France is Raising Taxes on Wealthy Individuals and Businesses to Stimulate Economic Activity

Posted by PITHOCRATES - September 30th, 2012

Week in Review

When a store wants to increase sales what do they do?  Raise prices?  Or lower prices?  Well, based on those sales papers, one has to say they lower prices to increase sales.  Because if someone stops buying from a store raising prices just isn’t going to bring them back to that store.  For how many people ever say they would shop more at a store if only they would raise their prices?  Zero people.  For no one ever shops where their money will buy less.

The higher the price of something the less we buy.  Something few people will dispute.  Unless, of course, it’s rich people investing in job-creating businesses.  As government people believe that rich investors will spend more money the less they can make from their investments.  Especially in France (see Hollande opts to punish French rich with €20bn of new taxes by John Lichfield posted 9/29/2012 on The Independent).

France’s Socialist government insisted yesterday that it could solve the conundrum of simultaneous deficit-cutting and growth which has eluded every other European country from Greece to Britain.

As new clouds gathered over the eurozone, President François Hollande pushed ahead with the country’s toughest budget for three decades, taking €20bn (£16bn) of new taxes from big businesses and the wealthy but imposing relatively moderate €10bn cuts on state spending.

With growth stagnant and unemployment rising sharply, the success or failure of the 2013 budget could decide whether Europe’s second-largest economy becomes part of solution to the eurozone crisis or a new, and devastating, part of the problem.

If we can learn anything from history it’s this.  Tax cuts stimulate economic activity.  Tax hikes don’t.  So growth will remain stagnant in France.  And unemployment will rise even further.  Especially when they will tax very successful business people at 75% on earnings and eliminate business tax breaks.

Among other things, the budget introduces Mr Hollande’s “temporary” 75 per cent tax on personal earnings over €1m and abolishes the tax breaks on large firms introduced by his predecessor, Nicolas Sarkozy.

The Prime Minister, Jean-Marc Ayrault, spoke of a “fighting budget” which would help to get France “back on track” after 38 years of successive state deficits. He insisted the target of 0.8 per cent growth next year was realistic and would be achieved.

But opposition politicians said the budget had been “muddled together”, and was more concerned with preserving Mr Hollande’s campaign promises than addressing France’s – and Europe’s – deepening economic crisis. They pointed out that, while almost all European countries were cutting back spending, the French budget for 2013 preserved the 56 per cent of GDP spent by the state and marginally increased the number of state employees, by 6,000…

Critics complained, however, that the budget did nothing to tackle the erosion of France’s international competitiveness, which has been blamed for large-scale redundancies in the car industry and other sectors. The cost of employing a worker in France has increase by 28 per cent in the past decade, compared with an 8 per cent increase in Germany.

A growth rate of 0.8%?  They’ll be able to achieve what many call a recessionary level of growth?  Not much of a goal.  No wonder France has one of the most uncompetitive workforces.  That massive welfare state costs money.  And there’s only one way to get the money to pay for that massive welfare state.  Taxes.  Even if a government runs a deficit they finance with borrowing.  Because they have to pay the interest on that debt with taxes.

Everything comes back to jobs.  The more jobs there are the more tax revenue the government can collect.  But to create more jobs businesses have to grow larger.  But when governments tax businesses (and business investors) so excessively there is little incentive to grow these businesses larger.  So France’s actions are not likely to have any of the intended results.  In fact they will probably only make a bad situation worse.  And may make them part of the problem in the Eurozone crisis.

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Henry Ford, Bill Hewlett & Dave Packard, Steve Jobs & Steve Wozniak, Howard Schultz, Ray Kroc and Richard Branson

Posted by PITHOCRATES - May 8th, 2012

History 101

Capitalism allows Entrepreneurs to bring their Great Ideas to Life

Entrepreneurs start with an idea.  Of how to do something better.  Or to create something we must have that we don’t yet know about.  They think.  They create.  They have boundless creative energies.  And the economic system that best taps that energy is capitalism.  The efficient use of capital.  Using capital to make profits.  And then using those profits to make capital.  So these ideas of genius that flicker in someone’s head can take root.  And grow.  Creating jobs.  And taxable economic activity.  Creating wealth for investors and workers.  Improving the general economy.  Pulling us out of recessions.  Improving our standard of living.  And making the world a better place.  Because of an idea.  That capitalism brought to life.

Entrepreneurs Risked Capital to bring Great Things to Market and to Create Jobs

Henry Ford established the Detroit Automobile Company in 1899.  Which failed.  He reorganized it into the Henry Ford Company in 1901.  Ford had a fight with his financial backers.  And quit.  Taking the Ford name with him.  And $900.  The Henry Ford Company was renamed Cadillac and went on to great success.  Ford tried again and partnered with Alexander Malcomson.  After running short of funds they reorganized and incorporated Ford Motor Company in 1903 with 12 investors.  The company was successful.  Some internal friction and an unexpected death of the president put Ford in charge.  Ford Motor built the Model A, the Model K and the Model S.  Then came the Model T.  And the moving assembly line.  Mass production greatly increased the number of cars he could build.  But it was monotonous work for the assembly line worker.  Turnover was high.  So to keep good workers he doubled pay in 1914 and reduced the 9-hour shift to 8 hours.  This increased productivity and lowered the cost per Model T.  Allowing those who built the cars to buy what they built.  In 2011 the Ford Motor Company employed approximately 164,000 people worldwide.

Bill Hewlett and Dave Packard established Hewlett-Packard (HP) in 1939.  In a garage.  They raised $538 in start-up capital.  In that garage they created their first successful commercial product.  A precision audio oscillator.  Used in electronic testing.  It was better and cheaper than the competition.  Walt Disney Productions bought this oscillator to certify Fantasound surround sound systems in theaters playing the Disney movie Fantasia.  From this garage HP grew and gave us calculators, desktop and laptop computers, inkjet and laser printers, all-in-one multifunction printer/scanner/faxes, digital cameras, etc.  In 2010 HP employed approximately 324,600 employees worldwide.  (Steve Wozniak was working for HP when he designed the Apple I.  Which he helped fund by selling his HP calculator.  Wozniak offered his design to HP.  They passed.)

Steve Jobs had an idea to sell a computer.  He convinced his friend since high school, Steve Wozniak, to join him.  They sold some of their things to raise some capital.  Jobs sold his Volkswagen van.  Wozniak sold his HP scientific calculator.  They raised about $1,300.  And formed Apple.  They created the Apple I home computer in 1976 in Steve Jobs’ garage.  From these humble beginnings Apple gave us the iPad, iPhone, iPod, iMac, MacBook, Mac Pro and iTunes.  In 2011 Apple had approximately 60,400 full time employees.

Jerry Baldwin, Zev Siegl, and Gordon Bowker opened the first Starbucks in 1971 in Seattle, Washington.  About 10 years later Howard Schultz drank his first cup of Starbucks coffee.  And he liked it.  Within a year he joined Starbucks.  Within another year while traveling in Italy he experienced the Italian coffeehouse.  He loved it.  And had an idea.  Bring the Italian coffeehouse to America.  A place to meet people in the community and converse.  Sort of like a bar.  Only where the people stayed sober.  Soon millions of people were enjoying these tasty and expensive coffee beverages at Starbucks throughout the world.  In 2011 Starbucks employed approximately 149,000 people.

