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.

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LESSONS LEARNED #25: “War is costly. Peace, too.” -Old Pithy

Posted by PITHOCRATES - August 5th, 2010

AT THE HEIGHT of the Roman Empire, the empire reached from North Africa to Britannia (England), from Hispania (Spain) to Mesopotamia (approximately modern day Iraq).  When Roman power ruled the civilized world, there was peace.  The Pax Romana (Roman Peace).  The Romans built empire through conquest.  And Rome grew rich with the spoils of conquest.  For awhile, peace was only those quiet intervals between growth and conquest.  But with secure borders, a uniform government, a rule of law, a stable currency, bustling trade & markets and a military to be the world’s policeman, peace broke out.  For some 200 years.

Life was good for the Roman citizen.  As well as for those living in the empire.  The Romans modernized the provinces they conquered.  Made life better.  Even for the conquered people.  Although there were those who hated being subjugated by a foreign power.

Reg: They bled us white, the bastards. They’ve taken everything we had. And not just from us! From our fathers, and from our father’s fathers.

Loretta: And from our father’s father’s fathers.

Reg: Yeah.

Loretta: And from our father’s father’s father’s fathers.

Reg: Yeah, all right Stan, don’t belabor the point. And what have they ever given us in return?

Revolutionary I: The aqueduct?

Reg: What?

Revolutionary I: The aqueduct.

Reg: Oh. Yeah, yeah, they did give us that, ah, that’s true, yeah.

Revolutionary II: And the sanitation.

Loretta: Oh, yeah, the sanitation, Reg. Remember what the city used to be like.

Reg: Yeah, all right, I’ll grant you the aqueduct and sanitation, the two things the Romans have done.

Matthias: And the roads.

Reg: Oh, yeah, obviously the roads. I mean the roads go without saying, don’t they? But apart from the sanitation, the aqueduct, and the roads…

Revolutionary III: Irrigation.

Revolutionary I: Medicine.

Revolutionary IV: Education.

Reg: Yeah, yeah, all right, fair enough.

Revolutionary V: And the wine.

All revolutionaries except Reg: Oh, yeah! Right!

Rogers: Yeah! Yeah, that’s something we’d really miss Reg, if the Romans left. Huh.

Revolutionary VI: Public bathes.

Loretta: And it’s safe to walk in the streets at night now, Reg.

Rogers: Yeah, they certainly know how to keep order. Let’s face it; they’re the only ones who could in a place like this.

All revolutionaries except Reg: Hahaha…all right…

Reg: All right, but apart from the sanitation, the medicine, education, wine, public order, irrigation, roads, the fresh-water system and public health, what have the Romans ever done for us?

Revolutionary I: Brought peace?

Reg: Oh, peace! Shut up!

(From Monty Python’s The Life of Brian, 1979.)

Maintaining a peaceful empire is costly.  As people got more accustomed to peace and plenty, they began to complain about taxes.  Citizens refused to volunteer to serve in the Roman Legions maintaining that peace.  Barbarians began to serve in the Legions.  Some rose to command them.  Some Roman commanders came from the very people they were fighting in the border regions.  Soon Rome would rely on mercenaries (hired soldiers) to defend their borders.  All of this cost the empire.  It had to pay more and more to maintain the loyalty of the military.  Ditto for the huge bureaucracy administrating the empire.  And they lost control.  Trouble on the borders and economic collapse ended the peace.  And, ultimately, the empire.  The civilized world broke down and collapsed.  And barbarian leaders on the borders, hungry for conquest, attacked.  Plunging the former Roman provinces into war and instability.

RISING FROM THE ashes of the Roman Empire were the seeds of new empires.  And the ground that proved most fertile was the northern limit of the old empire.  England.

England started to assert herself with the growth of her navy.  With her borders secured, a uniform government, a rule of law, a stable currency, bustling trade & markets and a military to be the world’s policeman, peace broke out.  Again.  For about a hundred years.  During the Industrial Revolution.  After the defeat of Napoleon. 

Imperial Britain stretched across the globe.  The sun never set on the British Empire.  And wherever she went, she brought the rule of law, modernity, a sound economy and political stability.  Her old colonial possessions went on to be some of the richest, most prosperous and peaceful nations in the world.  India.  Australia.  New Zealand.  South Africa.  Canada.  And, of course, the United States of America.  She achieved her century of peace (Pax Britannia) by a balance of power.  She maintained peace by intervening in disputes, often on the side of the weaker nation.  She prevented stronger, aggressive nations from threatening her weaker neighbors.   And she provided a safe environment for the weaker nation to live peacefully in the shadows of stronger, more aggressive neighbors.

