is highly applicable within the context of today’s welfare-state democracies.

All of the Western industrialized nations have evolved into what F. A. Hayek called “absolute democracies.” They are democratic because popular vote determines the composition of representative governments. But they are absolute in scope and degree because the administrative agencies staffing those governments are answerable to no voter. And increasingly the executive, legislative and judicial branches of the governments wield powers that are virtually unlimited. In practical effect, voters vote on which party will wield nominal executive control over the agencies and dominate the legislature. Instead of a single dictator, voters elect a government body with revolving and rotating dictatorial powers.

As the power of government has grown, the power at stake in elections has grown commensurately. This explains the burgeoning amounts of money spent on elections. It also explains the growing rancor between opposing parties, since ordinary citizens perceive the loss of electoral dominance to be subjugation akin to living under a dictatorship. But instead of viewing this phenomenon from the perspective of John Q. Public, view it from within the brain of a policymaker or decisionmaker.

For example, suppose you are a completely fictional Chairman of a completely hypothetical Federal Reserve Board. We will call you “Bernanke.” During a long period of absurdly low interest rates, a huge speculative boom has produced unprecedented levels of real-estate investment by banks and near-banks. After stoutly insisting for years on the benign nature of this activity, you suddenly perceive the likelihood that this speculative boom will go bust and some indeterminate number of these financial institutions will become insolvent. What do you do? 

Actually, the question is really more “What do you say?” The actions of the Federal Reserve in regulating banks, including those threatened with or undergoing insolvency, are theoretically set down on paper, not conjured up extemporaneously by the Fed Chairman every time a crisis looms. These days, though, the duties of a Fed Chairman involve verbal reassurance and massage as much as policy implementation. Placing those duties in their proper light requires that our side trip be interrupted with a historical flashback.

Let us cast our minds back to 1929 and the onset of the Great Depression in the United States. At that time, virtually nobody foresaw the coming of the Depression – nobody in authority, that is. For many decades afterwards, the conventional narrative was that President Herbert Hoover adopted a laissez faire economic policy, stubbornly waiting for the economy to recover rather than quickly ramping up government spending in response to the collapse of the private sector. Hoover’s name became synonymous with government passivity in the face of adversity. Makeshift shanties and villages of the homeless and dispossessed became known as “Hoovervilles.”

It took many years to dispel this myth. The first truthteller was economist Murray Rothbard in his 1962 book America’s Great Depression, who pointed out that Hoover had spent his entire term in a frenzy of activism. Far from remaining a pillar of fiscal rectitude, Hoover had presided over federal deficit spending so large that his successor, Democrat Franklin Delano Roosevelt, campaigned on a platform of balancing the federal-government budget. Hoover sternly warned corporate executives not to lower wages and officially adopted an official stance in favor of inflation.

Professional economists ignored Rothbard’s book in droves, as did reviewers throughout the mass media. Apparently the fact that Hoover’s policies failed to achieve their intended effects persuaded everybody that he couldn’t have actually followed the policies he did – since his actual policies were the very policies recommended by mainstream economists to counteract the effects of recession and Depression and were largely indistinguishable in kind, if not in degree, from those followed later by Roosevelt.

The anathematization of Herbert Hoover drover Hoover himself to distraction. The former President lived another thirty years, to age ninety, stoutly maintaining his innocence of the crime of insensitivity to the misery of the poor and unemployed. Prior to his presidency, Hoover had built reputation as one of the great humanitarians of the 20th century by deploying his engineering and organizational skills in the cause of disaster relief across the globe. The trashing of his reputation as President is one of history’s towering ironies. As it happened, his economic policies were disastrous, but not because he didn’t care about the people. His failure was ignorance of economics – the same sin committed by his critics.

Worse than the effects of his policies, though, was the effect his demonization has had on subsequent policymakers. We do not remember the name of the captain of the California, the ship that lay anchored within sight of the Titanic but failed to answer distress calls and go to the rescue. But the name of Hoover is still synonymous with inaction and defeat. In politics, the unforgivable sin became not to act in the face of any crisis, regardless of the consequences.

Today, unlike in Hoover’s day, the Chairman of the Federal Reserve Board is the quarterback of economic policy. This is so despite the Fed’s ambiguous status as a quasi-government body, owned by its member banks with a leader appointed by the President. Returning to our hypothetical, we ponder the dilemma faced by the Chairman, “Bernanke.”

Bernanke only directly controls monetary policy and bank regulation. But he receives information about every aspect of the U.S. economy in order to formulate Fed policy. The Fed also issues forecasts and recommendations for fiscal and regulatory policies. Even though the Federal Reserve is nominally independent of politics and from the Treasury department of the federal government, the Fed’s policies affect and are affected by government policies.

It might be tempting to assume that Fed Chairmen know what is going to happen in the economic future. But there is no reason to believe that is true. All we need do is examine their past statements to disabuse ourselves of that notion. Perhaps the popping of the speculative bubble that Bernanke now anticipates will produce an economic recession. Perhaps it will even topple the U.S. banking system like a row of dominoes and produce another Great Depression, a la 1929. But we cannot assume that either. The fact that we had one (1) Great Depression is no guarantee that we will have another one. After all, we have had 36 other recessions that did not turn into Great Depressions. There is nothing like a general consensus on what caused the Depression of the 1920s and 30s. (The reader is invited to peruse the many volumes written by historians, economic and non-, on the subject.) About the only point of agreement among commentators is that a large number of things went wrong more or less simultaneously and all of them contributed in varying degrees to the magnitude of the Depression.

Of course, a good case might be made that it doesn’t matter whether Fed Chairman can foresee a coming Great Depression or not. Until recently, one of the few things that united contemporary commentators was their conviction that another Great Depression was impossible. The safeguards put in place in response to the first one had foreclosed that possibility. First, “automatic stabilizers” would cause government spending to rise in response to any downturn in private-sector spending, thereby heading off any cumulative downward movement in investment and consumption in response to failures in the banking sector. Second, the Federal Reserve could and would act quickly in response to bank failures to prevent the resulting reverse-multiplier effect on the money supply, thereby heading off that threat at the pass. Third, bank regulations were modified and tightened to prevent failures from occurring or restrict them to isolated cases.

Yet despite everything written above, we can predict confidently that our fictional “Bernanke” would respond to a hypothetical crisis exactly as the real Ben Bernanke did respond to the crisis he faced and later described in the book he wrote about it. The actual and predicted responses are the same: Scare the daylights out of the public by predicting an imminent Depression of cataclysmic proportions and calling for massive government spending and regulation to counteract it. Of course, the real-life Bernanke claimed that he and Treasury Secretary Henry O’Neill correctly foresaw the economic future and were heroically calling for preventive measures before it was too late. But the logic we have carefully developed suggests otherwise.

Nobody – not Federal Reserve Chairmen or Treasury Secretaries or California psychics – can foresee Great Depressions. Predicting a recession is only possible if the cyclical process underlying it is correctly understood, and there is no generally accepted theory of the business cycle. No, Bernanke and O’Neill were not protecting America with their warning; they were protecting themselves. They didn’t know that a Great Depression was in the works – but they did know that they would be blamed for anything bad that did happen to the economy. Their only way of insuring against that outcome – of buying insurance against the loss of their jobs, their professional reputations and the possibility of historical “Hooverization” – was to scream for the biggest possible government action as soon as possible. 

Ben Bernanke had been blasé about the effects of ultra-low interest rates; he had pooh-poohed the possibility that the housing boom was a bubble that would burst like a sonic boom with reverberations that would flatten the economy. Suddenly he was confronted with a possibility that threatened to make him look like a fool. Was he icy cool, detached, above all personal considerations? Thinking only about banking regulations, national-income multipliers and the money supply? Or was he thinking the same thought that would occur to any normal human being in his place: “Oh, my God, my name will go down in history as the Herbert Hoover of Fed chairmen”?

Since the reasoning he claims as his inspiration is so obviously bogus, it is logical to classify his motives as personal rather than professional. He was protecting himself, not saving the country. And that brings us to the case of Chief Justice John Roberts.

Chief Justice John Roberts: Selfless, Self-Interested or Self-Preservationist?

For centuries, economists have identified self-interest as the driving force behind human behavior. This has exasperated and even angered outside observers, who have mistaken self-interest for greed or money-obsession. It is neither. Rather, it merely recognizes that the structure of the human mind gives each of us a comparative advantage in the promotion of our own welfare above that of others. Because I know more about me than you do, I can make myself happier than you can; because you know more about you than I do, you can make yourself happier than I can. And by cooperating to share our knowledge with each other, we can make each other happier through trade than we could be if we acted in isolation – but that cooperation must preserve the principle of self-interest in order to operate efficiently.

Strangely, economists long assumed that the same people who function well under the guidance of self-interest throw that principle to the winds when they take up the mantle of government. Government officials and representatives, according to traditional economics textbooks, become selfless instead of self-interested when they take office. Selflessness demands that they put the public welfare ahead of any personal considerations. And just what is the “public welfare,” exactly? Textbooks avoided grappling with this murky question by hiding behind notions like a “social welfare function” or a “community indifference curve.” These are examples of what the late F. A. Hayek called “the pretense of knowledge.”

Beginning in the 1950s, the “public choice” school of economics and political science was founded by James Buchanan and Gordon Tullock. This school of thought treated people in government just like people outside of government. It assumed that politicians, government bureaucrats and agency employees were trying to maximize their utility and operating under the principle of self-interest. Because the incentives they faced were radically different than those faced by those in the private sector, outcomes within government differed radically from those outside of government – usually for the worse.

If we apply this reasoning to members of the Supreme Court, we are confronted by a special kind of self-interest exercised by people in a unique position of power and authority. Members of the Court have climbed their career ladder to the top; in law, there are no higher rungs. This has special economic significance.

When economists speak of “competition” among input-suppliers, we normally speak of people competing with others doing the same job for promotion, raises and advancement. None of these are possible in this context. What about more elevated kinds of recognition? Well, there is certainly scope for that, but only for the best of the best. On the current court, positive recognition goes to those who write notable opinions. Only Judge Scalia has the special talent necessary to stand out as a legal scholar for the ages. In this sense, Judge Scalia is “competing” with other judges in a self-interested way when he writes his decisions, but he is not competing with his fellow judges. He is competing with the great judges of history – John Marshall, Oliver Wendell Holmes, Louis Brandeis, and Learned Hand – against whom his work is measured. Otherwise, a judge can stand out from the herd by providing the deciding or “swing” vote in close decisions. In other words, he can become politically popular or unpopular with groups that agree or disagree with his vote. Usually, that results in transitory notoriety.

But in historic cases, there is the possibility that it might lead to “Hooverization.”

The bigger government gets, the more power it wields. More government power leads to more disagreement about its role, which leads to more demand to arbitration by the Supreme Court. This puts the Court in the position of deciding the legality of enactments that claim to do great things for people while putting their freedoms and livelihoods in jeopardy. Any judge who casts a deciding vote against such a measure will go down in history as “the man who shot down” the Great Bailout/the Great Health Care/the Great Stimulus/the Great Reproductive Choice, ad infinitum.