Ray Kroc sold Prince Castle Multi-Mixer milk shakes mixers to a couple of brothers who owned a restaurant.  Who made hamburgers fast.  Richard and Maurice McDonald had implemented the Speedee Service System.  It was the dawn of fast food.  Kroc was impressed.  Facing tough competition in the mixer business he opened a McDonald’s franchise in 1955.  Bringing the grand total of McDonald’s restaurants to 9.  He would go on to buy out the McDonald brothers (some would say unscrupulously).  Today there are over 30,000 stores worldwide.  In 2010 McDonald’s employed approximately 400,000 people.

Richard Branson started a magazine at 16.  He then sold records out of a church crypt at discount prices.  The beginning of Virgin Records.  In 1971 he opened a record store.  He launched a record label in 1972.  And a recording studio.  Signing the Sex Pistols.  And Culture Club.  In 1984 he formed an airline.  Virgin Atlantic Airways.  In 1999 he went into the cellular phone business.  Virgin Mobile.  In 2004 he founded Virgin Galactic.  To enter the space tourism business.  His Virgin Group now totals some 400 companies.  And employs about 50,000 people.

The Decline of Capitalism and the Rise of the Welfare State caused the European Sovereign Debt Crisis

And we could go on.  For every big corporation out there will have a similar beginning.  Corporations that use capital efficiently.  Bringing great things to market.  Introducing us to new things.  Always making our lives better.  And more comfortable.  One thing you will not find is a great success story like this starting in the Soviet Union.  The People’s Republic of China (back in the days of Mao Zedong).  East Germany (before the Berlin Wall fell).  North Korea.  Or Cuba.  No.  The command economies of communist countries basically froze in time.  Where there was no innovation.  No ideas brought to life.  Because the government kind of frowned on that sort of thing.

There is a reason why the West won the Cold War.  And why we won that war without the Warsaw Pack and NATO forces fighting World War III.  And why was this?  Because we didn’t need to.  For the communist world simply could not withstand the forces of living well in the West.  Whenever they could their people escaped to the West.  To escape their nasty, short and brutish lives.  In the command economies of their communist states.  Where the state planners failed to provide for their people.  Even failing to feed their people.  The Soviet Union, the People’s Republic of China and North Korea all suffered population reducing famines.  But not in the West.  Where we are not only well fed.  But our poor suffer from obesity.  Which is not a good thing.  But it sure beats dying in a famine.

Sadly, though, the West is moving towards the state planning of their one time communist foes.  Social democracies are pushing nations in the European Union to bankruptcy.  Japan’s generous welfare state is about to implode as an aging population begins to retire.  Even in the United States there has been a growth of government into the private sector economy like never before.  Which is causing the Great Recession to linger on.  As it caused Japan’s lost decade to become two decades.  And counting.  As it is prolonging the European sovereign debt crisis.  With no end in sight.  The cause of all their problems?  The decline of capitalism.  And the rise of the welfare state.  Which just kills the entrepreneurial spirit.  And the creation of jobs.  Which is one cure for all that ails these countries.  And the only one.  For only robust economic activity can pull a country out of recession.  And for that you need new jobs.  And the entrepreneurial spirit.  In short, you need capitalism.

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Tax Cuts, Roaring Twenties, Farm Prices, Smoot-Hawley Tariff, Stock Market Crash, New Deal, Great Depression and the Great Recession

Posted by PITHOCRATES - March 20th, 2012

History 101

Tax Cuts and the Small Government Policies of Harding and Coolidge gave us the Roaring Twenties

Keynesians blame the long duration of the Great Depression (1929-1939) on the government clinging to the gold standard.  Even renowned monetarist economist Milton Friedman agrees.  Though that’s about the only agreement between Keynesians and Friedman.   Their arguments are that the US could have reduced the length and severity of the Great Depression if they had only abandoned the gold standard.  And adopted Keynesian policies.  Deficit spending.  Just like they did in the Seventies.  The decade where we had both high unemployment and high inflation.  Stagflation.  Something that’s not supposed to happen under Keynesian economics.  So when it did they blamed the oil shocks of the Seventies.  Not their orgy of spending.  Or their high taxes.  And they feel the same way about the Great Depression.

Funny.  How one price shock (oil) can devastate all businesses in the US economy.  So much so that it stalled job creation.  And caused high unemployment.  Despite the government printing and spending money to create jobs.  And to provide government benefits so recipients could use those benefits to stimulate economic activity.  All of that government spending failed to pull the country out of one bad recession.  Because of that one price shock on the cost of doing business.  Yet no one talks about the all out assault on business starting in the Hoover administration that continued and expanded through the Roosevelt administration.

Herbert Hoover may have been a Republican.  But he was no conservative.  He was a big government progressive.  And believed that the federal government should interfere into the free market.  To make things better.  Unlike Warren Harding.  And Calvin Coolidge.  Who believed in a small government, hands-off policy when it came to the economy.  They passed tax cuts.  Following the advice of their treasury secretary.  Andrew Mellon.  Which gave business confidence of what the future would hold.  So they invested.  Expanded production.  And created jobs.  It was these small government policies that gave us the Roaring Twenties.  An economic boom that electrified and modernized the world.  With real economic growth. 

If an Oil Shock can prevent Businesses from Responding to Keynesian Policies then so can FDR’s all out War on Business

The Roaring Twenties was a great time to live if you wanted a job.  And wanted to live in the modern era.  Electric power was spreading across the country.  People had electric appliances in their homes.  Radios.  They went to the movies.  Drove cars.  Flew in airplanes.  The Roaring Twenties was a giant leap forward in the standard of living.  Factories with electric power driving electric motors increased productivity.  And reduced air pollution as they replaced coal-fired steam boilers that up to then powered the Industrial Revolution.  This modernization even made it to the farm.  Farmers borrowed heavily to mechanize their farms.  Allowing them to grow more food than ever.  Bumper crops caused farm prices to fall.  Good for consumers.  But not those farmers who borrowed heavily.

Enter Herbert Hoover.  Who wanted to use the power of government to help the farmers.  By forcing Americans to pay higher food prices.  Meanwhile, the Federal Reserve raised interest rates.  Thinking that a boom in the stock market was from speculation and not the real economic growth of the Twenties.  So they contracted the money supply.  Cooling that real economic growth.  And making it very hard to borrow money.  Causing farmers to default on their loans.  Small rural banks that loaned to these farmers failed.  These bank failures spread to other banks.  Weakening the banking system.  Then came the Smoot-Hawley Tariff.  Passed in 1930.  But it was causing business uncertainty as early as 1928.  As the Smoot-Hawley Tariff was going to increase tariffs on just about everything by 30%.  Basically adding a 30% tax on the cost of doing business.  That the businesses would, of course, pass on to consumers.  By raising prices.  Because consumers weren’t getting a corresponding 30% pay hike they, of course, could not buy as much after the Smoot-Hawley Tariff.  Putting a big cramp in sales revenue.  Perhaps even starting an international trade war.  Further cramping sales.  Something investors no doubt took notice of.  Seeing that real economic growth would soon come to a screeching halt.  And when the bill moved through committees in the autumn of 1929 the die was cast.  Investors began the massive selloff on Wall Street.  The Stock Market Crash of 1929.  The so-called starting point of the Great Depression.  Then the Smoot-Hawley Tariff became law.  And the trade war began.  As anticipated.

