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-201 for week of 1-12-14: No Bravos for Bernanke

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No Bravos for Bernanke

Last weekend’s Wall Street Journal featured an op-ed by the former Chairman of President Obama’s Council of Economic Advisors, Austan Goolsbee. Goolsbee’s tenure obviously familiarized him with the chief requirement for policymaking success in a Democrat regime; namely, the ability to define success down. His op-ed, “Brave for Bernanke and the QE Era,” is a spectacular example of the art.

Goolsbee contrasts the enthusiastic reception given to Federal Reserve Chairman Bernanke’s farewell address to the American Economic Association convention with the wide-ranging criticism directed at Bernanke from across the political spectrum. He briefly summarizes the Fed’s policies under Bernanke, confining himself to the last 3 ½ years of the so-called QE (quantitative easing) Era. Bernanke’s imminent departure and the start of the “exit-strategy countdown” signaled by QE tapering mean that “it is time to take stock of the QE Era – and time for the critics to admit they were wrong.”

Partisan divisions being what they are, it is a foregone conclusion that Goolsbee’s call will not resonate with many on both sides of the political spectrum. But it is not necessary to invoke partisan politics to criticize it. Bernanke’s policies – and Goolsbee’s – are anathema to free-market economists. But one need not espouse laissez faire in order to gaze askance at Goolsbee’s case for Bernanke’s actions. Bernanke’s tenure should be viewed as a disaster regardless of one’s political preference or economic philosophy.

Indeed, the propriety of Bernanke’s policy choices is not up for debate at this point. They are what economists would call a sunk cost; their costs have been incurred (or are unavoidable) and can’t be changed or escaped. No doubt Bernanke should have chosen differently and we would be better off if he had done so. But the question before the house is: What were the actual results of his choices? Goolsbee finds those results to be very good and purports to explain why. We can and should quarrel with his verdict and his explanations.

Bernanke and Stimulus

“…Looking back…it is clear that the Fed was right to try to help improve the [economy] and the critics were wrong [about inflation].” Goolsbee assigns Bernanke’s policies a grade of A for activism.  The implication is that it is better for a Federal Reserve Chairman to do something rather than nothing, even if activism requires a program of unprecedented scope and unknown impact.

“Think back to the days before the 2008 crisis or recession. If confronted with the scenario that would follow – five years of GDP growth of only around 2% a year, five years of unemployment rates around or above 7%, core inflation consistently below 2% – the near-universal response of economists would have been for the Fed to cut interest rates.” But would economists have reacted that way knowing that all of these effects accompanied a policy of zero interest rates? It’s one thing to say “we should have cut interest rates and all these bad things wouldn’t have happened,” but quite another to say “all these bad things happened anyway in spite of our interest rate cuts.” An objective observer would have to consider the possibility that the interest rate cuts were the wrong medicine. Of course, Goolsbee pretends that this is unthinkable; that the only possible action in the face of adversity is cutting rates. But if that were really true, his review of Bernanke’s reign is a mere formality; Bernanke’s decisions were right by definition, regardless of result. In reality, of course, the zero-interest-rate policy was not a foregone conclusion but rather an evaluative action subject to serious question. And its results do not constitute a ringing endorsement.

To appreciate the truth of this, ponder the wildly varying conclusions reached by Keynesian economists who are not ideologically hostile to Bernanke and Goolsbee. Larry Summers considers macroeconomic policy under Obama a failure because the U.S. suffers from “secular stagnation.” He prescribes a cure of massive public spending to replace the structural collapse of private investment and private over-saving. While Bernanke cannot take the blame for the failings of fiscal policy, Summers criticizes him for not doing more to provide liquidity and increase (!) inflation. Summers’ colleague Paul Krugman is even more emphatic. Bernanke should crank up the printing press to create bubbles because wasteful spending by government and the private sector is necessary to create employment. Without waste and profligacy, unemployment will persist or even rise. Alan Blinder has the temerity to point out what free-market economists noticed years ago – that the money created by Bernanke was mostly sitting idle in excess bank reserves because the Fed had chosen to pay interest on excess reserves. But Blinder is too gentlemanly to ask the obvious question: If the money creation is supposed to be “economic stimulus,” why has Bernanke prevented the money from actually stimulating?

These Keynesian economists are the farthest thing from free-market, laissez faire doctrinaires. But they are not about to give Ben Bernanke a passing grade merely for showing up, trying hard and looking very busy.

To be sure, Goolsbee does make a case that Bernanke actually succeeded in stimulating the U.S. economy. He names two of his colleagues, fellow attendees at the AEA convention, whose “research indicates that [Bernanke’s] Fed policies have helped the economy, albeit modestly… they lowered long-term Treasury rates by about 30 basis points and a bit more for mortgage spreads and corporate bond yields…Americans were able to refinance their homes at more affordable rates, and the drop led to an increase in consumer spending on automobiles and other durables.” Fifty years ago, John Maynard Keynes’ picture appeared on the cover of Time Magazine as an avatar of the end of the business cycle. Now, our Fed prosecutes a policy characterized by a leading English central banker as “the greatest government-bond bubble in history,” and economists have to do research in order to dig up “modest benefits” of the policy that would otherwise go unnoticed. And Goolsbee offers them up with a straight face as the blessings that justify our gratitude to Ben Bernanke.

Bernanke and Inflation

“The QE Era did not create inflation. Not even close. The people who said it would were looking only at the growth in the monetary base… the people arguing that QE means simply printing money (it doesn’t, really) didn’t recognize that the policy was simply offsetting the reverse printing of money resulting from the tight credit channels in the damaged financial system.” Milton Friedman devoted the bulk of his career to refuting the claims of this type of thinking; it would require a lengthy article to review his insights and a book-length analysis to review the economics issues raised by Goolsbee’s nonchalant assertions. But one sentiment popularized by Friedman suffices to convey the concern of “the people” Goolsbee dismisses so condescendingly: “Inflation is always and everywhere a monetary phenomenon.”

At no point in human history has a monetary expansion like Bernanke’s occurred without leading to hyperinflation. So Bernanke’s critics are not a gaggle of tinfoil-hat-sporting, tennis-shoe-wearing conspiracy theorists. They have history on their side. Goolsbee’s confident assurance that Bernanke leaves office with inflation under control is based on a planted axiom the size of an iceberg; namely, that Bernanke’s successor(s) can somehow corral the several trillion dollars of excess reserves still loitering around the financial system before they emerge into circulation in the form of expenditures chasing a limited stock of goods and services. But that’s only the beginning; the Fed must also conduct this money wrangling in such a way as to keep interest rates from rising too greatly and thereby dealing the economy a one-two death blow of overwhelming government debt service and private-sector constriction of economic activity. It is not immediately obvious how this might be accomplished.

Friedman made a case that the Great Depression began in the early 1930s with bank failures that had a multiple contractionary effect on the U.S. money supply. Like generals always fighting the last war, the Fed has since been grimly determined not to be hung for monetary tightness. As F.A. Hayek pointed out, a central bank that always errs on the side of loose money and inflation and never on the side of tight money or deflation will inevitably bias its policy toward inflation. That is the status quo today. Japan’s longtime low inflation is miscalled “deflation,” thereby providing a rhetorical justification for revving up the inflationary printing press. A similar boomlet is building here in the U.S.

Presumably, this explains Goolsbee’s reference to QE credit creation as an offset to credit destruction. But whether you accept Friedman’s analysis or not, Goolsbee’s rationale doesn’t hold water. The bank bailouts of 2008-09 – which were forced on sound banks and shaky ones alike by the Fed and the Treasury – were explicitly sold as a means of guaranteeing financial liquidity. QE did not come along until mid-2010. By then, banks had already repaid or were repaying TARP loans. Thus, Goolsbee cannot sell the QE Era as the solution to a problem that had already been solved. Instead, the evidence favors QE as the palliative for the financial problems of the U.S. Treasury and the spending addiction of the U.S. Congress – matters that Goolsbee delicately overlooks.