Almost all Supreme Court justices have little to gain but a lot to lose from opposing a measure that promotes government power. They have little to gain because they cannot advance further or make more money and they do not compete with J. Marshall, Holmes, Brandeis or Hand. They have a lot to lose because they fear being anathematized by history, snubbed by colleagues, picketed or assassinated in the present day, and seeing their children brutalized by classmates or the news media. True, they might get satisfaction from adhering to the Constitution and their personal conception of justice – if they are sheltered under the umbrella of another justice’s opinion or they can fly under the radar of media scrutiny in a relatively low-profile case.

Let us attach a name to the status occupied by most Supreme Court justices and to the spirit that animates them. It is neither self-interest nor selflessness in their purest forms; we shall call it self-preservation. They want to preserve the exalted status they enjoy and they are not willing to risk it; they are willing to obey the Constitution, observe the law and speak the truth but only if and when they can preserve their position by doing so. When they are threatened, their principles and convictions suddenly go out the window and they will say and do whatever it takes to preserve what they perceive as their “self.” That “self” is the collection of real income, perks, immunities and prestige that go with the status of Supreme Court Justice.

Supreme Court Justice John Roberts is an example of the model of self-preservation. In both of the ObamaCare decisions, his opinions for the majority completely abdicated his previous conservative positions. They plumbed new depths of logical absurdity – legal absurdity in the first decision and semantic absurdity in the second one. Yet one day after the release of King v. Burwell, Justice Roberts dissented in the Obergefell case by chiding the majority for “converting personal preferences into constitutional law” and disregarding clear meaning of language in the laws being considered. In other words, he condemned precisely those sins he had himself committed the previous day in his majority opinion in King v. Burwell.

For decades, conservatives have watched in amazement, scratching their heads and wracking their brains as ostensibly conservative justices appointed by Republican presidents unexpectedly betrayed their principles when the chips were down, in high-profile cases. The economic model developed here lays out a systematic explanation for those previously inexplicable defections. David Souter, Anthony Kennedy, John Paul Stevens and Sandra Day O’Connor were the precursors to John Roberts. These were not random cases. They were the systematic workings of the self-preservationist principle in action.

DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

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Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.

 

It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.

 

It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-303 for week of 5-11-14: The Real ‘Stress Test’ is Still to Come

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The Real ‘Stress Test’ is Still to Come

Timothy Geithner, former Treasury Secretary and former head of the New York Federal Reserve, is in the news. Like virtually every former policymaker, he has written a book about his experiences. He is currently flogging that book on the publicity circuit. Unlike many other such books, Geithner’s holds uncommon interest – not because he is a skillful writer or a keen analyst. Just the opposite.

Geithner is a man desperate to rationalize his past actions. Those actions have put us on a path to disaster. When that disaster strikes, we will be too stunned and too busy to think clearly about the past. Now is the time to view history coolly and rationally. We must see Geithner’s statements in their true light.

Power and the Need for Self-Justification

In his Wall Street Journal book review of Geithner’s book, Stress Test, James Freeman states that “Geithner makes a persuasive case that he is the man most responsible for the federal bailouts of 2008.” Mr. Freeman finds this claim surprising, but as we will see, it is integral to what Geithner sees as his legacy.

This issue of policy authorship is important to historians, whose job is getting the details right. But it is trivial to us. We want the policies to be right, regardless of their source. That is why we should be worried by Geithner’s need to secure his place in history.

Geithner and his colleagues, Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson, possessed powers whose exercise would have been unthinkable not that long ago. Nobody seems to have considered how the possession of such vast powers would distort their exercise.

Prior to assumption of the Federal Reserve Chairmanship, Ben Bernanke wrote his dissertation on the causes of the Great Depression. Later, his academic reputation was built on his assessment of mistakes committed by Fed Board members during the 1920s and 30s. When he joined the Board and became Chairman, he vowed not to repeat those mistakes. Thus, we should not have been surprised when he treated a financial crisis on his watch as though it were another Great Depression in the making. Bernanke was the living embodiment of the old saying, “Give a small boy a hammer and he will find that everything he encounters needs pounding.” His academic training had given him a hammer and he proceeded to use it to pound the first crisis he met.

In an interview with “Bloomberg News,” Geithner used the phrase “Great Depression” three times. First, he likened the financial crisis of 2008 to the Great Depression, calling it “classic” and comparing it to the bank runs of the Great Depression. Later, he claimed that we had avoided another Great Depression by following his policies. For Geithner, the Great Depression isn’t so much an actual historical episode or an analytical benchmark as it is an emotional button he presses whenever he needs justification for his actions.

When we give vast power to individuals, we virtually guarantee that they will view events through the lens of their own ego rather than objectively. Bernanke was bound to view his decisions in this light: either apply principles he himself had espoused and built his career upon or run the risk of going down in history as exactly the kind of man he had made his name criticizing – the man who stood by and allowed the Great Depression to happen. Faced with those alternatives, policy activism was the inevitable choice.

Geithner had tremendous power in his advisory capacity as President of the New York Federal Reserve. His choices were: use it or not. Not using it ran the risk of being Hooverized by future generations; that is, being labeled as unwitting, uncaring or worse. Using it at least showed that he cared, even if he failed. The only people who would criticize him would be some far-out, laissez-faire types. Thus, he had everything to gain and little to lose by advising policy activism.

Now, after the fact, the incentive to seek the truth is even weaker than it is in the moment. Now Bernanke, Geithner et al are stuck with their decisions. They cannot change their actions, but they can change anything else – their motivations, those of others, even the truths of history and analysis. If they can achieve by lying or dissembling what they could not achieve with their actions at the time, then dishonesty is a small price to pay. Being honest with yourself can be difficult under the best of circumstances. When somebody is on the borderline between being considered the nation’s savior and its scourge, it is well-nigh impossible.

And a person who begins by lying to himself cannot end up being truthful with the world. No, memoirs like Stress Test are not the place to look for a documentary account of the financial crisis told by an insider. The pressures of power do not shape men like Paulson, Bernanke and Geithner into diamonds, but rather into gargoyles.

We cannot take their words at face value. We must put them under the fluoroscope.

“We Were Three Days Away From Americans Not Being Able to Get Money from ATMs”

Not only are Geithner’s actions under scrutiny, but his timing is also criticized. Many people, perhaps most prominently David Stockman, have insisted that the actual situation faced by the U.S. economy wasn’t nearly dire enough to justify the drastic actions urged by Geithner, et al.

Geithner’s stock reply, found in his book and repeated in numerous interviews, is that the emergency facing the nation left no time for observance of legal niceties or economic precedent. He resuscitates the old quote: “We were three days away from Americans not being able to get money from their ATMs.”

There is an effective reply because its psychological shock value tends to stun the listener into submission. But meek silence is the wrong posture with which to receive a response like this from a self-interested party like Paulson, Bernanke or Geithner. Instead, it demands minute examination.

First, ask ourselves this: Is this a figure of speech or literal truth? That is, what precise significance attaches to the words “three days?”

Recall that Bernanke and Paulson have told us that they realized the magnitude of the emergency facing the country and determined that they must (a) violate protocol by going directly to Congress; and (b) act in secret to prevent public panic. Remember also that Paulson told Congress that if they did not pass bailout legislation by the weekend, Armageddon would ensue. And remember also that, typically, Congress did not act within the deadline specified. It waited  ten days before passing the bailout deal. And the prophesied disaster did not unfold.

In other words, Paulson, Bernanke, et al were exaggerating for effect. How much they were exaggerating can be debated.

That leads to the next logical point. What about the ATM reference itself? Was it specific, meaningful? Or was it just hooey? To paraphrase the line used in courtroom interrogation by litigators (“Are you lying now or were you lying then?”), is Geithner exaggerating now just as Paulson and Bernanke exaggerated then?

Well, Geithner is apparently serious in using this reference. In the same interviews, Geithner calls the financial crisis “a classic financial panic, similar to the bank runs in the Great Depression.” In the 1930s, U.S. banks faced “runs” by depositors who withdrew deposits in cash when they questioned the solvency of banks. Under fractional-reserve banking, banks then (as now) kept only a tiny ratio of deposit liabilities on hand in the form of cash and liquid assets. The runs produced a rash of bank failures, leading to widespread closures and the eventual “bank holiday” proclaimed by newly elected President Franklin Delano Roosevelt. So Geithner’s borrowing of the ATM comment as an index of our distress seems to be clearly intended to suggest an impending crisis of bank liquidity.

There is an obvious problem with this interpretation, the problem being that it is obvious nonsense. Virtually every commentator and reviewer has treated Geithner’s backwards predictions of a “Great Depression” with some throat-clearing version of “well, as we all know, we can’t know what would have happened, we’ll never know, we can’t replay history, history only happens once,” and so forth. But that clearly doesn’t apply to the ATM case. We know – as incontrovertibly as we can know anything in life – what would have happened had bank runs and bank illiquidity a la 1930s so much as threatened in 2008.

Somebody would have stepped to a computer at the Federal Reserve and started creating money. We know this because that’s exactly what did happen in 2010 when the Fed initiated its “Quantitative Easing” program of monetary increase. The overwhelming bulk of the QE money found its way to bank reserve accounts at the Fed where it has been quietly drawing interest ever since. We also know that the usual formalities and intermediaries involving money creation by the Fed could and would have been dispensed with in that sort of emergency. As Fed Chairman, Ben Bernanke was known as “Helicopter Ben” because he was fond of quoting Milton Friedman’s remark that the Fed could get money in public hands by dropping it from helicopters in an emergency, if necessary. Bernanke would not have stood on ceremony in the case of a general bank run; he would have funneled money directly to banks by the speediest means.

In other words, the ATM comment was and is the purest hooey. It has no substantive significance or meaning. It was made, and revived by Geithner, for shock effect only. This is very revealing. It implies a man desperate to achieve his effect, which means his words should be received with utmost caution.

“The Paradox of Financial Crises”

Geithner’s flagship appearance on the promotion circuit was his op-ed in The Wall Street Journal (5/13/2014), “The Paradox of Financial Crises.” The thesis of this op-ed – the “paradox” of the title – is that “the more aggressive the government is in designing a rescue plan, the easier it is to force more restructuring in the financial sector, and the better the chances of leaving the surviving system stronger and less dependent on the taxpayer.” Alas, Geithner complains, “Americans don’t give their presidents much in the way of emergency authority to fight” financial crises. As evidence of the need for this emergency authority, Geithner cites the loss of 16% of U.S. household net worth in 2008, “several times as large as the losses at the start of the Great Depression.”

No doubt eyebrows were raised throughout the U.S. when Geithner bemoaned the lack of emergency authority for a President who has appointed dozens of economic and regulatory “czars,” single-handedly suspended execution of legislation and generally behaved high-handedly. Geithner’s thesis – a generous description of what might reasonably be called a desperate attempt at self-justification – apparently consists of three components: (1) the presumption that financial crises are uniquely powerful and destructive; (2) the claim that, nevertheless, a financial crisis can be counteracted by sufficiently forceful action, taken with sufficient dispatch; and (3) the further claim that he knows what actions to take.