For a hundred years Britannia kept the peace.  In large part due to her Royal Navy, the most powerful and potent navy at the time.  If you ate any imported food or used any imported goods, it was thanks to the Royal Navy that kept the world’s sea lanes safe.  But this peace came with a price.  The rise of nationalism, the quest of new empires to establish their own overseas colonies and a change in the balance of power in Europe with the rise of Germany added to that price.  And then a shot fired in Sarajevo by a Serbian terrorist ignited a tinderbox.  The assassination of Archduke Franz Ferdinand by Gavrilo Princip started World War I.  The most bloody and expensive war at the time, it bankrupted Great Britain and ended her empire.  And left the world a less safe place. 

From the ashes of World War I rose new leaders with aspirations of world conquest.  Fascist Italy led by Benito Mussolini.  Nazi Germany led by Adolf Hitler.  Communist Russia led by Joseph Stalin.  Imperial Japan led by Hideki Tojo.  And the nation that led the victors in World War II would, by default, become the new world power.  The new world policeman.  The United States of America.

SO WHAT HAPPENED during the inter-war years that led to World War II?  War exhausted Britain and France.  Neither had the stomach for another war.  Britain continued to rely on the Royal Navy for protection (as an island nation, sea power is indispensable).  France built fixed fortifications (the Maginot Line).  Both were primarily defensive strategies. 

In America, General Billy Mitchell demonstrated the vulnerability of battleships to air power by sinking a battleship with an airplane (greatly flustering the naval high command).  Colonel George S. Patton developed an armored doctrine for an unenthused army and eventually transferred back to the horse cavalry.  Meanwhile, Imperial Japan was building aircraft carriers.  And Nazi Germany, Fascist Italy and Communist Russia developed air and armored doctrine while fighting in the Spanish Civil War.

Fascist Italy attacked Ethiopia in 1935 to rebuild the Roman Empire and make the Mediterranean Sea a Roman lake once again.  Nazi Germany launched World War II in 1939 by an armored assault on Poland with tactical air support.  Poland resisted with horse cavalry.  And lost.  Imperial Japan attacked Pearl Harbor in 1941 to destroy American naval power in the Pacific.  They did a lot of damage.  But the American carriers, their prime objective, were at sea.  They would eventually meet those carriers later at the Battle of Midway.  Where they would lose four of their best carriers and many of their best aviators.  This tipped the balance of power in the Pacific to the Americans.

America was ill-prepared for war.  But American industry, the Arsenal of Democracy, ramped up and built the planes, tanks, guns, rifles and ships that would win the war.   It would come with a heavy price tag.  Global wars typically do.  Had there been a balance of power that would have checked the territorial ambitions of the aggressor nations, it would have been a different story.  Of course, having the power is one thing.  How you use it is another. 

France had more tanks than Germany before the outbreak of hostilities.  But the Nazis quickly overran France.  Why?  Doctrine.  France’s doctrine was to hide behind the security of the Maginot Line.  It was a defensive-only strategy.  She developed no armored doctrine.  The lesson they learned from World War I was that armies killed themselves attacking fixed defenses.  Germany, too, learned that lesson.  So their doctrine called for going around fixed defenses with fast-moving armor spearheads with tactical air support (i.e., blitzkrieg).  Formidable though the Maginot Line was, it could not attack.  And if the Nazis didn’t attack it, it did nothing but concentrate men and firepower away from the battle.

WHEN WE PULLED out of South Vietnam, we agreed to use American air power if North Vietnam violated the terms of the treaty ending that war.  Watergate changed all of that.  Even though JFK got us into Vietnam, it became Nixon’s war.  And a vindictive Congress wouldn’t have anything more to do with it.  The North tested the American will.  Saw that there was none.   Attacked.  And overran South Vietnam.  The message was clear to tyrants.  America will quit in the long run.  Especially after a large loss of life.

Other ‘retreats’ would reinforce this perception.  Especially in the Arab world.  The withdrawal from Lebanon after the bombing of the Marines’ barracks.  The withdrawal from Somalia after the Somalis dragged dead American troops through the streets of Mogadishu.  The Arab world even saw the victory in Desert Storm as a retreat.  The anti-American Arab world said that our invasion was about oil.  That what we really wanted was to topple Saddam Hussein and take his oil.  It was just another Christian Crusade into holy Islamic lands.  When we didn’t do that, the Arab world saw it as another American retreat.  That America didn’t have the will to endure a bloody battle to conquer Iraq. 