Bernanke and Greenspan: The Perils of Premature Congratulation

When Alan Greenspan left office, he had presided over nearly two decades of economic prosperity. The news media had dubbed him “The Maestro.” It is not hard to understand why he was showered with accolades upon retirement. Yet within a few short years his reputation was in tatters. Bernanke gave us an industrial-strength version of Greenspan loose-money policies. But the economy spent most of Bernanke’s tenure in the tank. And Bernanke leaves office having bequeathed us a monetary sword of Damocles whose swing leaves our hair blowing in its breeze.

With the example of Greenspan still fresh in mind, we can justifiably withhold judgment on Bernanke without being accused of rank political prejudice.

Bernanke as Savior

“…We should all be able to agree that fashion standards during a polar vortex shouldn’t be the same as in normal times.” Goolsbee is suggesting that Bernanke has adopted the stern measures called for by the hard times thrust upon him. This is indeed the leitmotiv for economic policy throughout the Obama Administration, not merely monetary policy – hey, just imagine how much worse things could have been, would have been, had we not done what we did. In order for this alibi to stand up, there must be general agreement about the nature and size of the problem(s) and the remedy(ies). Without that agreement, we cannot be sure that Bernanke hasn’t worsened the situation rather than helping it – by addressing non-existent problems and/or applying inappropriate solutions.

In this case, we have had only the word of Chairman Bernanke and Treasury Secretary O’Neill (under President Bush) that economic collapse was threatened in 2008. Despite the wild talk of imminent “meltdown,” none occurred. Indeed, there is no theoretical event or sequence that would meet that description in economics. General economic activity worsened markedly – after the bailout measures were authorized by Congress. The emergency stimulus program did not affect this worsening, nor did it effect the official recovery in June 2009; stimulus funds were so slow to reach the economy that the recovery was well underway by the time they arrived.

The QE program itself has been advertised as “economic stimulus” but is notable for not living up to this billing. (To be sure, this is misleading advertising for the reasons cited above.) If anybody feels grateful to Bernanke for launching it, it is presumably officials of the Treasury and Congress – the former because QE prevented interest rates from rising to normal levels that would have swamped the federal budget in a debt-service tsunami, the latter because the precious spending programs beloved of both parties were spared. But Goolsbee comes nowhere within sight or shouting distance of these financial truths.

It makes sense to hail a savior only when you have reached safety. We haven’t even crossed the icy waters yet, because we’ve had the benefits – tenuous though they’ve been – of QE without having to bear the costs. In other words, the worst is yet to come. Bernanke has made all of us protagonists in an old joke. A man jumps out of a skyscraper. As he falls toward earth, the inhabitants of the building on each successive lower floor hear him mutter, “Well – so far, so good.”

The Politicization of Economics

Why make so much of Austan Goolsbee’s valedictory salute to Ben Bernanke? If the quality of Bernanke’s economic policy is a sunk cost at this point, doesn’t that also moot our assessment of his job performance? If Austan Goolsbee has badly misjudged that performance, that doesn’t say much for Goolsbee, but why should we care? After all, Goolsbee is no longer employed by the Obama Administration; he is now safety ensconced back in academia.

Goolsbee’s judgments matter because they are clearly motivated by politics. They are part of a disturbing pattern in which liberal economists provide a thin veneer of economics – or sometimes no economics at all – to cover their espousal of left-wing causes. Goolsbee pooh-poohs the claim that QE was both dangerous and unnecessary, claiming that the rise in the stock market is not a bubble because it has “tracked increases in corporate earnings.” But earlier in the same article, Goolsbee claimed that QE lowered long-term interest rates on Treasuries and corporate bonds (thus reducing costs of corporate finance) and increased spending on consumer durables. So QE induced increases in corporate earnings that wouldn’t otherwise have occurred, causing increased stock prices – but is absolved from charges of creating a stock bubble because the stock prices were caused by autonomous increases in corporate earnings? Goolsbee claims credit for QE on Bernanke’s behalf at one stage, and then disclaims QE’s influence on exactly the same point at another. This is the type of circular contradiction masquerading as economics that Goolsbee and other Keynesians use to sell their politics.

“Forgoing the Fed’s unconventional monetary policies – inviting real and quantifiable damage to the economy – just to prevent the possibility of a potentially dangerous bubble forming somewhere in the economy would have been cruel and unnecessary,” Goolsbee concludes. Foregoing the “modest benefits” that Goolsbee’s pals managed to dig up merely because the Fed had to create “the greatest government-bond bubble in history” in order to generate them would have been “cruel and unnecessary.” Oh, wait – what about the loss of interest income suffered by hundreds of millions of Americans – many of them retirees, the disabled and other fixed-income investors – thanks to the zero-interest-rate policy ushered in by the QE Era? Was this cruel and/or unnecessary? Goolsbee delicately avoids the subject.

But Goolsbee’s fellow Keynesian, Paul Krugman, is not so circumspect. Krugman comes right out and says that nobody has the right to expect a positive interest return on safe assets while the economy was in a depression; they can either make do with an infinitesimal interest return or lose the value of their money to inflation. (In the same blog post, Krugman had previously accused his critics of callous indifference to the pain caused by business liquidations in a depression.)

This is not economics. It is half-baked value judgment hiding behind the mask of social science. Similarly, Austan Goolsbee’s evaluation of Ben Bernanke’s term as Federal Reserve Chairman may have the imprimatur of economics, but it lacks any of the substance.

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-277 for week of 11-3-13: Why Are There No Economists Among Leading Opinion-Molders Today?

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Why Are There No Economists Among Leading Opinion-Molders Today?

Today the discipline of economics occupies a strange position within the general public. The Financial Crisis of 2008 and ensuing Great Recession brought economics to the daily attention of Americans more forcefully than since the Great Depression of the 1930s. The Federal Reserve’s monetary policies, particularly its recent tactic of Quantitative Expansion (QE) of the stock of money, have made monetary policy the object of attention to a greater extent than at any time since the days of stagflation and supply-side economics during the Reagan administration in the early 1980s. One would expect to find economists occupying center stage almost every day.

Not so, surprisingly enough. Contrast the position of economics today with, say, that in the 1960s and 70s, just prior to Ronald Reagan’s election as President. At that point, three economists were familiar on sight and sound to a great many Americans: John Kenneth Galbraith, Paul Samuelson and Milton Friedman. Today, the venues, space and time available to economists far outnumber those existing forty years ago. Yet no economist today even approaches the influence and familiarity of the Big Three in their heyday. A brief recollection of each is in order for the benefit of younger readers.

The Big Three of Yesteryear: Galbraith, Samuelson and Friedman

The Big Three economists of yesteryear bestrode the 20th century like colossi and stood tall into the 21st. They were all born and died within a few years of each other: Galbraith (1908-2006) slightly outlasted Samuelson (1915-2009) and Friedman (1911-2006) in longevity although he died first, in April 2006. They were all self-made and experienced the Depression first hand. Each was a prolific writer but appealed to a different audience.

The best-selling writer of the three was John Kenneth Galbraith, whose literary zenith produced The Affluent Society (1958) and The New Industrial State (1967). Compactly put, Galbraith’s thesis was that Americans were satiated with consumer goods but starved for so-called “public goods;” i.e., the goods government was uniquely situated to provide. The economy thrived not on competition but on monopoly exercised by giant corporations, who artificially created the demand for their products via advertising rather than merely responding to the inchoate demands expressed by consumers. Since consumer wants depended on the same process that satisfied them, that process of want-satisfaction could not be justified or defended as simply “giving the people what they want.” Therefore, government was not merely allowed but morally required to tax and regulate business to restrain their behavior and acquire the resources necessary to redress the imbalance between public and private spending. Galbraith’s views resonated with the general public much more than with the economics profession itself, where only the New Left, radicals, institutionalist admirers of Thorstein Veblen and quasi-Marxists found them attractive. Needless to say, Galbraith’s ideas seem quaint today in light of the decline and fall of the supposedly invulnerable giant corporations he worshipped.