The power of financial crises is a trendy idea given currency by a popular scholarly work by two economists named Rogoff and Reinhart, who surveyed recessions featuring financial panics going back several centuries and ostensibly discovered that their recoveries tended to be slow. How much merit their ideas have is really irrelevant to Geithner’s thesis because Geithner’s interest in financial crises is entirely opportunistic. It began in 2008 with Geithner’s improvisations when faced with the impending failure of Bear Stearns, Lehman Brothers, et al. It perseveres only because Geithner’s legacy is now tied to the success of those machinations – which, unlikely as it might have seemed six years ago, is still in dispute.

Geithner’s theory of financial crises is not the Rogoff/Reinhart theory. It is the Geithner theory, which is: financial crises are uniquely powerful because Geithner needs them to be uniquely powerful in order to justify his unprecedented recommendations for unilateral executive actions. In his book and interviews, Geithner peddles various vague, vacuous generalities about financial crises. In order to these to make sense, they must be based on historical observation and/or statistical regularities. But they cannot jibe with the sentiments expressed above in the Journal. Geithner claims to be enunciating a general theory of financial crisis and rescue. But he is really telling a story of what he did to this particular financial system in the particular financial crisis of 2008.

And no wonder, since the financial system existing in the U.S. in 2008 was and still is like no financial system that existed previously. Instead of “banks” as we previously knew them, the failing financial institutions in 2008 were diversified financial institutions – nominally investment banks, although that activity had by then assumed a minor part of their work – some of whose liabilities would once have been called “near monies.” Meanwhile, the true banks were also diversified into securities and investment banking, and the larger ones controlled the overwhelming bulk of deposit liabilities in the U.S. This historically unprecedented configuration accounted for the determination of Paulson, Bernanke, and Geithner to bail them out at all costs. But they weren’t drawing upon a general theory of crises, because no previous society ever had a financial structure like ours.

Geithner stresses the need to “force more restructuring in the financial sector,” as though every financial crisis was caused by corporate elephantiasis and cured by astute government pruning back of financial firms. This is not only historically wrong but logically deficient, since the past government pruning couldn’t have been very astute if crises kept recurring. Indeed, that is the obvious shortcoming of the second component. There are no precedents – none, zero, nada – for the idea that government policy can either forestall or cure recessions, whether financial or otherwise. This is not for want of trying. If there is one thing governments love to do, it is spend money. If there is another thing governments love to do, it is throw their weight around. Neither has solved the problem of recession so far.

What leads us to believe that Timothy Geithner was and is well qualified to pronounce on the subject of financial crises? Only one thing – his claims that “we did do the essential thing, which was to prevent another Great Depression, with its decade of shantytowns and bread lines. We put out the financial fire…because we wanted to prevent mass unemployment.”

Incredible as it seems now, Timothy Geithner had even fewer economic credentials for his post as Chairman of the New York Federal Reserve than Ben Bernanke had for his as Chairman of the Federal Reserve Board of Governors. Geithner had only one economics course as a Dartmouth undergraduate (he found it “dreary”). His master’s degree at John’s Hopkins was split between international economics and Far Eastern studies. (He speaks Japanese, among other foreign languages.) He put in a three-year stint as a consultant with Henry Kissinger’s consulting firm before graduating to the Treasury, where he spent 13 years before moving to the International Monetary Fund, then becoming Chairman of the New York Fed at age 42. As Freeman observed in his book review, Geithner “never worked in finance or in any type of business” save Kissinger’s consulting firm.

This isn’t exactly a resume of recommendation for a man taking the tiller during a financial typhoon. Maybe it explains what Freeman called Geithner’s “difficulty in understanding the health of large financial firms.”

When asked by interviewers if he had any regrets about his tenure, Geithner regrets not foreseeing the crisis in time to act sooner. This certainly contradicts his theory of crises and his claim of special knowledge – if he was the man with a plan and the man of the moment, why did he fail to foresee the crisis and have to go begging for emergency authorization for Presidential action at the 11th hour? Why should we now eagerly devour the words of a man who claims responsibility for saving the nation while simultaneously admitting that he “didn’t see the crisis coming and didn’t grasp the severity of the problems when it appeared?” He now boasts a special understanding of financial crises, but “didn’t require the banks he was overseeing to raise more capital” at the time of the crisis. In fact, as Freeman discloses, the minutes of the Federal Reserve show that Geithner denies that the banking system in general was undercapitalized even while other Fed governors were proposing that banks meet a capital call.

Geithner offers no particular reason why we should believe anything he says and ample reasons for doubt.

“The Government and the Central Bank Have to Step In and Take Risks”

Geithner’s book and publicity tour are a public-relations exercise designed to change his image. Ironically, this involves a tradeoff. He had image problems with both the right wing and the left wing, so gains on one side rate to lose him support on the other side. The Wall Street Journal piece shows that he wants to burnish his left profile. He closes by lamenting that “we were not able to do all that was important or desirable.  …Long-term unemployment remains alarmingly high. There are very high levels of poverty and appalling inequality, not just in income and wealth, but in the opportunities Americans have for a quality education or economic mobility.” Having spent the bulk of the op-ed apologizing for not allowing undeserving Wall Street bankers to go broke, he now nods frantically to every left-wing preoccupation. None of this has anything to do with a financial crisis or emergency authorizations or stress tests, of course – it is just Geithner stroking his left-wing critics.

The real sign that Geithner’s allegiance is with the left is his renunciation of the concept of “moral hazard.” Oh, he gives lip service to the fact that when the government bails out business and subsidizes failure, this will encourage subsequent businessmen to take excessive risks on a “heads I win, tails the government bails me out” expectation. But he savagely criticizes the moral hazard approach as “Old Testament” thinking. (The fact that “Old Testament” is now a pejorative is significant in itself; one wonders what significance “New Testament” would have.) “What one has to do in a panic is the opposite of what seems fair and just. In a financial crisis, the natural instinct is to let creditors suffer losses, let firms fail, and protect taxpayers from any risk of loss. But in a financial panic, a strategy based on those instincts will lead to depression-level unemployment. Instead, the government and the central bank have to step in and take risks on a scale that the private sector can’t and won’t… reduce the incentive for investors, lenders and depositors to run…raise the confidence of businesses and individuals… breaking a vicious cycle in which the fear of a financial-system collapse and a deep recession feed on each other and become self-fulfilling.”

This is surely the clearest sign that Geithner is engaging in ex post rationalization and improvisation. For centuries, economists have debated the question of whether recessions are real or monetary in origin and substance. Now Geithner emerges with the secret: they are psychological. Keynes, it seems, was the second-most momentous thinker of the 1930s, behind Sigmund Freud. All we have to do is overcome our “natural instinct” and rid ourselves of those awful “Old Testament” morals and bail out the right people – creditors – instead of the wrong people – taxpayers.

Once again, commentators have glossed over the most striking contradictions in this tale. For five years, we have listened ad nauseum to scathing denunciations of bankers, real-estate brokers, developers, investment bankers, house flippers and plain old home buyers who went wild and crazy, taking risks right and left with reckless abandon. But now Geithner is telling us that the problem is that “the private sector can’t and won’t …take risks on a scale” sufficient to save us from depression! So government and the central bank (!) must gird their loins, step in and do the job.

But this is a tale left unfinished.  Geithner says plainly that his actions saved us from a Great Depression. He also says that salvation occurred because government and the Fed assumed risks on a massive scale. What happened to those risks? Did they vanish somewhere in a puff of smoke or cloud of dust? If not, they must still be borne. And if the risks are still active, that means that we have not, after all, been saved from the Great Depression; it has merely been postponed.

It is not too hard to figure out what Geithner is saying between the lines. He wants to justify massive Federal Reserve purchases of toxic bank assets and the greatest splurge of money creation in U.S. history – without having to mention that these put us all on a hook where we remain to this day.

In this sense, Timothy Geithner’s book was well titled. Unfortunately, he omitted to mention that the most stressful test is yet to come.

DRI-234 for week of 11-17-13: Economists Start to See the Light – and Speak Up

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Economists Start to See the Light – and Speak Up

In order for dreadful economic policies to be ended, two things must happen. Economists must recognize the errors – then, having seen the light, they must say so publicly. For nearly five years, various economists have complained about Federal Reserve economic policies. Unfortunately, the complaints have been restrained and carefully worded to dilute their meaning and soften their effect. This has left the general public confused about the nature and degree of disagreement within the profession. It has also failed to highlight the radicalism of the Fed’s policies.

Two recent Wall Street Journal economic op-eds have broken this pattern. They bear unmistakable marks of acuity and courage. Both pieces focus particularly on the tactic of quantitative easing, but branch out to take in broader issues in the Fed’s conduct of monetary policy.

A Monetary Insider Kneels at the Op-Ed Confessional to Beg Forgiveness

Like many a Wall Street bigwig, Andrew Huszar has led a double life as managing director at Morgan Stanley and Federal Reserve policymaker. After he served seven years at the Fed from 2001-2008, good behavior won him a parole to Morgan Stanley. But when the Great Financial Crisis hit, TARP descended upon the landscape. This brought Huszar a call to return to public service in spring, 2009 as manager of the Fed’s program of mortgage-backed securities purchases. In “Confessions of a Quantitative Easer” (The Wall Street Journal, 11/12/2013), Huszar gives us the inside story of his year of living dangerously in that position.

Despite his misgivings about what he perceived as the Fed’s increasing subservience to Wall Street, Huszar accepted the post and set about purchasing $1.25 trillion (!) of mortgage-backed securities over the next year. This was the lesser-known half of the Fed’s quantitative-easing program, the little brother of the Fed’s de facto purchases of Treasury debt. “Senior Fed officials… were publicly acknowledging [past] mistakes and several of those officials emphasized to me how committed they were to a major Wall Street revamp.” So, he “took a leap of faith.”

And just what, exactly, was he expected to have faith in? “Chairman Ben Bernanke made clear that the Fed’s central motivation was to ‘affect credit conditions for households and businesses.'” Huszar was supposed to “quarterback the largest economic stimulus in U.S. history.”

So far, Huszar’s story seems straightforward enough. For over half a century, economists have had a clear idea of what it meant to stimulate an economy via central-bank purchases of securities. That idea has been to provide banks with an increase in reserves that simultaneously increases the monetary base. Under the fractional-reserve system of banking, this increase in reserves will allow banks to increase lending, causing a pyramidal increase in reserves, money, spending, income and employment. John Maynard Keynes himself was dubious about this use of monetary policy, at least during the height of a depression, because he feared that businesses would be reluctant to borrow in the face of stagnant private demand. However, Keynes’ neo-Keynesian successors gradually came to understand that the simple Keynesian remedy of government deficit spending would not work without an accompanying increase in the money stock – hence the need for reinforcement of fiscal stimulus with monetary stimulus.

