LESSONS LEARNED #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 19th, 2010

WHAT GAVE BIRTH to the Federal Reserve System and our current monetary policy?  The Panic of 1907.  Without going into the details, there was a liquidity crisis.  The Knickerbocker Trust tried to corner the market in copper.  But someone else dumped copper on the market which dropped the price.  The trust failed.  Because of the money involved, a lot of banks, too, failed.  Depositors, scared, created bank runs.  As banks failed, the money supply contracted.  Businesses failed.  The stock market crashed (losing 50% of its value).  And all of this happened during an economic recession.

So, in 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed).  This was, basically, a central bank.  It was to be a bank to the banks.  A lender of last resort.  It would inject liquidity into the economy during a liquidity crisis.  Thus ending forever panics like that in 1907.  And making the business cycle (the boom – bust economic cycles) a thing of the past.

The Fed has three basic monetary tools.  How they use these either increases or decreases the money supply.  And increases or decreases interest rates.

They can change reserve requirements for banks.  The more reserves banks must hold the less they can lend.  The less they need to hold the more they can lend.  When they lend more, they increase the money supply.  When they lend less, they decrease the money supply.  The more they lend the easier it is to get a loan.  This decreases interest rates (i.e., lowers the ‘price’ of money).  The less they lend the harder it is to get a loan.  This increases interest rates (i.e., raises the ‘price’ of money). 

The Fed ‘manages’ the money supply and the interest rates in two other ways.  They buy and sell U.S. Treasury securities.  And they adjust the discount rate they charge member banks to borrow from them.  Each of these actions either increases or decreases the money supply and/or raises or lowers interest rates.  The idea is to make money easier to borrow when the economy is slow.  This is supposed to make it easier for businesses to expand production and hire people.  If the economy is overheating and there is a risk of inflation, they take the opposite action.  They make it more difficult to borrow money.  Which increases the cost of doing business.  Which slows the economy.  Lays people off.  Which avoids inflation.

The problem with this is the invisible hand that Adam Smith talked about.  In a laissez-faire economy, no one person or one group controls anything.  Instead, millions upon millions of people interact with each other.  They make millions upon millions of decisions.  These are informed decisions in a free market.  At the heart of each decision is a buyer and a seller.  And they mutually agree in this decision making process.  The buyer pays at least as much as the seller wants.  The seller sells for at least as little as the buyer wants.  If they didn’t, they would not conclude their sales transaction.  When we multiply this basic transaction by the millions upon millions of people in the market place, we arrive at that invisible hand.  Everyone looking out for their own self-interest guides the economy as a whole.  The bad decisions of a few have no affect on the economy as a whole.

Now replace the invisible hand with government and what do you get?  A managed economy.  And that’s what the Fed does.  It manages the economy.  It takes the power of those millions upon millions of decisions and places them into the hands of a very few.  And, there, a few bad decisions can have a devastating impact upon the economy.

TO PAY FOR World War I, Woodrow Wilson and his Progressives heavily taxed the American people.  The war left America with a huge debt.  And in a recession.  During the 1920 election, the Democrats ran on a platform of continued high taxation to pay down the debt.  Andrew Mellon, though, had done a study of the rich in relation to those high taxes.  He found the higher the tax, the more the rich invested outside the country.  Instead of building factories and employing people, they took their money to places less punishing to capital.

Warren G. Harding won the 1920 election.  And he appointed Andrew Mellon his Treasury secretary.  Never since Alexander Hamilton had a Treasury secretary understood capitalism as well.  The Harding administration cut tax rates and the amount of tax money paid by the ‘rich’ more than doubled.  Economic activity flourished.  Businesses expanded and added jobs.  The nation modernized with the latest technologies (electric power and appliances, radio, cars, aviation, etc.).  One of the best economies ever.  Until the Fed got involved.

The Fed looked at this economic activity and saw speculation.  So they contracted the money supply.  This made it hard for business to expand to meet the growing demand.  When money is less readily available, you begin to stockpile what you have.  You add to that pile by selling liquid securities to build a bigger cash cushion to get you through tight monetary times.

Of course, the economy is NOT just monetary policy.  Those businesses were looking at other things the government was doing.  The Smoot-Hartley tariff was in committee.  Across the board tariff increases and import restrictions create uncertainty.  Business does not like uncertainty.  So they increase their liquidity.  To prepare for the worse.  Then the stock market crashed.  Then it got worse. 