In addition to his economic works, which also included American Capitalism (1952) and A Theory of Price Control (1952), Galbraith wrote novels and memoirs of his travels and tenure as Ambassador to India. His iconoclastic views – he minted the phrase “the conventional wisdom” – and ironic style endeared him to the general public, whose distrust of authority he shared. This seems odd of a man whose World War II service as deputy head of the Office of Price Administration made him one of America’s chief bureaucrats, but Galbraith’s early life was spent on a farm in Canada. Another of his books was a novel satirizing America’s foreign-policy establishment (“Foggy Bottom”). Perhaps the chief object of his scorn over the years was the corporate hierarchy, whose morals and mores he never tired of mocking despite his exaggerated opinion of their power over markets.

Paul Samuelson was the leading theoretician among American economists and the first American awarded the economics version of the Nobel Prize in 1970. His scholarly articles numbered in the hundreds, but he is remembered today chiefly for two books: Foundations of Economic Analysis, based on his doctoral dissertation, which signaled a turning point in economics to mathematics as the formal mode of analysis; and Economics, his all-time best-selling college text that combined principles textbooks in microeconomics and macroeconomics in order to integrate the two analytically into the so-called “Neoclassical synthesis. Samuelson combined the elements of classical price theory as developed by Alfred Marshall and refined by subsequent generations with Keynesian macroeconomics as modified from Keynes by the neo-Keynesian generation that included Samuelson himself, Franco Modigliani and James Tobin, among others. This book (really, a double book) taught generations of economists through over twenty editions from the 1940s until the 21st century.

Samuelson’s central conceit was that individual free markets worked beautifully, but markets in the aggregate were prone to unemployment or inflation. This aggregate shortcoming could only be corrected by government spending directed by… well, by men like Samuelson himself; although he always refused to take a policy post in the Democrat administrations he supported and advised.

As with Galbraith, it is difficult for non-economists today to credit the veneration Samuelson inspired in certain quarters. In the late 1950s, Samuelson began predicting that the Soviet Union would soon overtake the U.S. in per-capita GDP (then GNP). He retained this prediction in successive editions of his textbook – until the final overthrow of the Soviet Union in 1991. Galbraith and Samuelson made an odd couple of Keynesians – the former supporting massive government spending in spite of his distrust of the bureaucracy and the latter embracing deficit spending by government because he had faith in the ability of government to fine-tune aggregate economic activity. Samuelson shared a forum in Newsweek Magazine in an alternating column with the third member of our Big Three, Milton Friedman.

Friedman became well-known among fellow economists long before he attracted public notice. He won the John Bates Clark medal awarded to the leading economist under the age of 40 and published a notable collection entitled Essays in Positive Economics that contains some of the best expository writing ever done in his subject. 1957 saw what he considered his best piece of work, A Theory of the Consumption Function, which successfully reconciled cross-section data on aggregate consumption among different groups over the same time period with time-series data on consumption among all groups over time.

In the early 1960s, Friedman published two books within a year of each other that catapulted him to public attention and professional eminence. Capitalism and Freedom made both the political and economic case for free markets, an analytical position that had almost deteriorated through neglect. A Monetary History of the United States, which he co-authored with Anna Schwartz of the National Bureau of Economic Research, made an empirical case for the money stock as perhaps the chief economic variable of interest both historically and for policy purposes. Milton Friedman became the world’s chief exponent of the Quantity Theory of Money, which had been around ever since David Hume in the 18th century but had never before been put to such comprehensive use in economic theory. Ironically, Friedman’s single-minded focus on the money stock proved to be his Achilles heel. Although still greatly respected for his manifold contributions to economic theory and his prodigious talents as a defender of freedom and popularizer of economic thought, Friedman’s monetary theory is little regarded among professionals of all ideological stripes.

As the 60s and 1970s wore on, Friedman headed up the disloyal opposition to Keynesian economics within the economics profession. Keynes had been posthumously crowned king in the 1950s and early 60s as Western economies began to adopt the policy of spending their way to prosperity. But the advent of simultaneous high inflation and high unemployment, or “stagflation,” in the 1970s put paid to the Keynesian tenure atop the profession. Friedman and Edmund Phelps independently and more or less simultaneously developed the hypothesis of a “natural rate of unemployment” that defied Keynesian efforts to reduce it via deficit spending. Only through continually increasing injections of money into the economy – producing ever-increasing rates of inflation and resulting unrest – could unemployment be reduced and held below this “natural rate.” Friedman’s Nobel Prize, received in 1976, was by this time a foregone conclusion.

In 1980, Friedman reached his zenith of public popularity with the best-selling book and accompanying PBS television series Free to Choose. This was a popularized version of Capitalism and Freedom, updated for the 80s. For the first time, an economist had scaled the heights of public popularity, professional acclaim and policy prominence. Like Samuelson, Friedman preferred to exercise his influence outside of government. Unlike Samuelson, though, Friedman had actually worked for government in World War II. It was Milton Friedman, of all people, who devised the concept of government tax withholding to streamline the process of revenue collection.

Vacuum at the Top

Today, economics is omnipresent in our lives. Yet there is nobody in the public square whose position rivals that of the Big Three of yesteryear. The closest would be Paul Krugman, who has written several popular books, whose Nobel Prize is spelled exactly like the one received by Samuelson and who believes that the stock of money can play an important role in economic policy. In other words, he is a pale shadow of Galbraith, Samuelson and Friedman.

Noted economist Sam Peltzman probed this seeming paradox in an article published in the May, 2013 issue of Econ Journal Watch, 10(2) pp. 205-209, entitled “Why Is There No Milton Friedman Today?” Peltzman’s analytical qualifications are impeccable. He has carved out a distinguished career as a critic of government regulation. His crown jewel is a famous 1975 study on automobile safety that introduced the pioneering concept of “risk compensation” to the social sciences.

Risk compensation refers to the behavioral effects created by safety improvements and regulations. When people take more risk in response to safety improvements and/or regulation, this change in behavior has been christened the “Peltzman Effect.” Thus, Sam Peltzman has been given the greatest scientific honor of all – a scientific principle has been named for him.

Peltzman notes the absence of successors to the Big Three. He especially abhors the vacuum created by the loss of Milton Friedman. Peltzman’s explains it by citing Friedman’s unique talents. The first of these was his knack for communicating economic insights to the masses. The same expository skill Friedman brought to his professional work equipped him to educate the general public.

Peltzman illustrates Friedman’s style with a revealing anecdote from his own (Peltzman’s) academic career. Peltzman’s first graduate-school class was Friedman’s legendary class in Price Theory at the University of Chicago. The students “eagerly awaited our introduction to the technical mysteries of our chosen profession. Instead, we got an extended paraphrase of an article entitled ‘I, Pencil,’ in which a humble pencil tells us of the herculean coordination problem required to get itself produced and distributed and of the virtues of markets in solving that problem.” Peltzman correctly attributes the essay to Leonard Read, founder of the Foundation for Economic Education and its journal, The Freeman, in which the essay originally appeared. Peltzman’s points are that Friedman’s pedagogy was time-tested and simple and he employed it before professional audiences as well as public ones.

Friedman’s second unique virtue was his zest for combat. Libertarian economists were scarce in Friedman’s day and he knew his arguments would be received with scorn and incredulity. Nevertheless, his rejoinders were cheerful and clever; he relished the opportunity to buck the tide of collectivist conformism. And his devotion to his principles was unyielding. “All against one makes for a good show,” observes Peltzman, “and Friedman liked the odds.” This brings to mind the answer made by John Wayne’s character J.B. Books, the dying gunfighter in the movie The Shootist, when asked to account for his luck in surviving so many gunfights over the years: “I was willing.”

It is clear that even Galbraith and Samuelson couldn’t measure up to Milton Friedman by Peltzman’s criteria. Galbraith had the communication skills and debating talent but little worthwhile to communicate; his theory badly needed shoring up. Samuelson had the theory but communicated largely by writing letters to his fellow economists in the language of differential equations. His text worked well enough for a captive academic audience but nobody ever characterized his persona as “dynamic.” Both these men were, to some greater or lesser extent, arguing for the status quo, while one of Friedman’s books was titled The Tyranny of the Status Quo.

So far, so good. Peltzman makes a concise, compelling case for Milton Friedman as sui generis. Now, though, Peltzman tries to explain why today’s economists do not measure up to the standard set by Friedman. Although his observations of the economics profession seem descriptively accurate, his attitude toward their change in behavior is disturbingly complacent.