Only, doggone it, things just didn’t seem to work out that way. Sure enough, the federal government passed a massive trillion-dollar spending measure that took effect in 2009. But “it wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were issuing wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.”

Just as worrisome was the reaction to the doubts expressed by Huszar and fellow colleagues within the Fed. Instead of worrying “obsessively about the costs versus the benefits” of their actions, policymakers seemed concerned only with feedback from Wall Street and institutional investors.

When QE1 concluded in April, 2010, Huszar observed that Wall Street banks and near-banks had scored a triple play. Not only had they booked decent profits on those loans they did make, but they also collected fat brokerage fees on the Fed’s securities purchases and saw their balance sheets enhanced by the rise in mortgage-security prices. Remember – the Fed’s keenness to buy mortgage-backed securities in the first place was due primarily to the omnipresence of these securities in bank portfolios. Indeed, mortgage-backed securities served as liquid assets throughout the financial system and it was their plummeting value during the financial crisis that caused the paralyzing credit freeze. Meanwhile, “there had been only trivial relief for Main Street.”

When, a few months later, the Fed announced QE2, Huszar “realized the Fed had lost any remaining ability to think independently from Wall Street. Demoralized, I returned to the private sector.”

Three years later, this is how Huszar sizes up the QE program. “The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its purchases have come to more than $4 trillion. Amazingly, in a supposedly free-market nation, QE has become the largest financial-market intervention by any government in world history.”

“And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrasts, experts outside the Fed…suggest that the Fed may have [reaped] a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output).” In other words, “QE isn’t really working” –

except for Wall Street, where 0.2% of U.S. banks control 70% total U.S. bank assets and form “more of a cartel” than ever. By subsidizing Wall Street banks at the expense of the general welfare, QE had become “Wall Street’s new ‘too big to fail’ policy.”

The Beginning of Wisdom

Huszar’s piece gratifies on various levels. It answers one question that has bedeviled Fed-watchers: Do the Fed’s minions really believe the things the central bank says? The answer seems to be that they do – until they stop believing. And that happens eventually even to high-level field generals.

It is obvious that Huszar stopped drinking Federal Reserve Kool-Aid sometime in 2010. The Fed’s stated position is that the economy is in recovery – albeit a slow, fragile one – midwived by previous fiscal and monetary policies and preserved by the QE series. Huszar doesn’t swallow this line, even though dissent among professional economists has been muted over the course of the Obama years.

Most importantly, Huszar’s eyes have been opened to the real source of the financial crisis and ensuing recession; namely, government itself. “Yes, those financial markets have rallied spectacularly…but for how long? Experts…are suggesting that conditions are again ‘bubble-like.'”

Having apprehended this much, why has Huszar’s mind stopped short of the full truth? Perhaps his background, lacking in formal economic training, made it harder for him to connect all the dots. His own verdict on the failings of QE should have driven him to the next stage of analysis and prompted him to ask certain key questions.

Why did banks “only issu[e] fewer and fewer loans”? After all, this is why QE stimulated Wall Street but not Main Street; monetary policy normally provides economic stimulus by inducing loans to businesses and (secondarily) consumers, but in this case those loans were conspicuous by their absence. The answer is that the Fed deliberately arranged to allow interest payments on excess reserves it held for its member banks. Instead of making risky loans, banks could make a riskless profit by holding excess reserves. This unprecedented state of affairs was deliberately stage-managed by the Fed.

Why has the Fed been so indifferent to the net effects of its actions, instead of “worry[ing] obsessively about the costs versus the benefits”? The answer is that the Fed has been lying to the public, to Congress and conceivably even to the Obama Administration about its goals. The purpose of its actions has not been to stimulate the economy, but rather to keep it comatose (for “its” own good) while the Fed artificially resuscitates the balance sheets of banks.

Why did the Fed suddenly start buying mortgage-backed securities after “never [buying] one mortgage bond…in its almost 100-year history”? Bank portfolios (more particularly, portfolios of big banks) have been stuffed to the gills with these mortgage-backed securities, whose drastic fall in value during the financial crisis threatened the banks with insolvency. By buying mortgage-backed securities like they were going out of style, the Fed increases the demand for those securities. This drives up their price. This acts as artificial respiration to bank balance sheets, just as Andrew Huszar relates in his op-ed.

The resume of Fed Chairman Ben Bernanke is dotted with articles extolling the role played by banks as vital sources of credit to business. Presumably, this – rather than pure cronyism, as vaguely hinted by Huszar – explains Bernanke’s obsession with protecting banks. (It was Bernanke, acting with the Treasury Secretary, who persuaded Congress to pass the enormous bailout legislation in late 2008.)

Why has “the Fed’s independence [been] eroding”? There is room for doubt about Bernanke’s motivations in holding both short-term and long-term interest rates at unprecedentedly low levels. These low interest rates have enabled the Treasury to finance trillions of dollars in new debt and roll over trillions more in existing debt at low rates. At the above-normal interest rates that would normally prevail in our circumstances, the debt service would devour most of the federal budget. Thus, Bernanke is carrying water for the Treasury. Reservoirs of water.

Clearly, Huszar has left out more than he has included in his denunciation of QE. Yet he has still been savaged by the mainstream press for his presumption. This speaks volumes about the tacit gag order that has muffled criticism of the Administration’s economic policies.

It’s About Time Somebody Started Yellin’ About Yellen

Kevin Warsh was the youngest man ever to serve as a member of the Federal Reserve Board of Governors when he took office in 2006. He earned a favorable reputation in that capacity until he resigned in 2011. In “Finding Out Where Janet Yellen Stands” (The Wall Street Journal, 11/13/2013), Warsh digs deeper into the views of the new Federal Reserve Board Chairman than the questions on everybody’s lips: “When will ‘tapering’ of the QE program begin? and “How long will the period of ultra-low interest rates last?” He sets out to “highlight – then question – some of the prevailing wisdom at the basis of current Fed policy.”

Supporters of QE have pretended that quantitative easing is “nothing but the normal conduct of monetary policy at the zero-lower-bound of interest rates.” Warsh rightly declares this to be hogwash. While central banks have traditionally lowered short-term interest rates to stimulate investment, “the purchase of long-term assets from the U.S. Treasury to achieve negative real interest rates is extraordinary, an unprecedented change in practice… The Fed is directly influencing the price of long-term Treasurys – the most important asset in the world, the predicate from which virtually all investment decisions are judged.”

Since the 1950s, modern financial theory as taught in orthodox textbooks has treated long-term U.S. government bonds as the archetypal “riskless asset.” This provides a benchmark for one end of the risk spectrum, a vital basis for comparison that is used by investment professionals and forensic economists in court testimony. Or rather, all this used to be true before Ben Bernanke unleashed ZIRP (the Zero Interest Rate Policy) on the world. Now all the finance textbooks will have to be rewritten. Expert witnesses will have to find a new benchmark around which to structure their calculations.

Worst of all, the world’s investors are denied a source of riskless fixed income. They can still purchase U.S. Treasurys, of course, but these are no longer the same asset that they knew and loved for decades. Now the risk of default must be factored in, just as it is for the bonds of a banana republic. Now the effects of inflation must be factored in to its price. The effect of this transformation on the world economy is incalculably, unfavorably large.

Ben Bernanke has repeatedly maintained that the U.S. economy would benefit from a higher rate of inflation. Or, as Warsh puts it, that “the absence of higher inflation is sufficient license” for the QE program. Once again, Warsh begs to differ. Here, he takes issue with Bernanke’s critics as much as with Bernanke himself. “The most pronounced risk of QE is not an outbreak of hyperinflation,” Warsh contends. “Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment – which do not augur well for long-term growth or financial stability.”

Déjà Va-Va-Vuum

Of all the hopeful signs to recently emerge, this is the most startling and portentous. For centuries – at least two centuries before John Maynard Keynes wrote his General Theory and in the years since – the most important effect of money on economic activity was thought to be on the general level of prices; i.e., on inflation. Now Warsh is breaking with this time-honored tradition. In so doing, he is paying long-overdue homage to the only coherent business-cycle theory developed by economists.

In the early 1930s, F.A. Hayek formulated a business-cycle theory that temporarily vied with the monetary theory of John Maynard Keynes for supremacy among the world’s economists. Hayek’s theory was built around the elements stressed by Warsh – capital misallocation and malinvestment caused by central-bank manipulation of the money supply and interest rates. In spite of Hayek’s prediction of the Great Depression in 1929 and of the failure of the Soviet economy in the 1930s, Hayek’s business-cycle theory was ridiculed by Keynes and his acolytes. The publication of Keynes’ General Theory in 1936 relegated Hayek to obscurity in his chosen profession. Hayek subsequently regained worldwide fame with his book The Road to Serfdom in 1944 and even won the Nobel Prize in economics in 1974. Yet his business-cycle theory has survived only among the cult of Austrian-school economists that stubbornly refused to die out even as Keynesian economics took over the profession.

When Keynesian theory was repudiated by the profession in the late 1970s and 80s, the Austrian school remained underground. The study of capital theory and the concept of capital misallocation had gone out of favor in the 1930s and were ignored by the economics profession in favor of the less-complex modern Quantity Theory developed by Milton Friedman and his followers. Alas, monetarism went into eclipse in the 80s and 90s and macroeconomists drifted back towards a newer, vaguer version of Keynesianism.

The Great Financial Crisis of 2008, the subsequent Great Recession and our current Great Stagnation have made it clear that economists are clueless. In effect, there is no true Macroeconomic theory. Warsh’s use of the terms “capital misallocation” and “malinvestment” may be the first time since the 1930s that these Hayekian terms have received favorable mention from a prominent figure in the economic Establishment. (In addition to his past service as a Fed Governor, Warsh also served on the National Economic Council during the Bush Administration.)

For decades, graduate students in Macroeconomics have been taught that the only purpose to stimulative economic policies by government was to speed up the return to full employment when recession strikes. The old Keynesian claims that capitalist economies could not achieve full employment without government deficit spending or money printing were discredited long ago. But this argument in favor of artificial stimulus has itself now been discredited by events, not only in the U.S. and Europe but also in Japan. Not only that, the crisis and recession proceeded along lines closely following those predicted by Hayek – lavish credit creation fueled by artificially low interest rates long maintained by government central banks, coupled with international transmission of capital misallocation by flexible exchange rates. It is long past time for the economics profession to wrench its gaze away from the failed nostrums of Keynes and redirect its attention to an actual theory of business cycles with a demonstrated history of success. Warsh has taken the key first step in that direction.

The Rest of the Story

When a central bank deliberately sets out to debase a national currency, the shock waves from its actions reverberate throughout the national economy. When the economy is the world’s productive engine, those waves resound around the globe. Warsh patiently dissects current Fed policy piece by piece.

To the oft-repeated defense that the Fed is merely in charge of monetary policy, Warsh correctly terms the central bank the “default provider of aggregate demand.” In effect, the Fed has used its statutory mandate to promote high levels of employment as justification for assuming the entire burden of economic policy. This flies in the face of even orthodox, mainstream Keynesian economics, which sees fiscal and monetary policies acting in concert.