It is at this time that the liquidity crisis became critical.  Depositors lost faith.  Bank runs followed.  But there just was not enough money available.  Banks began to fail.  Time for the Fed to step in and take action.  Per the Federal Reserve Act of 1913.  But they did nothing.  For a long while.  Then they took action.  And made matters worse.  They raised interest rates.  In response to England going off the gold standard (to prop up the dollar).  Exactly the wrong thing to do in a deflationary spiral.  This took a bad recession to the Great Depression.  The 1930s would become a lost decade.

When FDR took office, he tried to fix things with some Keynesian spending.  But nothing worked.  High taxes along with high government spending sucked life out of the private sector.  This unprecedented growth in government filled business with uncertainty.  They had no idea what was coming next.  So they hunkered down.  And prepared to weather more bad times.  It took a world war to end the Great Depression.  And only because the government abandoned much of its controls and let business do what they do best.  Pure, unfettered capitalism.  American industry came to life.  It built the war material to first win World War II.  Then it rebuilt the war torn countries after the war.

DURING THE 1980s, in Japan, government was partnering with business.  It was mercantilism at its best.  Japan Inc.  The economy boomed.  And blew great big bubbles.  The Keynesians in America held up the Japanese model as the new direction for America.  An American presidential candidate said we must partner government with business, too.  For only a fool could not see the success of the Japanese example.  Japan was growing rich.  And buying up American landmarks (including Rockefeller Center in New York).  National Lampoon magazine welcomed us to the 90s with a picture of a Japanese CEO at his desk.  He was the CEO of the United States of America, a wholly owned subsidiary of the Honda Motor Company.  The Japanese were taking over the world.  And we were stupid not to follow their lead.

But there was no invisible hand in Japan.  It was the hand of Japan Inc.  It was Japan Inc. that pursued economic policies that it thought best.  Not the millions upon millions of ordinary Japanese citizens.  Well, Japan Inc. thought wrong. 

There was collusion between Japanese businesses.  And collusion between Japanese businesses and government.  And corruption.  This greatly inflated the Japanese stock market.  And those great big bubbles finally burst.  The powerful Japan Inc. of the 1980s that caused fear and trembling was gone.  Replaced by a Japan in a deflationary spiral in the 1990s.  Or, as the Japanese call it, their lost decade.  This once great Asian Tiger was now an older tiger with a bit of a limp.   And the economy limped along for a decade or two.  It was still number 3 in the world, but it wasn’t what it used to be.  You don’t see magazine covers talking about it owning other nations any more.  (In 2010, China took over that #3 spot.  But China is a managed economy.   Will it suffer Japan’s fate?  Time will tell.)

The Japanese monetary authorities tried to fix the economy.  Interest rates were zero for about a decade.  In other words, if you wanted to borrow, it was easy.  And free.  But it didn’t help.  That huge economic expansion wasn’t real.  Business and government, in collusion, inflated and propped it up.  It gave them inflated capacity.  And prices.  And you don’t solve that problem by making it easier for businesses to borrow money to expand capacity and create jobs.  That’s the last thing they need.  What they need to do is to get out of the business of managing business.  Create a business-friendly climate.  Based on free-market principles.  Not mercantilism.  And let that invisible hand work its wonders.

MONETARY POLICY CAN do a lot of things.  Most of them bad.  Because it concentrates far too much power in too few hands.  The consequences of the mistakes of those making policy can be devastating.  And too tempting to those who want to use those powers for political reasons.  As we can see by Keynesian ‘stimulus’ spending that ends up as pork barrel spending.  The empirical data for that spending has shown that it stimulates only those who are in good standing with the powers that be.  Never the economy.

Sound money is important.  The money supply needs to keep pace with economic expansion.  If it doesn’t, a tight money supply will slow or halt economic activity.  But we have to use monetary policy for that purpose only.  We cannot use it to offset bad fiscal policy that is anti-business.  For if the government creates an anti-business environment, no amount of cheap money will encourage risk takers to take risks in a highly risky and uncertain environment.  Decades were lost trying.