The Contemporary Economist as Engineer

In assessing the state of the profession today, Peltzman at first sounds optimistic. It’s true that there is no Milton Friedman leading the charge for freedom and free markets. But that isn’t due to a lack of free-market economists. “There are…numbers of them within our gates, perhaps more than in Friedman’s time…But they lack something that Friedman had in…his time.” Actually, they lack several somethings.

First, they lack the kind of dedicated, first-rate opponents Friedman had in abundance. “…The range of belief within economics has narrowed, partly because of Friedman’s efforts…the modal economist is less [interventionist]… than the modal economist of Friedman’s era…Market solutions…are given a respectable hearing or are part of the consensus today (think flexible exchange rates or unregulated railroad rates). There is less room today for a good fight among economists.” Apparently, Peltzman does not read Paul Krugman’s column in the New York Times.

If this sounds dubious, just listen to Peltzman’s next assertion. “Consider…what has happened in the aftermath of the financial crisis of 2008. The chattering class pronounced with excited joy that Capitalism is now Dead, but the political center hardly moved, and in some countries even moved right – to fiscal rectitude, labor market reform, etc. Hardly any left party that moved away from socialism in Friedman’s heyday has moved back since. What is a committed free-market economist spoiling for a good fight to do when the other side is not so far away?”

This narrative hardly sounds like a description of the multi-trillion dollar stimulus, multiple bailouts of big banks and financial firms, government seizure and handover to autoworkers of two of the Big Three auto companies, impending nationalization of health care, regulatory reign of terror and Federal-Reserve money-creation and asset-purchase binges that have characterized the U.S. since 2008. Contrary to Peltzman, events since 2008 have conformed more to Newsweek‘s famous cover headline: “We Are All Socialists Now.” And what has today’s “modal economist” done in response to this overwhelming frontal assault on free markets?

If Peltzman’s judgment that the economics profession has gravitated toward freer markets were correct, we would expect to read protests from our modal economist. Instead, he has, according to Peltzman, turned into “a much cooler customer. This one tends to be less committed to any politico-economic system.” Wait a minute – what happened to all those “numbers of …free-market economists…within our gates” just a minute ago? We could sure use them, because it now turns out that among the cooler customers, “the animating spirit is more the engineer solving specific problems than the philosopher seeking a unified world view. The questions asked tend to be smaller than, say, the connection between capitalism and freedom.”

Strangely, Peltzman doesn’t seem perturbed about this loss of ideological fervor, because “the skill with which the question is answered tends to be greater than in times past.” What about their professional duty to educate the public in the great truths of economics? “At some point,” Peltzman declares airily, “today’s leading economists may want to communicate their results to a wider audience. But this is an afterthought, in the sense that what is valued within the profession – the skill in obtaining the result – is not what the outside audience is interested in.”

Peltzman is surely wrong about the outside audience, who is intensely interested in “the skill in obtaining the result” because (at least in principle) it should affect the veracity of the result. Presumably what Peltzman meant to say is that the audience doesn’t care what method economists use to get the answer as long as they get the right one. And in this connection, it is hard to see what economics profession Peltzman is referring to – surely not the one that actually exists. For over two decades, Deirdre McCloskey and Steven Ziliak have proclaimed that econometric practice within the social sciences – in economics and elsewhere – is scandalously incompetent. Most empirical articles in the leading professional journals over-rely upon and misuse the principle of “statistical significance.” Thus the foundation of empirical economics has rotted away – and with it has gone Peltzman’s claim of greater skill.

Peltzman is not merely blind to the failings of his profession today; he is complacent about its future prospects. “It is hard for me to see a reversal of the kind of trends I have described…in…fields where the engineer has replaced the philosopher. Perhaps an economic calamity will shake things up in economics. But we had one in 2008, and very little changed within the profession. There was a period of befuddlement [after which] economists went back to their tinkering and were largely irrelevant to the political response to the crisis.”

Peltzman’s complacency even extends back to Friedman’s work. He attributes the fact that “there is no serious socialist faction left within economics” to “Friedman’s success,” which “makes it harder for someone to follow in his footsteps.” Peltzman declares flatly that “there is no serious political/economic alternative to some form of capitalist organization in any major economy.” Peltzman cannot have forgotten – can he? – that this was exactly the point made by Ludwig von Mises and reinforced by Mises and his student F.A. Hayek in the Socialist Calculation debates of the 1930s. This was a central contention of Hayek in his great polemic The Road to Serfdom in 1944. It was Hayek, the guiding spirit behind the Mont Pelerin Society of worldwide free-market economists who sparked Friedman’s interest in political activism in the late 1950s. Friedman admitted all this in his Introduction to the 1994 edition of The Road to Serfdom and in interviews with Hayek’s biographer, Alan Ebenstein.

Peltzman’s most outrageous error is his claim that “the Fed chairman learned from Friedman not to permit a credit freeze to turn into a monetary implosion.” Milton Friedman would have slit both wrists and reclined in a warm bath before endorsing the policies followed by Ben Bernanke before, during or after the Financial Crisis of 2008. Friedman’s criticism of Federal Reserve policy during the Great Depression did not pertain to a “credit freeze” but rather to the wholesale failure of banks throughout the U.S. and resulting nosedive taken by the money stock when deposits were destroyed. A credit freeze – whatever else it might entail – implies no such rapid decline in the money supply and therefore does not demand a “helicopter drop” of money, a la Milton Friedman, in order to cure it. Peltzman’s jaw-dropping attempt to imply a posthumous endorsement of Bernanke by Friedman is as inexcusable as it is inexplicable.

Peltzman has chosen the wrong model for his model economist – Friedman rather than Hayek. He has also chosen the wrong model for his modal economist – the engineer rather than the philosopher. In The Counter-Revolution of Science (recently republished under its original planned title, Studies on the Abuse and Decline of Reason), Hayek outlines the disastrous effects of subjecting society to control by the “mind of the engineer.”

The engineer strives to bring all aspects of a problem under his conscious control in order to achieve a technical optimum. He chafes at external constraints such as prices, incomes and interest rates; they are not “objective attributes of things but reflections of a particular human situation at a given time and place.” He sees them as meaningless, irrational interferences with his optimization techniques. When an engineer confronts a machine, for instance, he typically strives to gain the maximum power or energy output from given inputs of resources. In fact, as Hayek points out, the engineer’s technical optimum is usually just the solution that would obtain if the supply of working capital or resources was unlimited or the interest rate was zero. In adopting the perspective of the engineer, the economist is losing his own unique perspective. A good real-world example of the engineering perspective gone wrong in economic practice would be the misguided activist economic policies of former-engineer Herbert Hoover in trying to combat the Great Depression.

Peltzman correctly recalls that Milton Friedman advanced the view that the profession should pursue “positive economics” by formulating hypotheses and testing them empirically. But Peltzman neglects to inform his readers that today this viewpoint is as dead as the dodo – deader, actually, since today we can clone dodos back to life but we are not about to resurrect the canard that econometrics can be used to test predictive hypotheses in the social sciences in the same way that laboratory experiments test natural scientific hypotheses. In academic economics today, nobody believes that anymore. The massive, sausage-producing enterprise of submitting articles to refereed professional journals for acceptance continues, but purely as a ritual for granting tenure. Nobody now pretends that this process has any value above the purely ceremonial. It is now axiomatic in economics that econometrics does not prove anything, test any hypotheses or rule out (or in) any part of economic theory.

The format mathematical models economists swear by give the appearance of scientific rigor, but this is spurious. In order to reduce actual human activity to systems of solvable equations and stable equilibria, economists have to remove so much realistic detail that their models are unrecognizable to the layman. They are virtually useless for making quantitative predictions. We know this because, as the former Donald McCloskey put it, economists cannot answer “the American question: If you’re so smart, why aren’t you rich?”

Today, economic policy is taking measured that economists have warned against for centuries. The attempt to create wealth and induce prosperity by massive money creation is traditionally a tactic of desperation, one that inevitably ends in crisis and chaos. Yet economists sit silent instead of rising in indignant protest. And Peltzman appears to approve both the desperation tactics and the compliance of his profession.