So some in the Arab world would test America.  Al Qaeda.  Headed by Osama bin Laden.  They started small and became more daring.  World Trade Center bombing.  Tanzanian Embassy bombing.  Kenyan Embassy bombing.  Khobar Towers bombing.  The USS Cole attack.  And they paid little for these attacks.  America didn’t fight back.  But their luck ran out on September 11, 2001.  Because America finally fought back.

PUBLIC ENEMY NUMBER one, Osama bin Laden, belonged to the conservative Sunni sect of Islam called Wahhabi.  They have a large following in Saudi Arabia.  The Wahhabi have a delicate relationship with the Saudi Royal family.  They disapprove of the Western displays of wealth in the House of Saud. 

Al-Qaeda was a shadowy enemy.  We confronted them in the mountains of Afghanistan where the Taliban gave them a safe sanctuary.  We attacked.  Knocked the Taliban from power.  Drove al-Qaeda underground.  But we could not stop their funding.

Wahhabi money from Saudi Arabia financed 9/11.  And the money continued to flow.  The Saudis would not intervene on behalf of America.  They feared any crackdown on the Wahhabi could unleash a civil war.  So America needed leverage to get Saudi cooperation.  And they found it in an old nemesis, Saddam Hussein. 

A Sunni minority ruled Iraq.  The Saudis did not like Saddam Hussein.  However, they liked the balance of power he offered to Iran.  Iran was Shiite.  As much as the Saudis did not like Saddam, they disliked Shiite Iran more.  This was the American lever.

After some diplomatic gymnastics, the invasion of Iraq was set.  The Saudis thought we were bluffing.  They didn’t believe we would invade Iraq.  Never in a million years.  If we didn’t do it in Desert Storm when we had the force in place to do it and didn’t, there was no way the Americans would amass another coalition and redeploy forces to the region again.  Especially because America doesn’t like long, drawn out, bloody wars.  Which an invasion of Iraq would surely be.

They asked us to remove our forces from the Saudi bases.  We did.  Now they were getting nervous.  That was the political game.  Make some noise to show the Arab world you weren’t an American toady.  But, secretly, you want those American forces to remain.  That American presence did provide security.  And stability.  After the invasion of Kuwait, it sure looked like Saudi Arabia would be next.  It was only that large American force in the desert that changed that inevitability. 

The Americans invaded.  And conquered.  Now the Saudis had a vested interest in helping the Americans.  They needed them to be successful in Iraq.  To contain Iran.  The lever worked.  The Saudis stemmed the flow of Wahhabi money to al-Qaeda.  The invasion of Iraq proved to be one of the most effective battles in the war on terrorism.  

HISTORY HAS SHOWN that a balance of power can lead to peace.  It has also shown that a superpower can enforce a larger peace.  But it also has shown that there is good and bad when it comes to power.  The Romans could be cruel, but so were most in that time.  The road to empire, after all, started out simply as a quest to provide a buffer between Rome and the hostile barbarians on her borders.  Rome, then, expanded in pursuit of peace.  (Initially, at least.)  And then used her power to maintain peace.

Many view Great Britain as the successor to the Roman Empire.  And many view America as the successor to the British Empire.  These powers share many things (rule of law, an advanced civilization, political stability, etc.).  Perhaps the greatest, though, is a powerful military.  And how it was/is used.  As a powerful deterrent to an aggressor nation.  To protect trade routes.  To maintain peace.  Malign these empires/nations all you will, but the greatest periods of world peace were due to their military power.  And their will to use that military power.  Expensive as that was.  Is.

So, yes, wars are costly.  Peace, too.  Sometimes, though, we must fight wars.  But we can avoid a lot of them.  By a peace-time military force that acts as a deterrent.  Because there are bad guys out there.  Who only respect one thing.  And it isn’t diplomacy.  Often the only thing preventing them from waging a cruel war of conquest is a potent military and a willing leader to use it.  If a tyrant knows he will face a military consequence for acting, he may not act.  When he knows that consequence will be devastating, he will not act.  But if he knows a nation hasn’t the military power or the will to use military power, he will act.  Just as Hitler did.  As Mussolini did.  As Tojo did.  And as Osama bin Laden did.

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