No, you don’t stimulate with monetary policy.  You stimulate with fiscal policy.  There is empirical evidence that this works.  The Mellon tax cuts of the Harding administration created nearly a decade of strong economic growth.  The tax cuts of JFK were on pace to create similar growth until his assassination.  LBJ’s policies were in the opposite direction, thus ending the economic recovery of the JFK administration.  Ronald Reagan’s tax cuts produced economic growth through two decades. 

THE EVIDENCE IS there.  If you look at it.  Of course, a good Keynesian won’t.  Because it’s about political power for them.  Always has been.  Always will be.  And we should never forget this.

www.PITHOCRATES.com

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LESSONS LEARNED #19: “Philosophical debates can be effective but character assassination is more expedient, especially when no one agrees with your philosophy.” -Old Pithy

Posted by PITHOCRATES - June 24th, 2010

THOMAS JEFFERSON HATED Alexander Hamilton.  So much so he hired Philip Freneau as a translator in his State Department in George Washington’s administration.  You see, Jefferson did not like confrontation.  So he needed a way to slander Hamilton, his policies and the Washington administration without getting his own hands dirty.  And that was what Freneau was supposed to do with the money he earned while working in the State Department.  Publish a newspaper (National Gazette) and attack Hamilton, his policies and the Washington administration.  Papers then were partisan.  More so than today.  Then, lies and libel were tools of the trade.  And they knew how to dig up the dirt.  Or make it up. 

Another scandalmonger, James Callender, was slinging dirt for Jefferson.  And he hit pay dirt.  Mr. and Mrs. Reynolds of Philadelphia had a lucrative business.  They were blackmailing Alexander Hamilton.  Mr. Reynolds had his wife seduce Hamilton.  Which she did.  And did well.  They had an affair.  And Mr. Reynolds then blackmailed him.  Jefferson pounced.  Or, rather, Callender did.  To keep Jefferson’s hands clean.  Hamilton, Callender said, was using his position at the Treasury Department for personal gain.  He was using public funds to pay the blackmailer.  They found no proof of this.  And they did look for it.  Hard.  But when they came up empty, Jefferson said that it just proved what a good thief Hamilton was.  He was so good that he didn’t leave any traces of his treachery behind.

Of course, when you lie down with dogs, you get up with fleas.  And Jefferson’s association with Callender would come back and bite him in the ass.  In a big way.  Upset because Jefferson didn’t appropriately compensate him for all his loyal dirt slinging (he wanted the postmaster’s job in Richmond), he publicized the Sally Hemings rumors.  And after breaking the true story of the Hamilton affair, many would believe this scoop.  That Jefferson was having an affair with one of his slaves.  It was a dark cloud that would forever hang over Jefferson.  And his legacy.

Hamilton admitted to his affair.  Jefferson admitted to no affair.  Hamilton would never hold public office again and would later die in a duel with Jefferson’s one-time toady, Aaron Burr.  This duel resulted because Hamilton was doing whatever he could to keep the amoral and unscrupulous Burr from public office (in this case, it was the governorship of New York).  When the election of 1800 resulted in a tie between Jefferson and Burr, Hamilton urged the House to vote for Jefferson, his archenemy.   Despite what had appeared in the press, Hamilton did have morals and scruples.  Unlike some.  Speaking of which, Jefferson would go on to serve 2 terms as president.  And all of that angst about Hamiltonian policies?  They all went out the window with the Louisiana Purchase (which was unconstitutional, Big Government and Big Finance).

RONALD REAGAN WAS routinely called old, senile and out of touch by the entertainment community, the media and his political foes.  But he bested Mikhail Gorbachev and the Soviet Union, something Jimmy Carter never did.  He said ‘no’ at Reykjavik because he told the American people that he wouldn’t give up the Strategic Defense Initiative (SDI).  He knew the Soviet Union was bleeding.  Communism was a farce.  It inhibited human capital.  And impoverished her people.  SDI may have been science fiction in the 1980s, but capitalism wasn’t.  It could do it all.  Including SDI.  The Soviet Union was on the ropes and Reagan would give no quarter.  The days of living in fear of the mushroom cloud were over.  And capitalism would deliver the knockout punch.

Reaganomics, of course, made this all possible.  Supply-side economics.  Which follows the Austrian school.  Say’s Law.  ‘Supply creates demand’.  You don’t stimulate the economy by taxing one group of people so another group can spend.  You stimulate it by creating incentives for risk takers to take risks.  And when they do, they create jobs.  And wealth.