Actually, Peltzman does betray deep-seated doubts about the current path of economics profession in his last sentence. It reads: “But one wonders still: is this only the calm before the storm?” And one wonders if Peltzman will have cause to regret his failure to speak out.

Whither Economics?

Sam Peltzman has courageously taken on one of the great contemporary mysteries. It is a missing-persons case. Where did the economist go in our public discourse? Peltzman succeeds in finding his quarry, all right. But having found him, he is distressingly indifferent to the runout. His confidence in the methods and motives of today’s economists seems utterly misplaced. Without realizing it, Peltzman himself is providing part of the explanation for the absence of economists from public discourse. He is sanctioning the abandonment of what they do best – teaching the philosophy behind economics – in favor of what they do worst – pretending to employ the methods and techniques of engineering in the foreign realm of economics.

DRI-312 for week of 9-29-13: Suppose They Gave a Government Shutdown and Nobody Cared?

An Access Advertising EconBrief:

Suppose They Gave a Government Shutdown and Nobody Cared?

Midnight on Tuesday, Oct. 1, 2013 is the deadline for the shutdown of the federal government. That is the start of the new federal fiscal year. The U.S. Constitution specifies that Congress must authorize spending by the executive branch. Strange as it seems to a country by now inured to executive and regulatory high-handedness, the government cannot legally initiate operations by writing checks on its own hook. Fiscal delinquency, delay and deceit have long been the hallmarks of Congressional action, so it seems only fitting that Congress has failed to agree on the spending authorizations for departments that would get the federal government up and running in the New Year. And this year’s calendar offers a special treat, since the Oct. 17 deadline for default looms on the horizon as the next bureaucratic drop-dead date for civilization as we know it.

Amid the breathless media countdown to Armageddon, a sober pause for introspection is in order. How big an emergency is the federal-government shutdown, really? What underlying significance does a government shutdown have? How did we reach this position? Has the underlying economic significance of our situation been correctly conveyed by commentators and news media?

OMG! The Federal Government is About to Shut Down! Oh, Wait, Time for Vacation…

The attitude of Congressional representatives toward the prospect of government shutdown might best be compared to that of college students facing final exams. The exam schedule is announced at the beginning of the semester; indeed, it is printed in the course catalog distributed at registration. The course syllabus carefully explains the importance of the final to the student’s grade. The student knows the format of the exam, its location and exact time of day.

So, having had nearly four months to prepare and all the advance warning anybody could ask for, students are well versed, confident and unruffled in the waning days of the semester, right? On the night before the exam, they spend a short time reviewing basic ideas before retiring to get a good night’s sleep, to arise refreshed and eager to meet their task on final-exam day, don’t they? And they pass the exam with flying colors?

No, students generally seek out any excuse to avoid studying the material – and excuses emerge in profusion. As time passes and the semester ages, the knowledge of their approaching fate weighs on students’ minds, producing a buildup of anxiety and kinetic energy in their bodies. This demands an outlet, and late semester is a popular time for beer busts and other recreational modes of escape. The waning days before the final exam are spent in frantic efforts to complete course work and accomplish several months’ worth of study in a few days. The culmination of this crash program arrives on execution eve, when the students cram as many isolated facts as possible into their brain cells, relying on short-term memory to pinch-hit for solid comprehension. The surprising success rate of this modus operandi is owed less to its inherent effectiveness than to the grade inflation that has overwhelmed higher education in recent decades.

Anybody who expected their Congressional representative to behave in a more mature, sensible fashion than a college underclassman has been bitterly disillusioned by experience. Consider this latest example of budget brinkmanship.

The end of the fiscal year is not a national secret. Congress has known all year it was coming. The issues dividing the two major parties were well-known from the first day; ObamaCare has been a dinosaur-sized-bone of contention since its proposal and passage in 2010 and shocking reaffirmation by the Supreme Court in 2011. There was ample time to resolve differences or remove the legislation as a political roadblock to process.

As the year wound down, it became increasingly clear that opponents were eyeball to eyeball, each waiting for the others to blink. Now it was August, with only two months left in which to stave out a shutdown. When the going get tough, the tough… go on vacation – which was exactly what Congress did, for five weeks.

For the last week, leaders like Senate Majority Leader Harry Reid (D-Nevada) and Republican Ted Cruz have suddenly come alive with frantic last-ditch efforts. Each side has crafted and passed proposals (in the Democrat-controlled Senate and the Republican House) that the other side has torpedoed. At this writing, we are down to the last-minute cramming… but it should not escape notice that Sen. Reid was not too appalled by the prospect of shutdown to leave town the weekend after superintending the defeat of Rep. Cruz’s proposal in the Senate.

A few of the more cynical commentators have observed that we have been down this road before without careening off the highway and down a mountainside into oblivion. One set of talking points refers to this as our third experience with actual shutdown, but this is far from true. In fact, the federal government has survived 19 previous shutdowns – 17 since 1977 alone, according to the Congressional Research Service. Most have lasted a few days; the most recent (and famous) one in 1996 lasted for 21 days. So much for the artificially contrived atmosphere of urgency surrounding this one, which has been another production of political theater brought to you by your national news media.

Is There a Point to the Shutdown? If So, What is It?

It should be obvious that the hype surrounding the shutdown is phony. Even if we make allowances for the timing coincidence of the fiscal-year dividing line and debt-ceiling deadline, the attention paid to the shutdown is out of all proportion to its real effects on American well-being. But even though the shutdown may be relatively innocuous in its effects, that does not make it a good idea. What does it accomplish – ostensibly or actually?

It goes without saying that detractors of the Tea Party and the Republican Congressional leadership foresee nothing good coming of the shutdown. Since these are the people who got America into the mess that now plagues it – or stood by while that happened – we can disregard their opinions.

If there is an overriding goal of those who drove the events leading to the shutdown, it is opposition to ObamaCare. This opposition has taken the form of attempts to “defund” it; that is, to deny the Obama Administration the money necessary to implement the program. Were this successful, the program would remain on the books de jure as law, but would be repealed de facto by the lack of funds to run it. The most direct means taken to achieve this end is by passing a spending authorization bill containing a rider that defunds the Affordable Care Act. The problem with this measure is that the President will never sign this bill; ObamaCare is the signature legislation of his presidency.

Plan B of the defunders has been to replace that defunding rider with one that delays implementation of ObamaCare provisions for individual citizens by one year. This is directly analogous to the delay instituted by the Obama administration itself for businesses; in effect, it simply gives private individuals the same one-year reprieve given to employers by the President himself. This measure not only has the virtue of symmetry but also of fairness and logistical convenience. It is not clear why the bill should be delayed for businesses and not for everybody else. The state exchanges that would enable individuals to acquire health insurance are not up and running anyway in several states, so this would give the system more time to iron out the kinks. And this delay is entirely legal, being instituted by the Congress and submitted for Presidential signature; the business delay was a flagrantly illegal action imposed by Presidential fiat.

But President Obama is not about to agree to this compromise measure, either. He knows that the longer ObamaCare is postponed, the longer opposition will have to build and the longer its defects will have to become manifest. Once in place, a national system this massive and bureaucratic will be almost impossible to dislodge if only due to the inertia that will set in. The President only delayed applying its business provisions out of direst necessity; everybody was so unprepared that imposition would have led to complete fiasco. So Obama wants to get half of ObamaCare going while the going is good – or at least feasible.

Republic Speaker of the House John Boehner is already confronted by panic in the ranks. Republican representatives have hardly faced the first unfriendly fire from the news media – accusing them of irresponsibly jeopardizing the welfare of the nation for their own petty political purposes – before bolting for cover. Boehner’s queries as he gives them the flat of his sword are: What is this all about if not standing on principle against the President’s program? If we can’t work for the repeal of a terrible law as soundly unpopular as ObamaCare, when will we ever oppose the President? If now isn’t the time to stand firm against policies that are spending the country into the ground and destroying the heritage of our children, when will a better time come around? Over 30 years ago, President Ronald Reagan asked: If not now, when? Well, we didn’t do it then. If we don’t reform the budget now, when?