Of course, the Keynesians ignore this lead up to the Great Depression.  This massive government intrusion into the free market.  And the next president would build on this intrusion into the free market.  Ignoring the success of the small-government and tax cuts of Harding and Coolidge.  As well as ignoring the big-government free-market-intrusion failures of Herbert Hoover.  The New Deal programs of FDR were going to explode government spending to heights never before seen in peace time.  Causing uncertainty like never seen before in the business community.  It was an all out assault on business.  Taxes and regulation that increased the cost of business.  And massive government spending for new benefits and make-work programs.  All paid for by the people who normally create jobs.  Which there wasn’t a lot of during the great Depression.  Thanks to programs like Reconstruction Finance Corporation, Federal Emergency Relief Administration, Civilian Conservation Corps, Homeowners Loan Corporation, Tennessee Valley Authority, Agricultural Adjustment Act, National Industrial Recovery Act, Public Works Administration, Federal Deposit Insurance Corporation, Glass–Steagall Act, Securities Act of 1933, Civil Works Administration, Indian Reorganization Act, Social Security Act, Works Progress Administration, National Labor Relations Act, Federal Crop Insurance Corporation, Surplus Commodities Program, Fair Labor Standards Act, Rural Electrification Administration, Resettlement Administration and Farm Security Administration, etc.  Oil shocks of the Seventies?  If an oil shock can prevent businesses from responding to Keynesian policies then an all out war on business in the Thirties could do the same.  And worse.  Far, far worse.  Which is why the Great Depression lasted 10 years.  Because the government turned what would have been a normal recession into a world-wide calamity.  By trying to interfere with market forces.

Only Real Economic Growth creates Jobs, not Government Programs

The unemployment rate in 1929 was 3.1%.  In 1933 it was 24.9%.  It stayed above 20% until 1936.  Where it fell as low as 14.3% in 1937.  It then went to 19.0%, 17.2% and 14.6% in the next three years.  These numbers stayed horrible throughout the Thirties because the government wouldn’t stop meddling.  Or spending money.  None of the New Deal programs had a significant effect on unemployment.  The New Deal failed to fix the economy the way the New Dealers said it would.  Despite the massive price tag.  So much for super smart government bureaucrats.

What finally pulled us out of the Great Depression?  Adolf Hitler’s conquering of France in 1940.  When American industry received great orders for real economic growth.  From foreign countries.  To build the war material they needed to fight Adolf Hitler.  And the New Deal programs be damned.  There was no time for any more of that nonsense.  So during World War II businesses had a little less uncertainty.  And a backlog of orders.  All the incentive they needed to ramp up American industry.  To make it hum like it once did under Harding and Coolidge.  And they won World War II.  For there was no way Adolf Hitler could match that economic output.  Which made all the difference on the battlefield.

Still there are those who want to blame the gold standard for the Great Depression.  And still support Keynesian policies to tax and spend.  Even today.  Even after 8 years of Ronald Reagan that proved the policies of Harding and Coolidge.  We’re right back to those failed policies of the past.  Massive government spending to stimulate economic activity.  To pull us out of the Great Recession.  And utterly failing.  Where the unemployment rate struggles to get below 9%.  The U-3 unemployment rate, that is.  The rate that doesn’t count everyone who wants full time work.  The rate that counts everyone, the U-6 unemployment rate, currently stands at 14.9%.  Which is above the lowest unemployment rate during the Great Depression.  Proving once again only real economic growth creates jobs.  Not government programs.  No matter how many trillions of dollars the government spends. 

So much for super smart government bureaucrats.

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Consumption, Savings, Fractional Reserve Banking, Interest Rates and Capital Markets

Posted by PITHOCRATES - January 23rd, 2012

Economics 101

Keynesians Prefer Consumption over Savings because Everyone Eventually Dies

Consumer spending accounts for about 70 percent of total economic activity.  This consumption drives the economy.  In fact, someone built a school of economics around consumption.  Keynesian economics.  And he loved consumption.  John Maynard Keynes even created a formula for it.  The consumption function.  Which basically says the more income a person has the more that person will consume.  Even created a mathematical formula for it.  No doubt about it, Keynesians are just gaga for consumption.

Of course, Keynesians don’t love everything.  They aren’t all that fond of saving.  Which they see as a drain on economic activity.  Because if people are saving their money they aren’t doing as much consuming as they could.  In fact, their greatest fear when they propose stimulus spending (by giving people more money to spend) to jump-start an economy out of a recession is that people may take that money and save it.  Or, worse yet, pay down their credit card balances.  Which is something most responsible people do during bad economic times.  To lower their monthly bills so they can still pay them if they find themselves living on a reduced income.  Of course, being responsible doesn’t increase consumption.  Nor does it make Keynesians happy.

Keynesians don’t like people behaving responsibly.  They want everyone to live beyond their means.  To borrow money to buy a house.  To buy a car.  Or two.  To use their credit cards.  To keep shopping.  Above and beyond the limits of their income.  To spend.  And to keep spending.  Always consuming.  Creating endless economic activity.  And never worry about saving.  Because everyone eventually dies.  And what good will all that saving be then?

To Help Create more Capital from a Low Savings Rate we use Fractional Reserve Banking

Intriguing argument.  But too much consuming and not enough saving can be a problem, though.  Because before we consume we must produce.  And those producing the things we consume need capital.  Large sums of money businesses use to pay for buildings, equipment, tools and supplies.  To make the things consumers consume.  And where does that capital come from?  Savings.

A low savings rate raises the cost of borrowing.  Because businesses are competing for a smaller pool of capital.  Which raises interest rates.  Because capital is an economic commodity, subject to the law of supply and demand.  Also, with people living beyond their means by consuming far more than they are saving has caused other problems.  Borrowing to buy houses and cars and using credit cards to consume more has led to dangerous levels of personal debt.  Resulting in record personal bankruptcies.  Further raising the cost of borrowing.  As these banks have to increase their interest rates to make up for the losses they incur from those personal bankruptcies.

To help create more capital from a low savings rate we use fractional reserve banking.  Here’s how it works.  If you deposit $100 into your bank the bank keeps a fraction of that in their vault.  Their cash reserve.  And loan out the rest of the money.  When lots of people do this the banks have lots of money to loan.  Which people and businesses borrow.  Who borrow to buy things.  And when buyers buy things sellers will then take their money and deposit it into their banks.  The buyer’s borrowed funds become the seller’s deposited funds.  These banks will keep a fraction of these new deposits in their vaults.  And loan out the rest.  Etc.  As this happens over and over banks will create money out of thin air.  Providing ever more capital for businesses to borrow.  Which all works well.  Unless depositors all try to withdraw their deposits at the same time.  Exceeding the cash reserve locked up in a bank’s vault.   Creating a run on the bank.  Causing it to fail.  Which can also raise the cost of borrowing.  Or just make it difficult to find a bank willing to loan.  Because banks not only loan to consumers and businesses.  They loan to other banks.  And when one bank fails it could very well cause problems for other banks.  So banks get nervous and are reluctant to lend until they think this danger has passed.

A Keynesian Stimulus Check may Momentarily Substitute for a Paycheck but it can’t Create Capital

Consumption, savings, investment and production are linked.  Consumption needs production.  Production needs investment.  And investment needs savings.  Whether it is someone depositing their paycheck into a bank that lends it to others.  Or rich investors who amassed and saved great wealth.  Who invest directly into a corporation by buying new shares of their stock (from an underwriter, not in the secondary stock market).  Or by buying their bonds.