The United States is “the linchpin in the international global economy.” When the Fed adopts extremely loose monetary policy, this places foreign governments in the untenable position of having either to emulate our monetary ease or to watch their firms lose market share and employment to U.S. firms. Not surprisingly, politics pulls them in the former direction and this tends to stoke global inflationary pressures. If the U.S. dollar should depreciate greatly, its status as the world’s vehicle currency for international trade would be threatened. Not only would worldwide inflation imperil the solidity of world trade, but the U.S. would lose the privilege of seigniorage, the ability to run continual trade deficits owing to the world’s willingness to hold American dollars in lieu of using them to purchase goods and services.

The Fed has made much of its supposed fidelity to “forward guidance” and “transparency,” principles intended to allow the public to anticipate its future actions. Warsh observes that its actions have been anything but transparent and its policy hints anything but accurate. Instead of giving lip service to these cosmetic concepts, Warsh advises, the Fed should simply devote its energies to following correct policies. Then the need for advance warning would not be so urgent.

Under these circumstances, it is hardly surprising that we have so little confidence in the Fed’s ability to “drain excess liquidity” from the markets. We are not likely to give way in awed admiration of the Fed’s virtuosity in monetary engineering when its pronouncements over the past five years have varied from cryptic to highly unsound and its predictions have all gone wrong.

Is the Tide Turning?

To a drowning man, any sign that the waters are receding seems like a godsend. These articles appear promising not only because they openly criticize the failed economic policies of the Fed and (by extension) the Obama Administration, but because they dare to suggest that The Fed’s attempt to portray its actions as merely conventional wisdom is utterly bogus. Moreover, they imply or (in Kevin Warsh’s case) very nearly state that it is time to reevaluate the foundations of Macroeconomics itself.

Is the tide turning? Maybe or maybe not, but at last we can poke our heads above water for a lungful of oxygen. And the fresh air is intoxicating.

DRI-250 for week of 1-27-13: What Are the Lessons of Econometrics?

An Access Advertising EconBrief:

What Are the Lessons of Econometrics?

Recently, Federal Reserve official Janet Yellen earned attention with a speech in which she justified monetary easing by citing the Fed’s use of a new “macroeconometric model” of the economy. The weight of the term seemed to give it rhetorical heft, as if the combination of macroeconomics and econometrics produced a synergy that each one lacked individually. Does econometrics hold the key to the mysteries of optimal macroeconomic policy? If so, why are we only now finding that out? And, more broadly, is economics really the quantitative science it often pretends to be?

Econometrics

As practiced for roughly eight decades, econometrics combines the knowledge of three fields – economics, mathematics and statistics. Economics develops the pure logic of human choice that gives logical structure to our quantitative investigations into human behavior. Mathematics determines the form in which economic principles are expressed for purposes of statistical analysis. Statistics allows for the systematic processing and analysis of sample data organized into meaningful form using the principles of economics and mathematics.

Suppose we decide to study the market for production and consumption of corn in the U.S. Economics tells us that the principles of supply and demand govern production and consumption. It further tells us that the price of corn will gravitate toward the point at which the aggregate amount of corn that U.S. farmers wish to produce will equal the aggregate amount that U.S. consumers wish to consume and store for future use.

Mathematics advises us to portray this relationship between supply and demand by expressing both as mathematical equations. That is, both supply and demand will be expressed as mathematical functions of relevant variables. The orthodox formulation treats the price of corn as the independent variable and the quantity of corn supplied and demanded, respectively, as the dependent variable of each equation. Other variables, called parameters, are included in the equations as well, but isolated from price in their effects on quantity. Finally, our model of the corn market will stipulate that the two equations will produce an equal quantity demanded and supplied of corn.

Statistics allows us to gather data on corn without having to compile every single scrap of information on every ear of corn produced during a particular year. Instead, sample data (probably provided by government bureaus) can be consulted and carefully processed using the principles of statistical inference.

In principle, this technique can derive equations for both the supply of corn and its demand. These equations can be used either to predict future corn harvests or to explain the behavior of corn markets in the past. For over a half-century, training in econometrics has been a mandatory part of postgraduate education in economics at nearly all American universities.

Does this procedure leave you scratching your head? In particular, are you moved to wonder why mathematics and simultaneous equations should intrude into the study of economics? Or have we outlined a beautiful case of interdisciplinary cooperation in science?

Historical Evolution

As it happens, the development of econometrics was partly owing to the collision of scientific research programs that evolved concurrently in similar directions. Economics has interacted with data virtually since its inception. In the 1600s, Sir William Petty utilized highly primitive forms of quantitative analysis in England to analyze subjects like taxation and trade. Adam Smith populated The Wealth of Nations with various homely numerical examples. In the early 19th century, a French economist named Cournot used mathematics to develop pathbreaking models of monopoly and oligopoly, which anticipated more famous work done many decades later.

A Swiss economist, Leon Walras, and an Italian, Enrico Barone, applied algebraic mathematics to economics by expressing economic relationships in the form of systems of simultaneous equations. They did not attempt to fill in the parametric coefficients of their economic variables with real numbers – in fact, they explicitly denied the possibility of doing so. Their intent was purely symbolic. In effect, they were saying: “Isn’t it remarkable how the relationships in an economic system resemble those in a mathematical system of simultaneous equations? Let’s pretend that an economy of people could be described and analyzed using algebraic mathematics as a tool – and then see what happens.”

At almost the same time (the early 1870s), the British economist William Stanley Jevons developed the principles of marginalism, which have been the cornerstone of economic logic ever since. Economic value is determined at the margin – which means that both producers and consumers gauge the effects of incremental changes in action. If the benefits of the action exceed the costs, they approve the action and take it. If the reverse holds, they spurn it. Their actions produce tendencies toward marginal equality of benefits and costs, similar in principle to the quantity supplied/quantity demanded equality cited above. Jevons thought it amazing that this incremental logic seemed to correspond so closely to the logic inherent in the differential calculus. So he developed his theory of consumer demand in mathematical terms, using calculus. (It is also fascinating that the Austrian simultaneous co-discoverer of marginalism, Carl Menger, refused to employ calculus in his formulations.)

By the early 1900s, the roots of mathematics in economics had taken root. Soon a British mathematician, Ronald Fisher, would modernize the science of statistics. It was only a matter of time until mathematical economists began using statistics to put numbers into the coefficient slots in their equations, which were previously occupied with algebraic letters serving as symbolic place-holders.

In 1932, economist and businessman Alfred Cowles endowed the Cowles Commission at the University of Chicago. The purpose of the Commission was to do economic research, but the research was targeted toward mathematics and economics. The original motto of the Commission was the same as that of the Econometric Society. It was taken from the words of the great physicist Lord Kelvin: “Science is measurement.”

Seldom have three words conveyed so much meaning. The implication was that economics was, or should strive to be, a “science” in exactly the same sense as physics, biology, chemistry and the rest of the hard physical sciences. The physical sciences did science by observing empirical regularities and expressing them mathematically. They tested their theories using controlled laboratory experiments. They were brilliantly successful. The progress of mankind can be traced by following the progression of their work.

In retrospect, it was probably inevitable that social sciences like economics should take this turn – that they should come to define their success, their very meaning, by the extent and degree of their emulation of the natural sciences. The Cowles Commission was the cutting edge of econometrics for the next 20 years, after which time its major focus shifted from empirical to theoretical economics – back to mathematical models of the economy using simultaneous equations. But by that time, econometrics had gained an impregnable beachhead in economics.

The Role of Econometrics

Great hopes were held out for econometrics. Of course, it was young as sciences go, but by careful study and endless trial and error, we would gradually get better and better at creating better economic models, choosing just the right mathematical forms and using exactly the right statistical techniques. Our forecasts would slowly, but surely, improve.

After all, we had a country full of universities whose economists had nothing better to do than monkey around with econometrics. They would submit their findings for review by their peers. The review would lead to revisions. The best studies would be published in the leading economics journals. At last, at long last, we would discover the empirical regularities of economics, the rules and truths that had remained hidden from us for centuries. The entire system of university tenure and promotion would be based on this process, leading to the notorious maxim “publish or perish.” Success would be tied to the value of government research grants acquired to do this research. The brightest young minds would succeed and climb the ladder of university success. They would teach in graduate school. A virtuous cycle of success would produce more learning, better economics, better econometrics, better models, better predictions, more economic prosperity in society, better education for undergraduates and graduate students alike and a better life for all.

As it turned out, none of these hopes have been fulfilled.

Well, that’s not entirely accurate. A system was created that has ruled academic life for decades and, incredibly, shows no sign of slowing down. Young economists are taught econometrics, after a fashion. They dutifully graduate and scurry to a university where they begin the race for tenure. Like workers in a sausage factory, they churn out empirical output that is read by nobody excepting a few of their colleagues. The output then dies an unlamented death in the graveyard of academic journals. The academic system has benefitted from econometrics and continues to do so. It is difficult to imagine this system flourishing in its absence.

Meanwhile, back at the ranch of reality, the usefulness of econometrics to the rest of the world asymptotically approaches zero. Periodically, well-known economists like Edmond Malinvaud and Carl Christ review the history of econometrics and the Cowles Commission. They are laudatory. They praise the Commission’s work and the output of econometricians. But they say nothing about empirical regularities uncovered or benefits to society at large. Instead, they gauge the benefits of econometrics entirely from the volume of studies done and published in professional journals and the effort expended by generations of economists. In so doing, they violate the very standards of their profession, which dictates that the value of output is judged by its consumers, not by its producers, and that value is determined by price in a marketplace rather than by weight on a figurative scale.

It is considered a truism within the economics profession that no theoretical dispute was ever settled by econometrics – that is a reflection of how little trust economists place in it behind closed doors. In practice, economists put their trust in theory and choose their theories on the basis of their political leanings and emotional predilections.

We now know, as surely as we can know anything in life, that we cannot predict the future using econometrics. As Donald (now Deirdre) McCloskey once put it, you can figure this out yourself without even going to graduate school. All you have to do is figuratively ask an econometrician the “American question:” “If you’re so smart, why ain’t you rich?” Accurate predictions would yield untold riches to the predictors, so the absence of great wealth is the surest index of the poverty of econometrics.

Decades of econometric research have yielded no empirical regularities in economics. Not one. No equivalent to Einstein’s equation for energy or the Law of Falling Bodies.

It is true that economists working for private business sometimes generate predictions about individual markets using what appears to be econometrics. But this is deceptive. The best predictions are usually obtained by techniques called “data mining,” that violate the basic precepts of econometrics. The economists are not interested in doing good econometrics or statistics – just in getting a prediction with some semblance of accuracy. Throwing every scrap of data they can get their hands on into the statistical pot and cooking up a predictive result doesn’t tell you much about which variables are the most important or the degree of independent influence each has on the outcome. But the only hope for predictive success may be in assuming that the future is an approximation of the past, in which case the stew pot may cook up a palatable result.