And those are indeed the relevant questions. Most Republicans oppose ObamaCare, all right; they have enough political courage to stand up against a law when the polls proclaim it heavily unpopular. But ObamaCare is merely the tip of the spending iceberg; the entitlement programs lie jutting beneath the surface waiting to scuttle the most unsinkable of reformers. There is no sign of Republicans boarding icebreakers, kissing wives and children goodbye and signing on for the duration of the voyage to clear the sea lanes of entitlements.

And Now for Some Opinion Completely Different

Holman Jenkins of The Wall Street Journal is a commentator not noted for his sunny optimism. Nevertheless, his take on the federal-budget stalemate is decidedly more upbeat than others commonly bruited. “What if, 10 years ago, Greece had made itself a laughingstock, sacrificed its credibility, brought shame on itself – all phrases used against Washington this week – by shutting down its government because certain legislators saw ideological and electoral rewards to be gained from making a fuss over unsustainable spending? Greek TV hosts would have shouted ‘Athens is broken!'”

Instead, as Jenkins knows only too well, Greece went sleepily on its corrupt, lazy, insouciant way, only to collapse in a heap nearly a decade later. Meanwhile, Americans today “all shake a fist at Washington, denouncing its irresponsibility because politicians are ‘playing politics’ with the debt ceiling and government shutdown.” But “then again, politics is how we govern ourselves. It’s better than despotism not because each moment is a model of stately order and reason, because America is a diverse, fractious society. The only way it works is by the endless grinding out of political compromises amid shrieking and making threats and turning blue.”

Jenkins anticipates the typical facile rejoinder. “The usual suspects at this point will be stamping their feet and insisting the U.S. isn’t Greece, as if this is an insight. No country can borrow and spend infinite amounts of money, and no political system is immune to the incentive to keep trying anyway. Herein lies the real point that applies as much to Washington as to Athens.”

“It would be nice if today’s fight were genuinely about the future. Oh, wait, that’s exactly what the ObamaCare fight is about. By trying to stop a brand new entitlement before it gets started, in a country already palpably and indisputably committed to more entitlement spending than it wants to pay for, those radical House Republicans aren’t trying to chop current spending amid a sluggish recovery (however much one begins to doubt that pump-priming from Washington is the solution the economy needs). Those terrible House Republicans aren’t trying to force colleagues to commit painful votes to take away established goodies from established voting blocs – votes that neither Republicans nor Democrats have the slightest yearning to cast.”

“Those disgraceful House Republicans have made the fight exactly about the long term. Where’s the grudging approval from our Keynesian friends who constantly say immediate spending must be protected and reform saved for the long term?” Again, Jenkins knows full well that Keynesian economics is no longer a putatively consistent set of theoretical propositions; it is now a policy admonition in search of a theory and for sale to any political sponsor willing to fork over lucrative, visible jobs to Keynesian economists.

“Not only will there by more such shutdowns,” Jenkins predicts. “What passes for progress each time will be tiny – until it’s not. The 2011 sequester, which caused critics to engage in choruses of disapproval and the S&P to downgrade U.S. debt, set us on a path to today’s modestly smaller current deficits. This week’s peculiar fight may be resolved by a near-meaningless repeal of ObamaCare’s self-defeating medical-device tax – a teensy if desirable adjustment, having no bearing on the deficit tsunami that begins when the baby boomers start demanding their benefits.”

Jenkins’s peroration combines elements of Churchill and Pericles. “We are at the beginning of the beginning. Yet the birth pangs of entitlement reform that will one day inspire the world (as we did with tax reform in ’80s) may be what we’re witnessing.” Hence the title of the column: “Behind the Noise, Entitlement Reform.”

Too Little, Too Late

Holman Jenkins’s vision is seductive, but unconvincing. Its visceral appeal lies in its pragmatism and its familiarity. Pragmatism is the great American virtue. We have grown up learning to accept and adapt to incremental change. Surely the changes necessary to cope with the downsizing of the welfare state will be just one more set of adjustments – painful but bearable. How many times have we heard Cassandras prophesy doom? How many times has it appeared? This is apparently the comforting set of rationalizations that insulates us from the truth of our situation.

Unfortunately, there is no reason to believe that a long series of small changes will be both timely and sufficient to our purpose. Not only has the Obama Administration’s fiscal policies shifted the velocity of fiscal decline to warp speed, but its monetary policies have changed our major problem from financial crisis to monetary collapse. Financial crisis is something that both individual countries and world systems recover from. Monetary collapse can lead to the destruction of a nation’s economy and the end of the civil order. We not only have to change our ways, we must reverse course by 180 degrees. And do it quickly.

It seems that Jenkins envisions entitlement reform from the austere perspective of an actuary contemplating the future of a program like Social Security. Tut-tut, the actuary admonishes, this program will be bankrupt in another 20 years or so. Well, in 20 years, a solid plurality of Wall Street Journal readers will be dead or near death. Quite a few will be financially independent of the program. Most of the rest view 20 years hence as imperceptibly distant – ample time to recover from the financial improvidence of youth.

But the real crisis on our trip planner is not actuarial. Social Security affects it long before it actually becomes insolvent because its unfunded status will be factored into the calculations of bond traders, credit-rating agencies and interest-rate setters. We may or may not be at Jenkins’s “beginning of the beginning,” but we are certainly not standing in the starting blocks in terms of debt. Government at every level is in hock up to its hairline. The private sector has been making a valiant effort to deleverage – and for its pains has caught hell from Keynesian economists who lecture us about the evils of saving in the middle of a recession. (Just prior to the Great Recession, the same people were decrying our “consumption binge” and running public-service ads begging us to save more.) American banks have trillions loitering in excess reserves, just spoiling for the chance to torch the value of the dollar at home and abroad. Foreign holders of dollars and dollar-denominated assets are dying for a convenient chance to unload them. Business forecasters need binoculars to view the upside potential of U.S. interest rates. And when interest rates skyrocket, interest payments on the federal debt will crowd out practically everything else on the docket, making the budget wars of today look like Sunday-school theology debates. The endpoint of this process is monetary collapse, when the U.S. dollar is abandoned as a medium of exchange, unit of account and store of value.

Oh, and just in case the foregoing doesn’t fill you with a sense of dread, there’s the little matter of international “currency war” to ponder. During the Great Depression, many nations used monetary expansion to deliberately trash the value of their own currencies. Their aim was to make their goods look cheap to foreigners, thereby hiking their number and value of their exports and increasing employment in their export industries. Since their depreciated domestic currency would also buy fewer imports, this would supposedly encourage the citizenry to buy fewer goods from abroad, thereby increasing domestic employment in import-competing industries. This game plan is well-known to economic historians as the “beggar thy neighbor” strategy. Its inherent flaw is that it can work if, and only if, only one nation employs it. When all or most nations do it simultaneously, the effects cancel each other out in the currency market and the only result is that international trade evaporates – which is roughly what did happen during the Depression. Since international trade is a good thing which makes practically everybody better off, its virtual elimination was a disaster for everybody. And guess what? The rest of the world, watching Ben Bernanke and the Fed at work creating money like there’s no tomorrow, may well suspect the U.S. of trying just this tactic. Whether they’re right or wrong is beside the point, since it is their belief that will determine whether they retaliate by starting a trade war that mimics the devastation of the 1930s.

It is barely possible that Congress might embark on a program of haphazard, gradual deficit reduction a la Jenkins. But a thoroughgoing reform of the process is not in the cards. Thus, the danger is not a collapse caused by a government shutdown. The danger is a collapse caused by the failure to shut the government down. It is government at all levels that has turned itself into a machine for spending citizens’ money to benefit employees without providing substantial benefits to the citizens. Since there is virtually no competition for government services, there is little or no way to gauge whether any government good or service is worth what we have to pay to get it. So government just keeps rolling along, like Old Man River, carrying us all along with the flow.