Collectively we call these capital markets.  Where businesses go when they need capital.  If interest rates are low they may borrow from a bank.  Or sell bonds.  If interest rates are high they may issue stock.  Generally they have a mix of financing that best fits the investing climate in the capital markets.  To protect them from volatile movements in interest rates.  And from competition from other corporations issuing new stock that could draw investors (and capital) away from their new stock issue.  Even to secure capital when no one is lending.  By going contrary to Keynesian policy and saving for a rainy day.  By buying liquid investments that earn a small return on investment and carrying them on their balance sheet.  They don’t earn much but can be sold quickly and converted into cash when no one is lending.

A lot must happen before consumers can consume.  In fact, high consumption can pull capital away from those who make the things they consume.  Because without capital businesses can’t expand production or hire more workers.  And no amount of Keynesian stimulus can change that.  Because there are two things necessary for consumption.  A paycheck.  And consumer goods produced with capital.  A stimulus check may momentarily substitute for a paycheck.  But it can’t create capital.  Only savings can do that.

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Government Bonds, Deficits, Debt, Interest and Inflation

Posted by PITHOCRATES - January 16th, 2012

Economics 101

Unlike Corporate Borrowing, Government Borrowing does not Translate into Consumer Goods and Services

When corporations need large sums of money to finance their businesses they issue stocks and bonds.  Investors respond by buying their stocks and bonds.  By loaning the business their money they are investing into these businesses.  Giving them capital to create more things to sell.  Thus stimulating the economy.  Because this investment translates into more consumer goods and services.  That consumers will ultimately buy.

When they offer these goods and services at prices consumers will pay the business does well.  As do the consumers.  Who are able to use their money to buy stuff they want.  So consumers do well.  Corporations do well.  And the investors do well.  For a corporation doing well maintains the value of their investments.  Everyone wins.  Unlike when the government enters the bond market.  For when they do there are some winners and, unfortunately, some losers.

Governments issue bonds when they spend more money than they collect in taxes.  They borrow instead of raising taxes because they know raising taxes reduces economic activity.  Which they want to avoid.  Because less economic activity means less tax revenue.  Which would make the original problem worse.  So like a corporation they have a financing need.  Unlike a corporation, though, the money they borrow will not translate into more consumer goods and services.  They will spend it inefficiently.  Reward political friends.  But mostly they will just pay for past spending.  In mature countries deficits and debt have grown so large that some governments are even borrowing to pay the interest on their debt.

Investors like Government Bonds because Government has the Power to Tax

When the government sells bonds it raises the borrowing costs for businesses.  Because their corporate bonds have to compete with these government bonds.  Corporations, then, pay a higher interest rate on their bonds to attract investors away from the government bonds.  Interest is a cost of business.  Which they add to the sales price of their goods and services.  Meaning the consumer ultimately pays these higher interest costs.  Worse, if a corporation can’t get financing at a reasonable interest rate they may not borrow.  Which means they won’t grow their business.  Or create new jobs.

As government debt grows they sell more and more bonds.  Normally not a problem for investors.  Because investors like government bonds.  (What we call sovereign debt.  Because it is the debt of sovereign states.)  Because government has the power to tax.  So investors feel confident that they will get their interest payments.  And that they will get back their principal.  Because the government can always raise taxes to service this debt.  And raise further funds to redeem their bonds.

But there is a downside for investors.  Too much government debt makes them nervous.  Because there is something governments can do that businesses can’t.  Governments can print money.  And there is the fear that if a government’s debt is so great and they have to pay higher and higher interest rates on their sovereign debt to attract investors that they may just start printing money.  Inflate the money supply.  By printing money to pay investors.  Sounds good if you don’t understand the consequences of printing money.  But ‘inflating the money supply’ is another way of saying inflation.  Where you have more dollars chasing the same amount of goods and services.

When Corporations Fail and go Bankrupt they don’t Increase Consumer Prices or Cause Inflation

Think of it this way.  The existing value of all available goods and services equals the amount of money in circulation.  When you increase the money supply it doesn’t change the amount of goods and services in the economy.  But it still must equal the amount of money in circulation.  So the dollar must now be worth less.  Because more of them still add up to the same value of goods and services.  That is, by printing more money they depreciate the dollar.  Make it worth less.  And if the dollar is worth less it will take more of them to buy the same things.  Causing consumer prices to rise.

Worse, inflation reduces the value of bonds.  When they depreciate the dollar the money locked into these long-term investments shrink in value.  And when people get their money back they can’t buy as much with it as they could before they bought these long-term investments.  Meaning they lost purchasing power while the government had their money.  Which gives investors a negative return on their investment.  And if a person invested their retirement into these bonds they will have less purchasing power in their retirement.  Because a depreciated dollar shrinks their savings.  And increases consumer prices.  So retirees are especially hard hit by inflation.

So excessive government borrowing raises consumer prices.  By making corporations compete for investment capital.  And by causing inflation.  Whereas excessive corporate borrowing does not.  They either provide goods and services at prices consumers willingly pay.  Or they fail and go bankrupt.  Hurting no one but their private investors.  And their employees who lose their jobs.  Sad, but at least their failure does not increase consumer prices.  Or cause inflation.

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Stocks and Bonds

Posted by PITHOCRATES - January 9th, 2012

Economics 101

When Companies grow their Capital Requirements grow beyond a Bank’s Lending Ability

We note a civilization as being modern when it has vigorous economic activity.  Advanced economies around the world all have the same things.  Grocery stores.  Clothing stores.  Electronic stores.  Appliance stores.  Coffee shops and restaurants.  Factories and manufacturing plants.  And lots and lots of jobs.  Where people are trading their human capital for a paycheck.  So they can take their earnings and engage in economic activity at these stores, coffee shops and restaurants.

To buy things off of shelves in these stores things have to be on those shelves first.  Which means selling things requires spending money before you earn money.  Businesses use trade credit.  Such as accounts payable.  Where a supplier will give them supplies and send them an invoice typically payable in 30-90 days.  They will establish a credit line at their bank.  Where they will borrow from when they need cash.  And will repay as they collect cash (such as when their customers pay their accounts payable).  And take out loans to finance specific things such as a delivery van or restaurant equipment.

Businesses depend on their bank for most of their credit needs.  But when companies grow so do their capital requirements.  Where capital is large amounts of money pooled together to purchase property, buildings, machinery, etc.  Amounts so great that it exceeds a bank’s ability to loan.  So these businesses have to turn to other types of financing.  To the equity and debt markets.

Investors Invest in Corporations by Buying their Stocks and Bonds

Equity and debt markets mean stocks and bonds.  Where we use stocks for equity financing.  And bonds for debt financing.  Stocks and bonds allow a corporation to spread their large financing needs over numerous people.  Investors.  Who invest in corporations by buying their stocks and bonds.

When a business ‘goes public’ they are selling stock in their company for the first time.  We call this the initial public offering (IPO).  If the company has a very promising future this will bring in a windfall of capital.  As investors are anxious to get in on the ground floor of the next big thing.  To be a part of the next Microsoft.  Or Apple.  This is when a lot of entrepreneurs get rich.  When they are in fact the next big thing.  And if they are, then people who bought stock in their IPO can sell it on the secondary market.  Where investors trade stocks with other investors.  By buying low and selling high.  Hopefully.  If they do they get rich.  Because the greater a company’s profits the greater its value and the higher its stock price.  And when a company takes off they can sell their stock at a much higher price than they paid for it in the IPO.