The Great “Statistical Significance” Scandal

In the science of medicine, doctors are sworn to obey the dictum of Hippocrates: “First, do no harm.” For over twenty years, economists Deirdre McCloskey and Stephen Ziliak have preached this lesson to their colleagues in the social sciences. The use of tests of “statistical significance” as a criterion of value was rampant by the 1980s, when the two began their crusade against its misuse. For, as they pointed out, the term is misunderstood not only by the general public but even by the professionals who employ it.

When a variable is found statistically significant, this does not constitute an endorsement of its quantitative importance. It merely indicates the likelihood that the sample upon which the test was conducted was, indeed, randomly chosen according to the canons of statistical inference. That information is certainly useful. But it is not the summum bonum of econometrics. What we usually want to know is what McCloskey and Ziliak refer to as the “oomph” of a variable (or a model in its totality) – how much quantitative effect it has on the thing it affects.

The two modern-day Diogenes conducted two studies of the econometric articles published in the American Economic Review, the leading professional journal. In the 1980s, most of the authors erred in their use and interpretation of the concept of statistical significance. In the 1990s, after McCloskey and Ziliak began writing and speaking out on the problem, the ratio of mistakes increased. Among the culprits were some of the profession’s most distinguished names, including several Nobel Prize winners. When it comes to statistics and econometrics, it seems, economists literally do not know what they are doing.

According to McCloskey – who is herself a practitioner and believer in econometrics – virtually all the empirical work done in econometrics to date will have to be redone. Most of the vast storehouse of econometric work done since the 1930s is worthless.

The Difference Between the Social Sciences and the Natural Sciences

Statistics has been proven to work well in certain contexts. The classical theory of relative-frequency probability is clearly valid, for example; if it weren’t, Las Vegas would have gone out of business long ago. Those who apply statistics properly, like W. Edward Deming, have used it with tremendous success in practical applications. Deming’s legendary methods of quality control involving sampling and testing have been validated time and again across time and cultures.

When econometrics was born, a small band of critics protested its use on the grounds that the phenomena being studies in the social sciences were not amenable to statistical inference. They do not involve replicative, repetitive events that resemble coin flips or dice throws. Instead, they are unique events that involving different elements whose structures differ in innumerable ways. The number of variables involved usually differs between the physical and social sciences, being vastly larger when human beings are the phenomena under study. Moreover, the free will exerted by humans is different from unmotivated, instinctive, chemically or environmentally induced behavior found in nature. Free will can defy quantitative expression, whereas instinctive behavior may be much more tractable.

In retrospect, it now seems certain that those critics were right. Whatever the explanation, the social sciences in general and economics in particular resist the quantitative measurement techniques that took natural sciences to such heights.

The Nature of Valid Economic Prediction

We can draw certain quantitative conclusions on the basis of economic theory. The Law of Demand says that when the price of something rises, desired purchases of that thing will fall – other things equal. But it doesn’t say how much they’ll fall. And we know intuitively that, in real life, other things are never unchanged. Yet despite this severely limited quantitative content, there is no proposition in economic theory that has demonstrated more practical value.

Economists have long known that agriculture is destined to claim a smaller and smaller share of total national income as a nation gets wealthier. There is no way to predict the precise pattern of decrease, but we know that it will happen. Why? Agricultural goods are mostly either food or fiber. We realize instinctively that when our real incomes increase, we will purchase more food and more clothing – but not in proportion to the increase in income. That is, a 20% increase in real income will not motivate us to eat 20% more food – not even Diamond Jim Brady was that gluttonous. Similarly, increases in agricultural productivity will increase output and lower price over time. But a 20% decline in food prices will not call forth 20% more desired food purchases. Economists say that the demand for agricultural good is price- and income-inelastic.

These are the types of quantitative predictions economists can make with a clear conscience. They are couched in terms of “more” or “less,” not in terms of precise numerical predictions. They are what Nobel laureate F. A. Hayek called “pattern predictions.”

It is one of history’s great ironies that Hayek, an unrelenting critic of macroeconomics and foe of statistics and econometrics, nevertheless made some of the most prescient economic predictions of the 20th century. In 1929, Hayek predicted that the economic boom of the 1920s would soon end in economic contraction – which it did, with a vengeance. (Hayek’s mentor, Ludwig von Mises, went even further by refusing a prestigious appointment because he anticipated that “a great crash” was imminent.) In the 1930s, both Hayek and von Mises predicted the failure of the Soviet economy due to its lack of a functioning price system, particularly the absence of meaningful interest rates. That prediction, too, eventually bore fruit. In the 1950s, Hayek declared that Keynesian economic policies would produce accelerating inflation. Western industrial nations endured withering bouts of inflation beginning in the late 1960s and lasting for over a decade. Then Hayek broke with his fellow economists by insisting that this inflationary cycle could be broken, but only by drastically slowing the rate of monetary growth and enduring the resulting recession for as long as it lasted. Right again – and the recession was followed by two decades of prosperity that came to be known as the Great Moderation.

Ask the Fed

One of the tipoffs to the complicity of the mainstream press in the Obama administration’s policies is the fact that nobody has thought to ask Janet Yellen questions like this: “If your macroeconometric model is good enough for you to rely on it as a basic for a highly unconventional set of policies, why did it not predict the decline in Gross Domestic Product in fourth quarter 2012? Or if it did, why did the Fed keep that news a secret from the public?”

The press doesn’t ask those questions. Perhaps they are cowed by the subject of “macroeconometrics.” In fact, macroeconomics and econometrics are the two biggest failures of contemporary economics. And there are those who would substitute the word “frauds” for “failures.” Unless you take the position that combining two failures rates to produce a success, there is no reason to expect anything valuable from macroeconometrics.

DRI-364 for week of 9-23-12: Revisiting the DRI and Related Economic Indices

An Access Advertising EconBrief:

Revisiting the DRI and Related Economic Indices

Periodically this space has revisited Access Advertising’s Driver Recruiting Index (DRI). This index tries to estimate the real-time ex ante demand for commercial drivers. It samples the classified ads placed to recruit drivers in 32 geographically dispersed major-metropolitan newspapers throughout the U.S. Every now and then, we place the DRI alongside other trucking, transport and freight indices and gauge its movements in relation to indices of overall income and employment.

The DRI in the 2nd and 3rd Quarters

Like the overall economy, the DRI got off to a reasonably fast start after a promising end to 2011. But it soon became clear that, like the U.S. economy, the DRI was going to fall short of expectations (let alone hopes) in 2012. The Index pierced the 200 barrier for the only time so far this year on March 25, flirting with a raw score of 500 (an achievement it exceeded 14 times in 2011).

After that, it has been all downhill. Year-over-year comparisons have occasionally fallen over 20% short of 2011; 10% shortfalls have been commonplace. Driver demand has never really caught fire, peaking in late spring and skipping both the normal summer high and the fall upturn.

Second-quarter GDP growth was also disappointing, ending up at a tepid 1.7%, even below the moderate 2% in first quarter. Although unemployment has now declined fractionally to 8.1%, this reflects only the decline in the size of the labor force. The number of new jobs created has continued to languish.

The only good news has been a Wall Street rally engineered largely in response to the latest quantitative easing by Ben Bernanke’s Federal Reserve. This is probably responsible for a recent upsurge in consumer confidence in the economy.

The DRI as Economic Indicator

If the DRI’s disappointing performance has mirrored that of general economic indicators, this very congruence speaks well for the DRI’s performance as an economic indicator. Trucking handles some two-thirds of all freight by volume and about 80% by value; many production inputs and final goods travel the nation’s roads and highways. We expect changes in trucking activity and driving demand to track overall trends in production, income and employment. (Whether the DRI is or should be a leading, coincident or lagging indicator is a complicated question that will be broached later.)

The DRI continues to display other desirable properties as well. One of those is (relative) stability. The very ubiquity and prominence of trucking strongly suggests that we should not expect to find the Index fluctuating widely from week to week. While trucking firms ordinarily experience high rates of turnover, this is a long-term phenomenon, responsive to demographic factors (average age, cultural shifts) and cyclical variables (wage changes, politico-regulatory changes). A particular trucking firm may well experience a sudden, substantial need for drivers, but this will usually represent a geographic shift of demand that is offsetting in the aggregate. Significant increases or decreases, when they occur, are usually persistent, cyclical changes in trend, not random fluctuations.

For a concrete illustration, compare the DRI with TransCore’s DAT North American Freight Index, which compiles data from the company’s load board network in the U.S. and Canada. Neither the DRI nor the NAFI is seasonally adjusted, but the contrast in variability is stark. Earlier in 2012, NADI racked up this record of month-over-month fluctuations: March 2012 – up 40%, April 2012 – up 3.5%, May 2012 – up 1.7%, June 2012 – down 2%, July 2012 – down 20%, August – up 1.1%. Monthly fluctuations of 20% in the DRI would be observed only at a seasonal or cyclical peak or turning point, and a 40% monthly change is unheard of.

The DRI and Comparable Economic Indicators

Given the importance of trucking in the production chain, it is surprising that the DRI is one of few time-tested, reliable trucking indices – and the only one to track driver demand. A rundown of the others reaffirms our understanding of what makes for a good index and confirms the DRI’s recent congruence with its brethren.

The Cass Freight Index compiles data from the expenditures of 350 of the largest freight shippers. Early in the year, the Index flexed its muscles with a 2.5% increase in February 2012. Then, along with the economy at large, it began to lose vitality. Increases diminished to 2.1% in March, 1.9% in April, 1.8% in May and 1.3% in June. In July, the Index turned negative with a 0.1% decrease, followed by a 1.1% fall in August. Sponsors and analysts cited a buildup of inventories, a fall in international trade and recent declines in manufacturing output as recorded by the Institute of Supply Management’s index, which had fallen for three straight months.

The American Trucking Associations are the Establishment of the trucking industry and Chief Economist Bob Costello is the voice of starched, high-collared authority. The ATA Truck Tonnage Index is perhaps the most widely cited trucking index, not only by private-sector analysts but even by the federal government. Although the ATA’s respect for authority imparts a big-government bias to its occasional obiter dicta, its economic data are accorded the utmost respect.

The TTI’s recent numbers paint the same by-now-familiar picture of a stalling, sluggish trucking sector. March saw a 0.2% increase, April improved to 1.1% but May backtracked to 0.9%. June went back up to 1.1% but July was unchanged. Typically, Costello’s public comments wrapped the language of an economist inside the rhetoric of a politician. He depicted “…an economy that has lost some steam but hasn’t stalled.” The ATA’s corporate commentary was more telling, noting that “…the index… has been moving mostly sideways in 2012.”

The Truck Tonnage Index is an important component in the federal government’s Transportation Services Index (TSI), which is published by the Bureau of Labor Statistics (BLS). For most of 2012, this index has alternated back and forth with little net increase to show for the year. In February, the TSI rose 0.5%, but it fell back 0.8% in March. April brought a modest rebound of 0.2% but in May the Index was unchanged. June and July saw offsetting 0.1% changes.