The mass delusion afflicting America is cognitive dissonance. Most of us agree with Jenkins that no government can increase spending indefinitely. Yet we do not admit that this requires our government to actually cut spending for the purposes that (we believe) benefit us – or, at least, we do not admit this necessity in our lifetime. The same people who normally consider government to be intrusive, inept and unproductive magically reverse their position 180 degrees and assume that government is efficient and productive when pursuing their pet project, benefitting them and saving the world from their latest hobgoblin. This is the politico-economic equivalent of William Saroyan’s lament that everybody had to die but he had always assumed that an exception would be made in his case.

The dissonance is actually three-sided. We fail to recognize not only its quantitative dimension but also its qualitative side – government’s utter failure to solve problems and produce things of value. Thus, the real entrenched constituency for big government is not its ostensible beneficiaries – the poor, downtrodden, minorities and such. It is the bureaucrats and their minions, who collect paychecks but whose real net contribution to the social product is negative.

Until this dissonance is dispelled, it is idle to blame politicians for acting true to form.

DRI-406: The Narrative of U.S. Manufacturing Decline

Cassandra was the Trojan seer who foresaw the end of the Trojan War – the Greek ploy that lulled Troy’s inhabitants with the gift of a gigantic wooden horse and the city’s consequent fall when emerging Greek commandos overpowered the Trojan garrison. Since her day, the business of making prophecies of doom has gained popularity but lost accuracy.

Cassandra’s imitators presumably are not out to emulate her subsequent career, which was short. They are following the rule of thumb that the first duty of any prognosticator is to reach an audience. In this respect, doomsayers have a built-in advantage. Good news labors under the handicap that it is a call to inaction. Bad news is both attention-getting and galvanizing.

Economics is a ready-made field for predictions of doom because change is constant and virtually all change is bad news for somebody. Industry has been a popular venue for doomsayers since the heyday of mercantilism in the 17th century. Mercantilists believed that international trade was a two-edged sword from which domestic industry must be carefully shielded, lest its sharp edge cut against the grain of prosperity by draining the country of specie (monetary precious metals).

Modern-day mercantilists have refined their arguments. Doom now appears in the form of endangered industry. Wily foreigners are exploiting the good nature and naïve faith of American businessmen and officials. Their manipulations usurp American competitive advantage and cost the U.S. revenue, profits and jobs. These wounds are not suffered randomly but strategically, in sectors and industries that benefit us extravagantly and whose loss inflicts disproportionate harm. The most readily identifiable of these seems to be the manufacturing sector.

 

The Decline and Imminent Fall of U.S. Manufacturing

Rather than traffic entirely in generalities, we will allow one recent narrative of U.S. manufacturing decline to speak for all. Worse Than the Great Depression: What the Experts Are Missing About American Manufacturing Decline was published in March, 2012 by The Information Technology & Innovation Foundation. Its authors are Robert D. Atkinson, Luke D. Stewart, Scott M. Andes and Stephen J. Ezell. Generally speaking, its thesis is that U.S. manufacturing has been going to hell in a handcart ever since 1979, but that the cart was motorized around the turn of the millennium.

We know what it means when a person goes downhill – it means their health suffers in obvious, well-understood ways. We know what that means for an individual business – revenue and profit suffer. There may be other, more subtle indicators as well, such as declining market share and market size. But what does it mean to say that an industry is going downhill? And what, in particular, does it mean to say that an entire industry sector – like manufacturing – is suffering? Can any such meaningful condition even be identified?

The authors obviously think it can. They address the question using the vocabulary of the individual firm – as if an industrial sector were no different than a great big business firm. They begin by saying that in the (approximate) decade of the 2000s, America lost 5.7 million manufacturing jobs. They call this the “worst performance in American history…[an] unprecedented negative performance” that was nonetheless accepted complacently by pundits and politicians, who wrongly attributed it to landmark increases in U.S. manufacturing productivity that made it possible to produce more manufacturing output with less labor input.

Yet, the authors contend, 13 of 19 U.S. manufacturing sectors now produce less real (e.g., inflation-adjusted) manufacturing output than in 2000. Here, the authors rely heavily on their contention that government computation of real manufacturing output is very badly overstated – which in turn badly overstates labor productivity in manufacturing.

Labor figures importantly in the authors’ lament for the loss of manufacturing jobs. Mainstream economists view a manufacturing job as – well, just a job like any other job. Wrong, the authors contend. A manufacturing job is special. “Manufacturing jobs pay more.” They are “a source of good jobs for non-college-educated workers.” Manufacturing “is the key driver of innovation” – which in turn determines productivity and wages.

The stage is set for the entrance of the villain. A good prophesy of doom cannot subsist on a simple explanation like “market forces” or “normal evolution.” That would be an anti-climax. The decline of U.S. manufacturing is attributed by the authors to our “lost ability to compete in global markets – some manipulated by egregious foreign mercantilist forces, others supported by better national competitive fitness policies, like lower corporate tax rates.”

 

Newton’s Law of Polemic

There is an informal but powerful law governing polemical exchanges, which states that each contention must be met by an opposing contention of (at least) equal and opposite power. That is, the visceral reaction to this sort of thesis of decline is to vigorously insist that American manufacturing is not declining. “No, by George – why, it’s even increasing! It’s clear as a bell – even a fool could see it. Just look at this indicator, not that silly one that my opponents used. Just look at my data, not that rubbish produced by those boneheads.”

And it is true that, in this case, there is some basis for this reaction. After 27 straight years of decline, real U.S. manufacturing output rose 21% between 2002 and 2007. Then, between 2007 and 2012, it rose 13%, even into the teeth of the Great Recession. Even if we accept the author’s hypothesis that the absolute gains are overstated, the relative trend over the last decade would certainly seem to be upward. That hardly squares with their hypothesis of Kryptonian doom for the sector. The authors’ trump card is manufacturing employment, which fell for 38 straight years between 1979 and 2007. But it, too, rose by some 4% recently; manufacturing has been the most improbable of silver linings in an otherwise solid overcast darkening the employment horizon.

According to David Wessel and James Haggerty in The Wall Street Journal, the rebound in U.S. manufacturing employment was fueled by a decline in manufacturing wages. If true, this would hardly be a surprise, since classical economic theory posits that flexible wages and prices serve as “shock absorbers” to cushion the effects of real shocks such as declines in demand and temporary decreases in supply due to transitory factors. Instead of a scenario in which markets are thwarted by dark forces and sinister agendas, this sounds more like well-functioning markets at work.

In spite of this countervailing evidence, though, the Newtonian reaction should be resisted. The real problem with these dueling arguments is that “manufacturing” is an artificial category, not a true economic one. Consumers do not buy “manufacturing” – they buy individual products that economists more or less arbitrarily classify inside or outside of the box known as “manufacturing.” Businessmen do not decide to produce “manufacturing” – they produce the produces they think consumers want to buy, where “consumers” could refer to buyers of final products or other businessmen buying intermediate products in the production chain.

The Expert’s Error

A central underpinning of the sectoral decline hypothesis is the assertion that the composition of U.S. industry “should” be weighted in favor of manufacturing. Supporters propound this with such confident nonchalance that non-specialists may be startled to realize its flimsiness.

There is no reason to suppose that any a priori pattern or organization of industry is preferable. In effect, declinists want to impose their will upon the structure of production so as to guarantee a pleasing result for consumers and input suppliers. But it is precisely the wants of consumers and the welfare of input suppliers that should dictate the pattern of production.

The hypothesis cites levels of manufacturing output attained during past halcyon periods as the norm or desideratum by which we should be guided. But every industrial sector has its historic ups and downs. Throughout the 20th century, farmers demanded price and income “parity” with their status in the first decade or so of the century – not surprisingly, a time of unprecedented agricultural prosperity. Despite their failure to reach this standard and despite a prolonged and continual exodus of farmers from the industry, U.S. agriculture has continued to supply the needs of the world.

The authors point to the high historic wages paid by manufacturers. They juxtapose this against a backdrop of falling real wages in the U.S. Surely this is not coincidence. Falling U.S. wages must be caused by the loss of U.S. manufacturing jobs.

This analysis suffers a kind of error common to an information age preoccupied with the views of experts. Teachers of the game of contract bridge recognize a species of error almost always found in the precincts of expert bridge. An “expert’s error” is so named because it requires an expert to think of it – an ordinary player would not have either the imagination or the background to dream up the reasons for committing the mistake. Now we have an economic version of the expert’s error.