When a corporation needs to borrow more than their bank can loan and doesn’t want to issue new stock they can sell bonds.  Which breaks up a very large amount into smaller amounts that investors can buy.  Typically each individual corporate bond has a face value of $1000.  (So a ten million dollar ‘loan’ would consist of selling ten thousand $1,000 bonds).  Like a loan a corporation pays interest on their bonds.  But not to a bank.  They pay interest to the investors who purchased their bonds.  Who can hold the bonds to maturity and collect interest.  Or they can trade them like stock shares.  (Changes in the interest rates and/or corporate financial strength can change the market value of these bonds.)  When a bond reaches maturity (say in 20 years) the company redeems their bonds from the current bondholders.  Hopefully with the new profits the bond issue helped to bring into the corporation.  Or they just issue new bonds to raise the money to redeem the older bonds.

A Company Usually has a Mix of Equity and Debt Financing that Balances all the Pros and Cons of Each

There are pros and cons to both equity and debt financing.  Selling stock transfers ownership of the company.  Sell enough so that someone can own more than 50% and that someone can replace the board of directors.  Who in turn can replace the CEO and the other corporate officers.  Even the business founder.  This is the big drawback of going public.  Founders can lose control of their company.

Stocks don’t pay interest.  So they are less threatening during bad economic times.  As business owners, stock shareholders are there for the long haul.  During the good times they may expect to collect dividends (like an interest payment).  During bad times they will wait it out while the company suspends dividend payments.  Or, if they lose confidence, they’ll try and sell their stock.  Even at a loss.  To prevent a future greater loss.  Especially if the corporation goes bankrupt.  Because stockholders are last in line during any bankruptcy proceedings.  And usually by the time they pay off creditors there is nothing left for the shareholders.  This is the price for the chance to earn big profits.  The possibility to lose everything they’ve invested.

Bonds are different.  First of all, there is no transfer of ownership.  But there is a contractual obligation to make scheduled interest payments.  And if they fail to make these payments the bondholders can force the company into bankruptcy proceedings.  Where a corporation’s assets can be liquidated to pay their creditors.  Including their bondholders.  Which, of course, often means the end of the corporation.  Or a major restructuring that few in management enjoy.

Stockholders don’t like seeing their share value diluted from issuing too many shares.  Bondholders don’t like to see excessive debt that threatens the corporation’s ability to service their debt.  So a company usually has a mix of equity and debt financing that balances the pros and cons of each.  A financing strategy that has been working for centuries.  That allows the advanced civilized world we take all too much for granted today.  From jetliners.  To smartphones.  To that new car smell.  For none of these would be possible without the capital that only the equity and debt markets can raise.

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The Great Depression

Posted by PITHOCRATES - December 20th, 2011

History 101

The  Roaring Twenties were a Time of Unprecedented Innovation and Manufacturing

The Roaring Twenties were good times.  Kicked off by the Warren Harding administration.  Thanks to one of the few honest guys in his administration besides Harding.  Andrew Mellon.  Secretary of the treasury extraordinaire.  Some say the best secretary of the treasury since our first.  Alexander Hamilton.  High praise indeed.

So what did Mellon do?  He did some research that showed rich people paid less in taxes the higher the tax rates were.  The higher the rate the less they invested in plant and equipment in America.  Instead they invested their money out of the country.  In other countries’ plant and equipment.  So Mellon was a tax-cutter.  And that was his advice to Harding.  And that’s what Harding did.  And Calvin Coolidge continued.  Kept taxes low.  And kept government out of the business of business.

And how business responded.  The 1920s were a time of unprecedented innovation and manufacturing.  Low taxes, little government spending and limited government produced record employment.  Record upward mobility.  And record per capita income.  Gains in the decade touched 37%.  How?  I’ll tell you how.

The auto industry was booming thanks to Henry Ford’s moving assembly line.  Everyone was driving who wanted to drive.  The car companies sold one car for every 5 people.  This production created a boom in other industries to feed this industry.  And cars did something else.  They gave people mobility.  And opportunity.  People left the farms in droves and drove to better jobs.  Which didn’t hurt the farmers in the least as mechanization on the farm put more land under cultivation with fewer people.  Housing and cities grew.  Radio debuted.  And radio advertising.  Motion pictures went from silent to talkies.  Telephones became more common.  New electric utilities brought electricity to homes.  And new electric appliances filled those homes.  Including radios.  New electric motors filled our factories, increasing productivity and slashing consumer prices.  More people than ever before flew.  An increase of nearly 1000%.  It’s nowhere near today’s number of flyers but it was a reflection of the new industrial dominance of the United States.  There was nothing we couldn’t do.  And Europe was taking notice.  And not liking what they saw.  And talked about a European union to compete against the Americans.

Businesses scaled back Production in Anticipation of the Smoot Hawley Tariff Act

So the spectacular economic growth of the Roaring Twenties was solid growth.  It wasn’t a bubble.  It was the real deal.  Thanks to capitalism.  And a government willing to leave the free market alone.  It was so dominating that the Europeans wanted to stop it anyway they could.  One way was protective tariffs on farm imports.

American farm exports boomed during World War I.  Because most of Europe’s farmers were busy fighting.  With the end of the war the Europeans went back to their farms.  Which reduced the need for American farm imports.  And the tariffs compounded that problem.  To make things worse, prices were already falling thanks to the mechanization of the American farm.  Producing bumper crops.  Which, of course, dropped farm prices.  Good for consumers.  But bad for farmers.  Especially with the Europeans shutting off their markets to the Americans.  Because they paid for a lot of that land and mechanization with borrowed money.  And this debt was getting harder and harder to service.  Throw in some weather and insect problems in some regions and it was just too much.   Some farms failed.  Then a lot.  And then the banks that loaned money to these farms began to fail.

We created the Federal Reserve to increase the money supply to keep pace with the growing economy.  By making money cheap to borrow for those businesses trying to expand to meet demand.  They weren’t exactly doing a stellar job, though, in keeping pace with this economic expansion.  And when the bank failures hit the money supply contracted.  Thanks to fractional reserve banking.  All that money the banks created simply disappeared as the banks failed.  Starving manufactures of money to maintain growth to meet demand.  Things were getting bad around 1928.  The Fed did not intervene to save these banks.  Worried that investors were the only ones borrowing money for speculation in the stock market, they shrunk the money supply further.  About a third by 1932.  Manufacturers had no choice but to cut production.

While businesses were dealing with a shrinking money supply they had something else to worry about.  Congress was moving the Smoot-Hawley Tariff Act through congressional committees in 1929 on its way to becoming law in 1930.  This act would add a 30% tax on most imports.  Meaning that the cost factories paid for raw materials would increase by up to 30%.  Of course, sales prices have to include all costs of production.  So sales prices would have to increase.  Higher prices mean fewer sales.  Because people just can’t afford to buy as much at higher prices.  Businesses knew that once the tariff was passed into law it would reduce sales.  So they took preemptive steps.  And scaled back production for the expected fall in sales.

It was Government Meddling that Turned a Recession in the Great Depression

This brings us to the stock market crash.  The Roaring Twenties produced huge stock market gains as industry exploded in America.  Things grew at an aggressive pace.  Stock prices soared.  Because the value of these manufacturers soared.  And investors saw nothing to indicate this growth was going to stop.  Until the contraction of the money supply.  And then the Smoot-Hawley Tariff Act.  Not only would these slow the growth, they would reverse it.  Leading to the great selloff.  The Great Crash.  And the Great Depression.

As feared the Europeans responded to the Smoot-Hawley Tariff Act.  They imposed tariffs on American imports.  Making things worse for American exports.  Then President Hoover increased farm prices by law to help farmers.  Which only reduced farm sales further.  Then the banking crisis followed.  And the Fed did nothing to help the banks.  Again.  When they did start helping banks in trouble they made public which banks were receiving this help.  Which, of course, caused further bank runs as people hurried to get their money out of these troubled banks.  Tax revenue plummeted.  So Hoover passed a new sales tax to raise more revenue.  Which only made things worse.