Tax and spend is a failed Keynesian, zero-sum economic policy.  When you take from the earners and give to the non-earners, we just transfer purchasing power.  We don’t create it.  For some to spend more, others must spend less.  Hence, zero-sum.  The net some of goods and services people are purchasing remains the same.  Different people are just doing the purchasing.

When Apple invented the Macintosh personal computer (PC), few were demanding a PC with a graphical user interface (GUI).  But Apple was innovative.  They created something they thought the people would want.  And they did.  They took a risk.  And the Macintosh with its mouse and GUI took off.  Apple manufacturing increased and added jobs.  Retail outlets for the Macintosh expanded and created jobs.  Software firms hired more engineers to write code.  And other firms hired more people to engineer and manufacture PC accessories.  There was a net increase in jobs and wealth.  Just as Say’s Law predicts.  Supply-side economics works.

Of course, the Left hates Reagan and attacked Reaganomics with a vengeance.  They attacked Reagan for being pro-rich.  For not caring about the poor.  And they revised history.  They say the only thing the Reagan tax cuts gave us were record deficits.  Of course, what those tax cuts gave us were record tax receipts.  The government never collected more money.  The House of Representatives (who spends the money), awash in cash, just spent that money faster than the treasury collected it.  The record shows Reaganomics worked.  Lower tax rates spurred economic activity.  More activity generated more jobs and more personal wealth.  Which resulted in more people paying more taxes.  More people paying taxes at a lower rate equaled more tax revenue in the aggregate.  It works.  And it works every time people try it. 

Because Reaganomics worked and showed the Left’s policies were failures, they had to attack Reagan.  To discredit him.  They had to destroy the man.  Except when they’re running for elected office.  Then they strive to show how much more Reagan-like they are than their conservative opponents.  Because they know Reaganomics worked.  And they know that we know Reaganomics worked.

GEORGE W. BUSH was routinely called an ‘idiot’ by the entertainment community, the media and his political foes.  Yet this ‘idiot’ seems to have outwitted the elite of the liberal Left time and time again.  I mean, if their policies were winning, they would be no reason to have attacked Bush in the first place.  The Left hated him with such vitriol that they said he blew up the Twin Towers on 9/11 as a justification for invading Iraq for her oil.  It was Big Oil’s lust for profit, after all, that was driving this Texan’s Big Oil policies.  And taking Iraq’s oil would increase Big Oil’s sales and give her even more obscene profits.

If Bush was an idiot, he must have been an idiot genius to come up with a plan like that.  Then again, gasoline prices crept to $4/gallon following the Iraq War.  Had all that oil gone on the market according to plan, that wouldn’t have happened.  Unless the plan was to keep that oil OFF of the market, thus, by rules of supply and demand, the price of oil (and the gasoline we make from it) would go up thus enriching Big Oil through higher prices resulting from a lower sales volume.  My god, what evil genius.  For an idiot.  Of course, gas taxes, numerous summer gas blends (required by the government’s environmental policies), an aging and over-taxed pipeline infrastructure and insufficient refinery capacity (the government’s environmental policies make it too punishing even to consider building a new refinery) to meet increasing demand (soaring in India and China) had nothing to do with the rise in gas prices.

IS THE POLITICAL Left evil?  Probably not.  Just amoral.  They have an agenda.  They survive on political spoils and patronage.  Old time politics.  Enrich themselves through cronyism.  If tribute is paid they’ll extend favorable treatment.  If tribute is not paid, they will release their wrath via hostile regulation, litigation, Congressional investigation and punitive taxation.  Just like they did to Big Tobacco (and, no, it wasn’t about our health.  They could have just made tobacco illegal.  But they didn’t.  Why?  It just brings in way too much money to the government.  Via sin taxes.  And federal lawsuits.  And with it being addictive, it’s a frickin cash piñata for them.)

They know few agree with their philosophy.  But they don’t care.  It’s not about national prosperity.  It’s about power.  And they want it.  That’s why they can’t debate the issues.  They know they can’t win.  So they attack the messenger.  Not the message.  If you don’t believe that, you can ask Abraham Lincoln, Ronald Reagan, George W. Bush, Sarah Palin and just about any other Republican.  Well, you can’t ask Lincoln or Reagan.  But you can guess what they would say.

www.PITHOCRATES.com

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