These indices display the bedrock virtues noted above: stability and congruence with general economic activity and with each other. One of the rising economic forecasting stars of recent years was the Ceridian Pulse of Commerce Index (PCI), compiled by respected econometrician Edward Leamer of UCLA. After recording some lackluster increases earlier this year, the Index ceased publishing somewhat mysteriously following its May release. Ceridian has responded to queries by saying that although the Index does not now publish its results, it is contemplating a return on a subscription basis and is soliciting indications of interest among potential customers.

Is the DRI a Leading, Lagging or Coincident Indicator?

Undergraduate students of economics are taught that economic indicators come in three flavors – leading, coincident and lagging. These indicate whether changes in the indicator lead, accompany or lag changes in the general level of economic activity. Since the unknown future preoccupies our attention, leading indicators are especially studied and prized.

There has long been a casual presumption that trucking indices are, or at least should be, leading indicators. Disruptive phenomena like layoffs and unemployment are presumably necessitated by the accumulation of unsold goods. Since trucks carry goods and the inputs necessary to produce them, freight shipments should register the incidence of cutbacks in production and materials. This is the sort of logic that supports the categorization of trucking as a leading indicator.

Early in its life, though, the DRI was observed to be a lagging indicator. We rationalized this as the caution of recruiters, who – unsure and suspicious of the depth and duration of any increases in freight supply after the Great Recession – waited to verify the persistence of demand before incurring the fixed costs of hiring. In fact, similar behavior had been recorded in connection with the Index of Classified Advertising, an economic index that bears a strong family resemblance to the DRI.

Since leading and lagging indicators are at opposite poles, this plants a seed of skepticism about the traditional taxonomy of economic indicators. Further consideration should nourish that thought.

The inherent logic of leading economic indicators says that they can be used to predict the economic future – or at least the turning points of business cycles. And this is simply impossible.

Anybody who can accurately predict the future onset of a recession – or, for that matter, the end date of one – can earn a fortune by so doing. Anybody who can repeat the performance reliably can become fabulously rich. Business forecasters are not fabulously rich. Ergo, they cannot predict the beginning or ends of recessions. Not reliably, anyway.

This must mean that leading economic indicators do not really lead. Maybe they don’t even indicate. In any case, something isn’t quite kosher. The question is: what?

The Theory of the Business Cycle – Such As It Is

Something else that all undergraduate students of economic statistics and econometrics learn is that economic theory and logic form the basis for all empirical work. Without theory, we cannot know what data to collect or what relationships to posit between the variables that make up the data. So an economic model is borrowed or created to embody the relationships upon which data is collected. Only then can the data gathering and testing begin.

But in business forecasting that runs us smack up against a formidable obstacle. There is no generally accepted business-cycle theory. The categories used by the National Bureau of Economic Research to codify episodes of the business cycle – expansion, peak, contraction and trough – were developed by institutional economist Wesley Mitchell in the early 1900s, based on years of observation and study of past recessions. Unfortunately, observation is not theory.

The national income and product accounts used to compile U.S. economic data were developed later, based largely on the economic categories developed by English economist John Maynard Keynes in his influential work The General Theory of Employment Interest and Money. But Keynes explicitly denied that the General Theory contained any theory of the business cycle. He simply declared that capitalist economies suffered from a chronic shortage of aggregate demand – e.g., private spending by households and producers. He never said why the shortage existed. Government should make up for this shortfall, Keynes maintained, by running budget deficits that increased the aggregate total of aggregate demand or spending. Essentially, government should commit to purchasing whatever volume of output is left unbought by households and producers, so as to insure full employment. Keynes didn’t supply a theory to account for the business cycle, only a purported remedy to cure the symptoms.

Without knowing where the shortfall in spending lies, we cannot predict where to look for leading indicators at any stage of the business cycle. There is one school of thought whose business-cycle theory offers general advice on this point. That is, it doesn’t offer a list of specific industries, sectors or indicators as such, but instead provides advice about where to look for them in general cases.

The Austrian theory of the business cycle pinpoints monetary expansion by government – probably supervised by a central bank – as the proximate culprit behind recessions. By driving interest rate below the “natural rate of interest,” the rate that would equate the saving households and producers want to do, the money creation will make interest rates artificially low. This makes long-lived, capital-intensive production processes artificially attractive to producers. In turn, this creates a “bubble,” or artificial excess prosperity, in the sector thus favored. While it lasts, this bubble can seem deliriously prosperous, almost too good to be true. That is because it is too good to be true, as the drawn-out period of housing prosperity in the U.S. proved. But when the bubble bursts – owing either to a rise in interest rates or a rising burden of debt – the artificially-prosperous sectors are the first to crash. They are the leading indicators of the coming recession.

In general, then, leading indicators are those pertaining to the sectors receiving the artificial encouragement. In the U.S. during the 1990s and early 2000s, this would have been the housing sector. But this does not mean, as many have implied or outright insisted, that the housing sector should be the first to recover its balance. And it does not mean that nobody can recover until the housing sector does. Indeed, the reverse is more nearly true – housing should be the last sector to recover fully. It also means that the stubborn attempts to stage-manage recovery in housing by holding interest rates low and artificially raise housing prices through government purchases of mortgages and securities are counterproductive. After all, this is exactly the process that caused the problem in the first place – repeating it merely enlarges the backlog of adjustments that must occur before recovery can take place.

An Austrian Look at Economic Indicators

The effect of this theory on forecasting practice is striking. Housing becomes a leading indicator for the downturn phase because it is a long-lived production process, extremely sensitive to interest rates. But it is a lagging indicator for the upturn; it cannot recover until all of the bad investments made during the bubble phase are liquidated and their resources reallocated.

What about trucking? Well, trucking feeds the housing industry its materials and some of its manpower, so trucking shares this dual forecasting status. Sometimes it will be a leading indicator, sometimes a lagging one. Moreover, trucking feeds other industries as well, so it simply cannot be pigeonholed by a simplistic taxonomy. A sophisticated approach to business cycles requires us to abandon our primitive definitions of economic indicators. First, we must classify industries and sectors according to their status in the production and consumption hierarchy. Second, we must recognize the difference between recession and recovery.

We have still not exhausted the reserves of analysis, since there is still the possibility of inherent cyclical movements in economic activity that are not driven by monetary mistakes made by the authorities. The fact that money substitutes for barter in allowing human beings to trade the product of their labors solves huge problems, but it also creates smaller ones. These subtle problems may well mean that we have to live with an unavoidable element of cyclical instability in our economic life. And this may demand still more adjustments in the terminology of forecasting.

Progress Report on the DRI

The DRI is completing its fourth year of operation. It has passed the standard tests of stability, reliability and usefulness that apply to economic indices. Of course, it has not unlocked the door to wealth and fame available to any economic index that could actually forecast the future – but, as we have seen, that is a chimera. Explaining the past and recognizing the present is tough enough and a worthy goal for any economic index. Many a worthwhile aspirant has fallen short of even this limited objective; Ceridian’s PCI may be the latest addition to this list.

Nearly four years in, the DRI is still trucking.

DRI-397 for week of 9-16-12: “QE3: Flying Blind”

An Access Advertising EconBrief: 

“QE3: Flying Blind”

Recently, Federal Reserve Chairman Ben Bernanke announced that the Federal Reserve would embark on still another venture in stimulative monetary policy – QE3. Bernanke characterized this sequel as intended to “help Main Street” by fighting unemployment, which “has remained stubbornly high.”

“QE” stands for “quantitative easing.” The meaning of this phrase will seem obscure to all but insiders; it implies that the focus of monetary policy is entirely on the quantity of money rather than something else. Economic textbooks of a half-century ago defined monetary policy according to the tenets of Keynesian economics – the manipulation of interest rates (usually downward) through changes in the quantity of money.

When interest rates are at or near zero, there is little further scope for employing this tool – at least in the orthodox manner. The idea behind quantitative easing is that further increases in the quantity of money may still have stimulative impact when selectively employed. Meanwhile, the increases have the effect of maintaining the Fed’s zero-interest-rate policy (ZIRP).

The third edition of the QE series both conforms to and differs from the first two. The additional money will come from monthly purchases of mortgage-backed securities by the Fed, in the amount of $40 billion. This is both a similarity and a difference. The .Fed has been trying since 2009 to raise home prices by buying mortgage-backed securities – without much success. Prior to QE3, however, this program was segregated from monetary policy as such and marketed as a kind of disaster relief for the housing industry.

The other element of QE3 is a continuation of “Operation Twist,” the revival of a little-remembered 1960s policy aimed at changing the maturity structure of federal-government debt. By buying and retiring long-term government bonds and selling short-term government debt instruments, the Fed has significantly shortened the average maturity of federal debt. Since short-term interest rates are being held artificially low, this has allowed the government to reduce its interest payments on the debt.

The Political Reactions to the QE Series

Technically, the Federal Reserve is an independent institution, neither completely governmental nor strictly private. Its actions are ostensibly motivated by non-partisan considerations and as such should be above politics. In practice, the Fed has become a sizzling hot potato on the election-year grill.

Most defenders of the administration – not all of them Democrats, surprising as that may seem – insist that the Fed’s actions since 2007 have been emergency actions aimed at rescuing us from the abyss of worldwide great depression, a la the 1930s. Since reported U.S. unemployment has not risen to 25% and GDP has not fallen precipitously, the Fed’s actions must have been successful.

Criticism of the Fed has been purely political, its defenders maintain, since its actions have been taken right out of the textbook – or perhaps “script” would be a more precise analogy – of measures designed to combat financial crisis, market crash and incipient depression. Since quantitative easing has been used only in Japan over the last dozen years or so and has been mostly deemed a failure, it is not clear why the Fed has called this play or why armchair quarterbacks tout this playbook so confidently.

Fed critics are aghast at the Fed’s actions and its rationale for them. Massive injections of liquidity and a long-term “zero-interest-rate-policy” (ZIRP) are draconian, unprecedented actions. Their justification can only be an emergency of life-threatening dimensions – to import an analogy from medical crisis management. But unlike the Great Depression that began in 1929, this emergency was never realized, only putative. There were no massive bank failures, no bread lines, no riots, no widespread unemployment. There was the popping of the government-policy-created housing bubble and an ensuing recession – the thirty-third if you believe the long line of U.S. recessions began in 1854, as the National Bureau of Economic Research does. But another decade-long depression was not inevitably in the cards.

Even more telling have been the Fed’s incoherent explanations for its actions. Bernanke says that this QE is supposed to fight unemployment. But each previous QE had the same rationale. Yet results were anemic at best – unemployment fell from almost 10% down to its present 8.1% mostly because the size of the labor force shrunk to a shocking, seldom-seen extent. Actual employment is still less than in 2007, prior to the onset of the recession.