Hoover was a Republican.  But he was a Big Government progressive.  Just like his successor.  FDR.  And all of their Big Government Keynesian solutions only prolonged the Great Depression.  It was government meddling that turned a recession into the Great Depression.  And further government meddling that prolonged the Great Depression.  Much of FDR’s New Deal programs were just extensions of the Hoover programs.  And they failed just as much as they did under Hoover.  The Great Depression only ended thanks to Adolf Hitler who plunged Europe back into war.  Providing an urgency to stop their government meddling.  And to let business do what they do best.  Business.  And they did.  Building the arsenal that defeated Hitler.

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Our Keynesian Mess isn’t as Bad as Europe’s Keynesian mess

Posted by PITHOCRATES - November 26th, 2011

Week in Review

As the Keynesian policies fail the Keynesians circle the wagons (see Treasury potatoes posted 11/22/2011 on The Economist).

TREASURY bond yields fell today as the supercommittee failed to agree on a deficit reduction plan. Paul Krugman says this means the market can’t be worried about long-term deficits. More likely, they are worried about near-term austerity (since the supercommittee’s failure makes an extension of the payroll tax cut less likely). Ezra Klein makes a similar point here about the stock market’s drop.

I don’t really know why bond yields fell today, though I’d guess it has more to do with what’s going on in Europe than America. Still, I wouldn’t dismiss the possibility that fears of deficits and default lead to lower, not higher, bond yields. In a liquidity trap, government bonds behave increasingly like money and will reflect not just the usual drivers of expected inflation and deficits, but the demand for liquidity and safety…

The Keynesian economists are wrong.  As usual.  So why do investors keep buying American bonds even after S&P downgrades their credit rating?  And when the supercommittee punts?  Much like the full House did?  The Keynesians say it’s not the debt or the deficit that scares them.  It’s that government may stop spending recklessly.  That’s what a Keynesian thinks an investor fears most.  The goofballs that they are.

Here’s a thought.  Could Keynesian economics have failed so grandly in the Eurozone that by comparison our Keynesian failures here look less risky?

If we keep spending like we are we will end up like Greece.  Italy.  And all of the other Eurozone countries that are desperately trying to avoid bankruptcy.  Note the key is ‘will end up like’.  Meaning that we haven’t.  Yet.  Which is why American bonds are more attractive than these others.  Because our Keynesian mess isn’t as bad as their Keynesian messes.  Yet.

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Continued Bad Economic Data sends Investors to Safe Harbors

Posted by PITHOCRATES - June 10th, 2011

Times are Good when the Junk Market is Good

Junk bonds were big in the Eighties.  During the great economic boom courtesy of Ronal Reagan.  Lower tax rates.  Fewer regulations.  It was a time for entrepreneurs to take chances.  And they did.  Some took some really big chances.  They were thinking way outside the box.  In new technologies.  So there weren’t a lot of people lining up to finance their risky ideas.  Because they were too risky for most.  That’s where junk comes in.  A junk bond is a high yield bond.  It pays a high interest rate.  Because there is a very good chance the bond issuer may fail.  Making those bonds worthless.  So to attract capital to fund these risky ideas required a larger return on investment.  And the junk bond market was the place to go.

A lot of things happened that wouldn’t have had it not been for junk.  MCI Communications is a junk bond success story.  The Chrysler bailout in the Eighties was another.  Even Ted Turner owes the success of Turner Broadcasting to junk.  Yes, there were a lot of failures.  But that’s what makes junk so enticing.  You get a high return for that high risk.  A lot of entrepreneurs became millionaires.  And a lot of rich investors got richer.  So when the junk market is doing well, people are taking chances.  Taking risks.  Creating things.  New technologies.  And jobs.  Growing the economy.  But when the junk market isn’t doing well, few are taking risks.  Few are creating jobs.  And the economy isn’t growing.  Or won’t be growing.  For if the economic outlook is bleak, investors look for safe harbors for their cash.  Until a more favorable business/investing climate returns (see Junk bonds hit a speed bump by Ben Rooney posted 6/10/2011 on CNNMoney).

Investors had been flocking to corporate “junk” bonds since the early months of 2009 amid a broad flight to risky assets because of the high yields that come along with that risk. But demand for those bonds has tapered off in the last few weeks following a spate of lousy economic news.

“There’s a lot of uncertainty in market,” said Jody Lurie, corporate credit analyst at Janney Capital Markets. “We’ve had a lot of bad news in the last few weeks and that’s making people hesitant.”

Business owners as well as investors hate uncertainty.  And there’s a lot of that these days.  Suffice it to say the Obama administration is not the most business-friendly administration.  Unless you’re a crony of the administration.  But few small business owners and entrepreneurs can afford what it takes to be a crony capitalist.  Because special favors don’t come cheap.  And there’s that ugly recession that just won’t end.  Few want to invest and create jobs when so many are unemployed and are unable to buy things.

“This market is extremely expensive,” [William Larkin, a bond portfolio manager at Cabot Money Management] said. “I’m afraid that we could get some hot inflation data on top of the prices,” he added. And that could leave bondholders with a negative return.

Inflation is another reason why the junk bond market is losing its appeal.  The value of a bond lies in the difference between your bond interest rate and the prevailing interest rate on the street.  Inflation increases interest rates.  So as inflation increases, that premium you had over the interest rates of ‘safe’ investments decreases.  Making the return on your junk more similar to ‘safe’ investments.  Only you still carry that high risk of your bonds becoming worthless.  If inflation pushes interest rates over your bond interest rate, you lose money.  Because your high-risk bonds pay less than safer investments like government treasury bonds.  So a bad economic outlook and/or inflation worries will make people run away from junk bonds to something safer.

A Six Week Losing Streak

In fact, when bad economic news comes out that says we’ll have more recession before we have any economic recovery, junk bond holders aren’t the only ones looking for safer investments.  Investors also flee the stock market.  Especially when the stock market is setting near-record losing streaks (see At noon: Dow surrenders 12,000 by David Berman posted 6/10/2011 The Globe and Mail).

The Dow was recently spotted at 11,980.78, down about 144 points or 1.2 per cent, marking its lowest level since March amid ongoing concerns about the health of the U.S. economy…

With Friday’s decline, U.S. indexes are well on their way to posting their sixth consecutive losing week – a losing streak noted by Bloomberg as the worst string of down weeks since 2002…

Meanwhile, investors have been diving into the safety of bonds. The yield on the 10-year U.S. Treasury bond recently dipped below 3 per cent as bond prices (which move in the opposite direction to yields) have risen to their highest levels since early December.

And this despite the possibility of a U.S. default after reaching their legal debt limit.  Everyone in the administration is predicting doom and gloom about a U.S. default.  Apparently the investors are more frightened by the horrible economy, high unemployment numbers and a recession that never ends.

Time to call the Recession a Depression?

Of course, this recession will end.  There hasn’t been one that hasn’t yet.  They’re usually over anywhere from 6 months to a year or so.  That’s usually sufficient for the market to correct.  But it may take a little longer this time (see U.S. Will Trail Global Growth for Decade: Fink by Sree Vidya Bhaktavatsalam and Charles Stein posted 6/10/2011 on Bloomberg).

BlackRock Inc. (BLK)’s Laurence D. Fink, chief executive officer of the world’s biggest asset manager, said the U.S. will trail the global economy for much of the next decade.