It would not occur to the average person to classify numerous, diverse business firms together according to the sole criterion that they transform physical inputs into a physical output. Still less would it occur to them to elevate this classification above all others on a normative scale. Only an “expert” in industrial organization would commit such a taxonomic blunder.

Classification and taxonomy, though, are activities in which experts regularly engage. They also make extensive use of government classifications such as the federal government’s Standard Industrial Classification (SIC) and North American Industrial Classification System (NAICS) codes, which classify business firms using a system in which longer numbers denote increasing degrees of fineness. To an expert, it seems only natural to see generalities and statistical regularities in these classifications, in the same way natural scientists discern the laws of nature from observation.

Thus, when the U.S. Commerce Department classifies thousands of businesses together as “manufacturers” because they perform various physical operations that seem to possess a family resemblance, the expert immediately grasps the opportunity to seem knowledgeable and important by referring to the “manufacturing sector” – as if all the firms inside this classification really and truly had enough in common to warrant such treatment.

But the overriding economic reason for viewing businesses analytically as a class is that they are competitors. That is, they produce goods and/or services that are viewed by consumers as economic substitutes. Since the SIC codes are organized by physical operation performed rather than by (consumer perceptions of) substitutability, this makes very little sense.

Similarly, when experts observe a big, successful nation that has lots of manufacturing firms, they tend to jump to the conclusion that – post hoc, ergo propter hoc – success must stem from manufacturing. But economists identify the locus of economic production value in a principle called comparative advantage, first noted in 1817 by English stockbroker-turned-economist David Ricardo. Ricardo explained that nations tend to specialize in producing goods in which their comparative costs of production (what economists have come to call opportunity costs) are lower than those of their trading partners. Comparative advantage has nothing to do with manufacturing or farming or finance or any sectoral designation as such.

The grand theses of sectoral decline have nothing to do with economics. They have everything to do with tradition and tribal loyalty and habit and appearance – almost everything except economics. They are not the result of profound, systematic thought. They are a substitute for thought.

This lends any analysis of manufacturing an artificial character that, in and of itself, should make anybody cautious about reaching conclusions, whether gloomy or sunny. Any that’s just the beginning of the reasons for rejecting the declinist hypothesis.

 

The Intellectual Pedigree of the Endangered Industry hypothesis

Another tipoff to the internal inconsistency of the industrial decline hypothesis is the behavioral history of the proponents. When their intellectual careers and pedigrees are examined, flagrant contradictions emerge.

A prime example is the common hostility toward finance. This is simply the mirror image of their insistence that a thriving nation must “make things;” that is, physical goods. Since the physical manifestation of a financial asset seldom amounts to more than a piece of paper – and may be merely digital symbols inside a computer – there is an apparent consistency between these attitudes. It is certainly ironic that a left wing that has lived by excoriating the crass materialism of capitalism should itself embrace such a crude form of materialism.

The materialists – descendants of early socialists like the Physiocrats and Mercantilists – are also devotees of the “limits to growth,” extreme environmentalist view that mankind must reverse the path of industrial society to avoid exhaustion of natural resources and planetary catastrophe. The substitution of services for goods and financial production for physical production should fit in with this strategy. After all, finance is defined as the allocation of resources over time under conditions of risk, which responds to the complaint of the physicalist school that capitalism takes a near-sighted, heedless view of reality.

In essence, the physicalists are reduced to saying not that markets are wrongly focused, but that they simply don’t work. But this contradicts not only with history, which clearly shows that only markets can successfully produce goods and services, but also with the doomsayers’ own position, which is that markets worked beautifully at providing manufactured goods – until they didn’t.

The fall-back position of the materialist, environmentalist school must then be that people just want the wrong things. The wants of the physicalists are inherently superior and should be substituted for those of the population at large – by force if necessary. And it will be necessary, because evidence and experience reveals a general unwillingness to forego the comforts and pleasures of modern industrial society for the dubious strictures of the totalitarian left.

What is the Remedy for Manufacturing Decline?

The authors prophesy a downward spiral for American manufacturing, presumably culminating in extinction. Unless – well, they list two types of remedial action: “egregious foreign mercantilist” ones and “national competitive fitness” ones. While they don’t actually advocate the former, note that they credit them with helping to wreck American manufacturing. This is another recurring theme of the doomsayer business – the bad guys have all the ammunition. Even their crudest tactics work; even the smallest and least capable countries can push America around because their very weakness and inferiority constitutes an advantage over us.

The concept of “national competitive fitness” is the really intriguing feature of their analysis. This is nothing more than the notion of industrial policy, thinly disguised. The national government decides which sectors, industries and firms will succeed, and then fulfills its own prophecies by choosing from a wide-ranging menu of economic policies. Some of those policies, like the previously mentioned lowering of corporate taxes, may have considerable merit quite apart from the question of industrial policy. That is, they may be the right thing to do not because they will help the “right” firms, industries or sectors emerge triumphant but because they will better serve the cause of economic growth.

Industrial policy itself, however, has a fairly long and decidedly undistinguished history. Readers with good memories will remember the 1980s, when the economic success story du jour was Japan. Conventional thinking ascribed its success to MITI, its industrial planning arm, which supposedly equipped its firms to rampage across the globe, undercutting domestic firms and wreaking export havoc. Bestsellers like the late Michael Crichton’s Rising Sun foretold that we would someday drink toasts to the yen in Saki.

How are the mighty fallen! Today nobody thinks about Japan at all, except to worry about whether radioactive fallout from its stricken nuclear reactors will reach our shores. Even before its disastrous earthquakes and tsunami, Japan had been an economic basket case for well over a decade, done in by its Keynesian over-spending and loose monetary policy. Apparently the wily Oriental mind is just as susceptible to bad economic advice as its Occidental counterpart.

The bald, bitter truth is that there is no precedent whatever for supposing that any government can micromanage its economic future to the extent of controlling the rise and fall of industries or industrial sectors. Bailouts of individual firms have never achieved unequivocally good results. Founding father Alexander Hamilton made a case for tariffs as industrial policy, but it is difficult to think of even one legitimate example of Hamilton’s famous “infant industry” – an industry picked out by the national government in its gestation period, carefully nurtured through its early, formative years and eventually growing to robust dominance and independence. Instead, firms and industries that feed at the federal trough become addicted and are never weaned away. They remain weak cripples for their entire business lives.

 

Industrial Declinism and Constructivism

The strong visceral appeal of industrial declinism probably traces to the emotional buttons it pushes. We had something good in the past. That thing is slipping away. We are losing control of our lives. That simply can’t be good, let alone necessary and inevitable. If we once had it, it must have been because we willed it so. By trying very hard, we can bring it back. We can will it to return. What we once created, we can once again regenerate.

In fact, there is no logic or empirical evidence to back up anything in the preceding paragraph – except for the fact that American manufacturing success was indeed a good thing. It may or may not actually be slipping away. But we are not losing control because we never had it. We never willed our manufacturing ascendancy and we cannot regain it simply through force of will.

Free markets work through a subtle and complex process of cultural evolution and information exchange that surpassed the full comprehension of any one person or any panel of experts. That is how markets extract the inchoate and dispersed information tucked away in the brains of billions of people and make it accessible to the world. It is a kind of hubris to pretend that national governments – one of humanity’s most cumbersome, least efficient, least benevolent institutions – can somehow reshape this process to the liking of a select group of politicians. This attitude was labeled constructivism by the late F. A. Hayek, Nobel laureate and social theorist extraordinaire.

Free markets allow consumers to dictate what is produced and in what quantities. Competition between producers determines what techniques are used in production. But the manner in which these determinations are made is impersonal rather than collaborative and consultative. There is no reason to think that a cartel or an industrial planning board could improve on the workings of the impersonal market and every reason to doubt it. That is why we should resist the urgings of the industrial declinists. They may be wrong. But even if they are right about the decline of manufacturing, they are wrong about the need to arrest it.

And if you’re wrong even when you’re right, you must really be missing the mark.