The political camps are miles apart, but even Bernanke’s supporters should acknowledge, as he himself does, that legitimate doubts plague public acceptance of the QE series. Two nagging questions lead the list. First, why should this QE succeed where the first two largely failed? Surely not because the technical details are different; purchases of mortgage-backed securities have scarcely budged home prices previously, so why should they lift the entire economy now? Without saying it in so many words, Bernanke is implying that his intentions are what determine the results of the policy. Previously, the policy now labeled as QE3 was not intended to be stimulative, so it should not be criticized for its lack of punch. But now, less than two months before the Presidential election that will determine whether he is reappointed as Fed Chairman, Bernanke has recognized that need to fight unemployment. So we should expect that the same policies that didn’t work before will work now.

Second, the phrasing of Bernanke’s remarks clearly suggests that previous QEs had a different purpose. What was it and why did Bernanke fail to disclose it then and now? After all, it’s not as if he can be excused for holding political cards close to his vest. The Fed is supposed to be independent of politics and government policy.

And while we’re posing questions, let’s not forget an even more obvious one: How do we know that the QE cure is not worse than the disease it is supposed to fight?

The Curious Rationale for the QE Series

This space has previously addressed what seems to be the true rationale for the QE series; namely, the desire to prop up the banking system by subsidizing banks. Because banks and Wall Street are in bad odor with the public, the subsidies have to be undercover. The QE series has involved purchases of securities by the Fed from commercial banks and payment in the form of deposits credited to bank reserves by the Fed. In order to induce the banks to hold this money as excess reserves instead of lending it out, the Fed began paying interest to banks on their excess reserves in 2010. By restraining bank lending rather than encouraging it, the Fed has itself prevented its policies from stimulating the economy. Indeed, for the last year or so the Fed has even “sterilized” the increases in bank reserves with asset sales so as to hold the supply of base money roughly constant.

We cannot know the reasons for this policy because Bernanke has not even acknowledged it, let alone explained it. Presumably, the Fed believes that too many U.S. commercial banks are at or near the point of insolvency. Normally, the Fed handles insolvent commercial banks by merging them with sound banks, but this is clearly infeasible when a sizable fraction of banks are unsound. Absent its standard form of treatment, the Fed may be putting the banking system in a therapeutic coma until conditions improve. In other words, the Fed may be allowing bank balance sheets to fatten on safe interest payments earned on excess reserves while buying time for housing prices to rise. Housing price increases would increase the value of the mortgage-backed securities that form the bulk of commercial-bank assets.

This is consistent with the form taken by QE3, in which Fed purchases of mortgage-backed securities are the backbone of stimulative policy. This unprecedented policy change reverses age-old Federal Reserve precedent of purchasing and selling only government securities, in order not to favor or harm particular industries or firms in the private economy.

There is an alternative explanation for the QE series and ZIRP. The state of the federal budget is so parlous that by 2020, interest on debt threatens to overwhelm it and comprise almost all the projected total. This would crowd out almost all social spending directly and indirectly crowd out private investment spending by forcing an increase in market interest rates in order to attract the bond investment necessary to finance the projected budget deficits. ZIRP can be viewed as a delaying action designed to hold down federal-government interest payments as long as possible and buy time for Congress and the President to deal with the nation’s fiscal problems.

We should note, first, that these two alternative explanations for the QE Series are not mutually exclusive. Indeed, there reinforce each other. But they are both thoroughly dishonest because, if either or both are true, they mean that Bernanke has been lying through his teeth for years. They also signal the end of Federal Reserve independence from politics. Both involve Fed implementation of fiscal policy as well as monetary policy, even though fiscal policy is supposedly the sole preserve of the Treasury and the political administration in power.

Why Is the Cure Worse Than the Disease?

Judging from the actions of the Federal Reserve since 2008, one might think that the only function served by interest rates is to serve as levers by which the Fed speeds up or slows down the pace of economic activity. This is miles away from the truth. The true function of interest is outlined in economic textbooks and reference books.

In The Fortune Encyclopedia of Economics, Paul Heyne informs us that “interest is the price people pay to have resources now rather than later.” At a consumer-loan rate of 11%, we can borrow $900 for one year and repay $1,000 in one year’s time. Obviously, since we have the wherewithal to repay the $1,000 loan in one year, we could have simply waited one year and enjoyed $1,000 worth of consumption goods. But we chose instead to consume $900 today, and the 11% ($100) premium we paid is the price for our anxiety to consume in the present. It reflects the degree of our time preference, a term suggesting that an inherent human tendency to prefer consumption sooner rather than later is what accounts for a positive interest rate. And it is the ability to utilize capital goods productively that allows us to finance them with borrowed money and use their product to repay both cost and interest on the loan.

This implies that interest is not purely a monetary phenomenon. “The fact that loans are usually made in money leads to the mistaken belief that interest is the ‘price paid for the use of money'” and can be lowered mechanically be by increasing the amount of money in circulation. “But interest would also exist in a pure barter economy where money was not used.”

This is not merely conjectural. In wartime prisoner-of-war camps, prisoners made loans to each other from their limited stocks of ration goods, demanding repayment of a larger quantity of the good. When cigarettes later became the medium of exchange in the camps, these constituted both principal and interest for the loans. The medieval church condemned the collection of interest as sinful, but it purchased annuities to the proceeds of land rents at less than their face value; e.g., it charged interest to sellers.

The fact that goods and money are valued differently at different points in time means that interest rates are key tools of human valuation. “The interest rate enters at least implicitly into all economic decisions, because economic decisions are made by comparing expected future benefits to costs.” The farther into the future a prospective benefit is deferred, the lower its current value. That current or present value is calculated numerically by discounting the benefit using a relevant interest rate.

Every sort of investment decision requires this kind of discounting calculation or its obverse, the future value calculation – both of which require the use of an interest rate. People who want to save for their retirement must do these calculations and supply relevant interest rates for their own use. Businesses pondering fixed investment will probably wish to calculate a “hurdle rate” or interest rate of return for comparison purposes. To do it they will need market rates of return to serve as benchmarks.

The Soviet Attempt to Control the Interest Rate

Soviet Russia virtually eliminated private property and capital markets from the Russian landscape beginning in 1917. In principle, this eliminated both the opportunity and the need for nominal interest rates. But economics predicts that the phenomenon of interest is necessary for people to behave rationally. Sure enough, Communist economic planners eventually tried to invent an interest rate to improve the effectiveness of their own planning. (They couldn’t call it an interest rate, for fear of being shot – they called it the “efficiency index.”)

The Soviet government had the advantage of being able to observe Western financial markets and interest rates in constructing their artificial interest rate. Even so, their attempt failed miserably. Although few realized it at the time, subsequent research and archival disclosures revealed that their economy declined more or less continuously

when its private features were suppressed. Ultimately it collapsed completely, beginning in 1989. One important cause of the collapse was the utter inability to tailor investment to meet consumer wants and needs.

The U.S. Economy Under ZIRP

How would we expect a free-market economy to react when the price signals that customary guide production and consumption decisions are disrupted, garbled and stopped entirely? We would expect confusion and indecision to result. We would expect the pace of economic activity to slow as people groped for substitute decision variables on which to base their actions. We would expect to find extreme reluctance in committing large amounts of resources and money to future endeavors, whether in hiring or investment. In short, we would expect to see an economy very much like the economy we observe all around us today.

The effects of ZIRP are even more pernicious than they might seem at first glance. Although the interest rates most directly (and indirectly) affected by ZIRP are short-term rates, long-term interest rates under ZIRP are also not unhampered free-market rates. Just as with the prices of goods and services, interest rates act through their relative relationship to each other rather than through their absolute magnitude alone. That is, the relationship of (say) six-month to one-year rates is just as important as either rate by itself. Even though the effect of ZIRP on interest rates becomes progressively smaller as the term structure of the rates lengthens, the relative relationship between long rates and shorter rates is still affected by distortions in the latter. These distortions cause changes in the supply of and demand for savings and investment that, in turn, affect long-term rates as well. This is not only acknowledged but welcomed by the Fed – Bernanke expressly claimed lower long-term rates as an intended effect of QE3.

The 1970s Inflation – Comparing Distortions

The last time that widespread distortions in relative interest rates occurred in the U.S. was the late 1970s. They were due to the high inflation that had accelerated thanks to Federal Reserve policies throughout that decade. Although all interest rates came to include an “inflation premium” intended to compensate asset holders for the loss of purchasing power of fixed-income interest payments, this market-imposed version of financial inflation indexing was an inexact science. In practice, the relative relationship of interest rates of differing terms was also distorted by inflation, if only because few if any asset holders had exactly the same consumption patterns. Consequently, inflation had a different effect on the real value of a given interest return for each investor.

An even greater degree of distortion was experienced in 1970s’ consumer goods markets, where rapidly rising prices did not all rise at the same rate. Consequently, relative prices changed dramatically compared to their pre-inflation levels. Consumers’ money incomes also did not rise pari passu with inflation, causing marked shifts in real income away from those on fixed incomes and dependent on fixed-income investments.

Today, the greater distortion is experienced in financial and investment markets. Interest rates are to the future what a plane’s instrument panel is to a pilot. When the instruments are broken or unreliable, the pilot’s navigational horizon is limited to what he can see. ZIRP gives us interest rates that are unreal, phony, untrustworthy. This limits our planning horizon severely, making us unwilling to look very far ahead, hire employees or commit substantial funds to the future. And it even distorts the choices we make in the present.

Flying Blind Under ZIRP

Lower interest rates cause producers to become more future-oriented, shifting production to good with longer production processes using more capital-intensive methods. Under normal circumstances, when lower interest rates are the result of an increase in saving by the public, this is appropriate. The public’s increase in saving is a signal that it wants more consumption in the future and less now. This insures an adequate volume of purchasing power to buy the volume of future goods produced, while changes in the prices of goods and services insure that the right amounts of particular goods and services are produced.

But when the low interest rates are contrived artificially by the Fed instead of organically by private saving, there is no assurance that the future volume of consumption spending that consumers have planned will be adequate to purchase the goods produced by producers. Producers of slower-gestating goods will suffer losses because their prices will have to fall to unremunerative levels to clear the market. This will lead to business failures, layoffs and unemployment. Ordinarily this cycle would be reversed by changes in interest rates – unless interest rates cannot rise to cut it short. Then producers are in a quandary. The market signals they have come to rely on are now telling them to do things that have just failed. On the other hand, government regulators are telling them they can’t do many of the things they want to do. So they do nothing, or as little as possible.

Free markets have evolved a delicate and complex system of price signals to guide producers and consumers. Prices of goods and services guide us in our purchases from day to day and over very short time horizons. Interest rates guide our planning decisions over significant lengths of time; they are the instrument panel that helps us to navigate a cloudy and uncertain future. But when this system of prices fails or is hamstrung by government, as happened in the Soviet Union and in 1970s America and now under ZIRP, we find ourselves flying blind.

QE3: The Substitution of Politics for Markets

Fed Chairman Bernanke’s justification for QE3 is impossible to take at face value and difficult to rationalize in any favorable way. Evaluated as economic policy, it further accelerates the trend first kicked into overdrive in 2008; namely, the substitution of bureaucratic and political criteria for those of markets. The verbal cosmetics applied to beautify these actions do not mask their flaws. And the emergency rationale invoked to justify them cannot overturn the verdict of history and logic.