The U.S. economy will grow 2 percent to 3 percent for the next five to 10 years, lagging behind global growth of 3 percent to 5 percent, Fink said today in a Bloomberg Television interview with Erik Schatzker from the Morningstar conference in Chicago. ..

A series of reports suggests the world’s largest economy is decelerating. Manufacturing grew at its slowest pace in more than a year in May, consumer spending rose less than forecast in April, and the unemployment rate unexpectedly climbed to 9.1 percent in May.

You know, after 10 years I don’t think you call it a recession anymore.  I think you start calling it a depression.

Where’s a Good World War when you Need One?

The last time we had a depression as bad as this there was a Big Government president in the White House.  He spent money like there was no tomorrow.  And none of it helped.  Every New Deal program was a failure.  They didn’t put people back to work in the private sector.  You know what did?  World War II.  It wasn’t FDR that ended the Great Depression.  It was Adolf Hitler.  Because someone had to build all that war material to defeat him.  And that someone was us. 

Things are different today, though.  There is no villain to come to Obama’s rescue.  It will be up to him alone to make his policies more business friendly.  Or his successor in 2012.

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LESSONS LEARNED #3 “Inflation is just another name for irresponsible government.” -Old Pithy

Posted by PITHOCRATES - March 4th, 2010

PEOPLE LIKE TO hate banks.  And bankers.  Because they get rich with other people’s money.  And they don’t do anything.  People give them money.  They then loan it and charge interest.  What a scam.

Banking is a little more complex than that.  And it’s not a scam.  Countries without good banking systems are often impoverished, Third World nations.  If you have a brilliant entrepreneurial idea, a lot of good that will do if you can’t get any money to bring it to market.  That’s what banks do.  They collect small deposits from a lot of depositors and make big loans to people like brilliant entrepreneurs.

Fractional reserve banking multiplies this lending ability.  Because only a fraction of a bank’s total depositors will ask for their deposits back at any one time, only a fraction of all deposits are kept at the bank.  Banks loan the rest.  Money comes in.  They keep a running total of how much you deposited.  They then loan out your money and charge interest to the borrower.  And pay you interest on what they borrowed from you so they could make those loans to others.  Banks, then, can loan out more money than they actually have in their vaults.  This ‘creates’ money.  The more they lend the more money they create.  This increases the money supply.  The less they lend the less money they create.  If they don’t lend any money they don’t add to the money supply.  When banks fail they contract the money supply.

Bankers are capital middlemen.  They funnel money from those who have it to those who need it.  And they do it efficiently.  We take car loans and mortgages for granted.  For we have such confidence in our banking system.  But banking is a delicate job.  The economy depends on it.  If they don’t lend enough money, businesses and entrepreneurs may not be able to borrow money when they need it.  If they lend too much, they may not be able to meet the demands of their depositors.  And if they do something wrong or act in any way that makes their depositors nervous, the depositors may run to the bank and withdraw their money.  We call this a ‘run on the bank’ when it happens.  It’s not pretty.  It’s usually associated with panic.  And when depositors withdraw more money than is in the bank, the bank fails.

DURING GOOD ECONOMIC times, businesses expand.  Often they have to borrow money to pay for the costs of meeting growing demand.  They borrow and expand.  They hire more people.  People make more money.  They deposit some of this additional money in the bank.  This creates more money to lend.  Businesses borrow more.  And so it goes.  This saving and lending increases the money supply.  We call it inflation.  A little inflation is good.  It means the economy is growing.  When it grows too fast and creates too much money, though, prices go up. 

Sustained inflation can also create a ‘bubble’ in the economy.  This is due to higher profits than normal because of artificially high prices due to inflation.  Higher selling prices are not the result of the normal laws of supply and demand.  Inflation increases prices.  Higher prices increase a company’s profit.  They grow.  Add more jobs.  Hire more people.  Who make more money.  Who buy more stuff and save more money.  Banks loan more, further increasing the money supply.  Everyone is making more money and buying more stuff.  They are ‘bidding up’ the prices (house prices or dot-com stock prices, for example) with an inflated currency.  This can lead to overvalued markets (i.e., a bubble).  Alan Greenspan called it ‘irrational exuberance’ when testifying to Congress in the 1990s.  Now, a bubble can be pretty, but it takes very little to pop and destroy it.

Hyperinflation is inflation at its worse.  Bankers don’t create it by lending too much.  People don’t create it by bidding up prices.  Governments create it by printing money.  Literally.  Sometimes following a devastating, catastrophic event like war (like Weimar Germany after World War II).  But sometimes it doesn’t need a devastating, catastrophic event.  Just unrestrained government spending.  Like in Argentina throughout much of the 20th century.

During bad economic times, businesses often have more goods and services than people are purchasing.  Their sales will fall.  They may cut their prices to try and boost their sales.  They’ll stop expanding.  Because they don’t need as much supply for the current demand, they will cut back on their output.  Lay people off.  Some may have financial problems.  Their current revenue may not cover their costs.  Some may default on their loans.  This makes bankers nervous.  They become more hesitant in lending money.  A business in trouble, then, may find they cannot borrow money.  This may force some into bankruptcy.  They may default on more loans.  As these defaults add up, it threatens a bank’s ability to repay their depositors.  They further reduce their lending.  And so it goes.  These loan defaults and lack of lending decreases the money supply.  We call it deflation.  We call deflationary periods recessions.  It means the economy isn’t growing.  The money supply decreases.  Prices go down.

We call this the business cycle.  People like the inflation part.  They have jobs.  They’re not too keen on the deflation part.  Many don’t have jobs.  But too much inflation is not good.  Prices go up making everything more expensive.  We then lose purchasing power.  So a recession can be a good thing.  It stops high inflation.  It corrects it.  That’s why we often call a small recession a correction.  Inflation and deflation are normal parts of the business cycle.  But some thought they could fix the business cycle.  Get rid of the deflation part.  So they created the Federal Reserve System (the Fed) in 1913.

The Fed is a central bank.  It loans money to Federal Reserve regional banks who in turn lend it to banks you and I go to.  They control the money supply.  They raise and lower the rate they charge banks to borrow from them.  During inflationary times, they raise their rate to decrease lending which decreases the money supply.  This is to keep good inflation from becoming bad inflation.  During deflationary times, they lower their rate to increase lending which increases the money supply.  This keeps a correction from turning into a recession.  Or so goes the theory.

The first big test of the Fed came during the 1920s.  And it failed. 

THE TWO WORLD wars were good for the American economy.  With Europe consumed by war, their agricultural and industrial output decline.  But they still needed stuff.  And with the wars fought overseas, we fulfilled that need.  For our workers and farmers weren’t in uniform. 

The Industrial Revolution mechanized the farm.  Our farmers grew more than they ever did before.  They did well.  After the war, though, the Europeans returned to the farm.  The American farmer was still growing more than ever (due to the mechanization of the farm).  There were just a whole lot less people to sell their crops to.  Crop prices fell. 

The 1920s was a time America changed.  The Wilson administration had raised taxes due to the ‘demands of war’.  This resulted in a recession following the war.  The Harding administration cut taxes based on the recommendation of Andrew Mellon, his Secretary of the Treasury.  The economy recovered.  There was a housing boom.  Electric utilities were bringing electrical power to these houses.  Which had electrical appliances (refrigerators, washing machines, vacuum cleaners, irons, toasters, etc.) and the new radio.  People began talking on the new telephone.  Millions were driving the new automobile.  People were traveling in the new airplane.  Hollywood launched the motion picture industry and Walt Disney created Mickey Mouse.  The economy had some of the most solid growth it had ever had.  People had good jobs and were buying things.  There was ‘good’ inflation. 

This ‘good’ inflation increased prices everywhere.  Including in agriculture.  The farmers’ costs went up, then, as their incomes fell.  This stressed the farming regions.  Farmers struggled.  Some failed.  Some banks failed with them.  The money supply in these areas decreased.

Near the end of the 1920s, business tried to expand to meet rising demand.  They had trouble borrowing money, though.  The economy was booming but the money supply wasn’t growing with it.  This is where the Fed failed.  They were supposed to expand the money supply to keep pace with economic growth.  But they didn’t.  In fact, the Fed contracted the money supply during this period.  They thought investors were borrowing money to invest in the stock market.  (They were wrong).  So they raised the cost of borrowing money.  To ‘stop’ the speculators.  So the Fed took the nation from a period of ‘good’ inflation into recession.  Then came the Smoot-Hawley Tariff.

Congress passed the Smoot-Hawley Tariff in 1930.  But they were discussing it in committee in 1929.  Businesses knew about it in 1929.  And like any good business, they were looking at how it would impact them.  The bill took high tariffs higher.  That meant expensive imported things would become more expensive.  The idea is to protect your domestic industry by raising the prices of less expensive imports.  Normally, business likes surgical tariffs that raise the cost of their competitor’s imports.  But this was more of an across the board price increase that would raise the cost of every import, which was certain to increase the cost of doing business.  This made business nervous.  Add uncertainty to a tight credit market and business no doubt forecasted higher costs and lower revenues (i.e., a recession).  And to weather a recession, you need a lot of cash on hand to help pay the bills until the economy recovered.  So these businesses increased their liquidity.  They cut costs, laid off people and sold their investments (i.e., stocks) to build a huge cash cushion to weather these bad times to come.  This may have been a significant factor in the selloff in October of 1929 resulting in the stock market crash. 

HERBERT HOOVER WANTED to help the farmers.  By raising crop prices (which only made food more expensive for the unemployed).  But the Smoot-Hawley Tariff met retaliatory tariffs overseas.  Overseas agricultural and industrial markets started to close.  Sales fell.  The recession had come.  Business cut back.  Unemployment soared.  Farmers couldn’t sell their bumper crops at a profit and defaulted on their loans.  When some non-farming banks failed, panic ensued.  People rushed to get their money out of the banks before their bank, too, failed.  This caused a run on the banks.  They started to fail.  This further contracted the money supply.  Recession turned into the Great Depression. 

The Fed started the recession by not meeting its core expectation.  Maintain the money supply to meet the needs of the economy.  Then a whole series of bad government action (initiated by the Hoover administration and continued by the Roosevelt administration) drove business into the ground.  The ONLY lesson they learned from this whole period is ‘inflation good, deflation bad’.  Which was the wrong lesson to learn. 

The proper lesson to learn was that when people interfere with market forces or try to replace the market decision-making mechanisms, they often decide wrong.  It was wrong for the Fed to contract the money supply (to stop speculators that weren’t there) when there was good economic growth.  And it was wrong to increase the cost of doing business (raising interest rates, increasing regulations, raising taxes, raising tariffs, restricting imports, etc.) during a recession.  The natural market forces wouldn’t have made those wrong decisions.  The government created the recession.  Then, when they tried to ‘fix’ the recession they created, they created the Great Depression.

World War I created an economic boom that we couldn’t sustain long after the war.  The farmers because their mechanization just grew too much stuff.  Our industrial sector because of bad government policy.  World War II fixed our broken economy.  We threw away most of that bad government policy and business roared to meet the demands of war-torn Europe.  But, once again, we could not sustain our post-war economy because of bad government policy.

THE ECONOMY ROARED in the 1950s.  World War II devastated the world’s economies.  We stood all but alone to fill the void.  This changed in the 1960s.  Unions became more powerful, demanding more of the pie.  This increased the cost of doing business.  This corresponded with the reemergence of those once war-torn economies.  Export markets not only shrunk, but domestic markets had new competition.  Government spending exploded.  Kennedy poured money into NASA to beat the Soviets to the moon.  The costs of the nuclear arms race grew.  Vietnam became more and more costly with no end in sight.  And LBJ created the biggest government entitlement programs since FDR created Social Security.  The size of government swelled, adding more workers to the government payroll.  They raised taxes.  But even high taxes could not prevent huge deficits.

JFK cut taxes and the economy grew.  It was able to sustain his spending.  LBJ increased taxes and the economy contracted.  There wasn’t a chance in hell the economy would support his spending.  Unwilling to cut spending and with taxes already high, the government started to print more money to pay its bills.  Much like Weimar Germany did in the 1920s (which ultimately resulted in hyperinflation).  Inflation heated up. 

Nixon would continue the process saying “we are all Keynesians now.”  Keynesian economics believed in Big Government managing the business cycle.  It puts all faith on the demand side of the equation.  Do everything to increase the disposable money people have so they can buy stuff, thus stimulating the economy.  But most of those things (wage and price controls, government subsidies, tariffs, import restrictions, regulation, etc.) typically had the opposite effect on the supply side of the equation.  The job producing side.  Those policies increased the cost of doing business.  So businesses didn’t grow.  Higher costs and lower sales pushed them into recession.  This increased unemployment.  Which, of course, reduces tax receipts.  Falling ever shorter from meeting its costs via taxes, it printed more money.  This further stoked the fires of inflation.

When Nixon took office, the dollar was the world’s reserve currency and convertible into gold.  But our monetary policy was making the dollar weak.  As they depreciated the dollar, the cost of gold in dollars soared.  Nations were buying ‘cheap’ dollars and converting them into gold at much higher market exchange rate.  Gold was flying out of the country.  To stop the gold flight, Nixon suspended the convertibility of the dollar. 

Inflation soared.  As did interest rates.  Ford did nothing to address the core problem.  During the next presidential campaign, Carter asked the nation if they were better off than they were 4 years ago.  They weren’t.  Carter won.  By that time we had double digit inflation and interest rates.  The Carter presidency was identified by malaise and stagflation (inflation AND recession at the same time).  We measured our economic woes by the misery index (the unemployment rate plus the inflation rate).  Big Government spending was smothering the nation.  And Jimmy Carter did not address that problem.  He, too, was a Keynesian. 

During the 1980 presidential election, Reagan asked the American people if they were better off now than they were 4 years ago.  The answer was, again, ‘no’.  Reagan won the election.  He was not a Keynesian.  He cut taxes like Harding and JFK did.  He learned the proper lesson from the Great Depression.  And he didn’t repeat any of their (Hoover and FDR) mistakes.  The recession did not turn into depression.  The economy recovered.  And soared once again.

MONETARY POLICY IS crucial to a healthy and growing economy.  Businesses need to borrow to grow and create jobs.  However, monetary policy is not the be-all and end-all of economic growth.  Anti-business government policies will NOT make a business expand and add jobs no matter how cheap money is to borrow.  Three bursts of economic activity in the 20th century followed tax-cuts/deregulation (the Harding, JFK and Reagan administrations).  Tax increases/new regulation killed economic growth (the Hoover/FDR and LBJ/Nixon/Ford/Carter administrations).  Good monetary policies complimented the former.  Some of the worst monetary policies accompanied the latter.  This is historical record.  Some would do well to learn it.

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