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

Posted by PITHOCRATES - August 17th, 2010

DURING UNCERTAIN ECONOMIC times, people act differently.  If business is down where you work, your company may start laying off people.  Your friends and co-workers.  Even you.  If there is a round of layoffs and you survive, you should feel good but don’t.  Because it could have been you.  And very well can be you.  Next time.  Within a year.  In the next few months.  Any time.  You just don’t know.  And it isn’t a good feeling.

So, should this be you, what do you do?  Run up those credit cards?  By a new car?  Go on a vacation?  Take out a home equity loan to pay for new windows?  To remodel the kitchen?  Buy a hot tub?  Or do you cut back on your spending and start hoarding cash?  Just in case.  Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc.  And another loan payment won’t help.  So, no.  You don’t run up those credit cards.  Buy that car.  You don’t go on vacation.  And you don’t take that home equity loan.  Instead, you hunker down.  Sacrifice.  Ride it out.  Prepare for the worse.  Hoard your cash.  Enough to carry you through a few months of unemployment.  And shred those pre-approved credit card offers.  Even at those ridiculously low, introductory interest rates.

To help hammer home this point, you think of your friends who lost their jobs.  Who are behind on their mortgages.  Who are in foreclosure.  Whose financial hardships are stressing them out to no ends.  Suffering depression.  Harassed by collection agencies.  Feeling helpless.  Not knowing what to do because their financial problems are just so great.  About to lose everything they’ve worked for.  No.  You will not be in their position.  If you can help it.  If it’s not already too late.

AND SO IT is with businesses.  People who run businesses are, after all, people.  Just like you.  During uncertain economic times, they, too, hunker down.  When sales go down, they have less cash to pay for the cost of those sales.  As well as the overhead.  And their customers are having the same problems.  So they pay their bills slower.  Trying to hoard cash.  Receivables grow from 30 to 45 to 90 days.  So you delay paying as many of your bills as possible.  Trying to hoard cash.  But try as you might, your working capital is rapidly disappearing.  Manufacturers see their inventories swell.  And storing and protecting these inventories costs money.  Soon they must cut back on production.  Lay off people.  Idle machinery.  Most of which was financed by debt.  Which you still have to service.  Or you sell some of those now nonproductive assets.  So you can retire some of that debt.  But cost cutting can only take you so far.  And if you cut too much, what are you going to do when the economy turns around?  If it turns around?

You can borrow money.  But what good is that going to do?  Add debt, for one.  Which won’t help much.  You might be able to pay some bills, but you still have to pay back that borrowed money.  And you need sales revenue for that.  If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan.  But you don’t have the sales now.  And the future doesn’t look bright.  Your customers are all going through what you’re going through.  Not a confidence builder.  So you’re reluctant to borrow.  Unless you really, really have to.  And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble.  Just what a banker wants to see in a prospective borrower.

Well, not really.  In fact, it’s the exact opposite.  A banker will want to avoid you as if you had the plague.  Besides, the banks are in the same economy as you are.  They have their finger on the pulse of the economy.  They know how bad things really are.  Some of their customers are paying slowly.  A bad omen of things to come.  Which is making them really, really nervous.  And really, really reluctant to make new loans.  They, too, want to hoard cash.  Because in bad economic times, people default on loans.  Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors.  And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail.  And all the money they created via fractional reserve banking will disappear.  Making money even scarcer and harder to borrow.  You see, banking people are, after all, just people.  And like you, and the business people they serve, they, too, hunker down during bad economic times.  Hoping to ride out the bad times.  And to survive.  With a minimum of carnage. 

For these reasons, businesses and bankers hoard cash during uncertain economic times.  For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty.  Uncertainty about when a recession will end.  Uncertainty about the cost of healthcare.  Uncertainty about changes to the tax code.  Uncertainty about new government regulations.  Uncertainty about new government mandates.  Uncertainty about retroactive tax changes.  Uncertainty about previous tax cuts that they may repeal.  Uncertainty about monetary policy.  Uncertainty about fiscal policy.  All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future.  Or severely reduce the purchasing power of their customers.  When this uncertainty is high during bad economic times, businesses typically circle the wagons.  Hoard more cash.  Go into survival mode.  Hold the line.  And one thing they do NOT do is add additional debt.

DEBT IS A funny thing.  You can lay off people.  You can cut benefits.  You can sell assets for cash.  You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset).  You can factor your receivables (sell your receivables at a discount to a 3rd party to collect).  You can do a lot of things with your assets and costs.  But that debt is still there.  As are those interest payments.  Until you pay it off.  Or file bankruptcy.  And if you default on that debt, good luck.  Because you’ll need it.  You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.

Profitable operations.  Yes, that’s the key to success.  So how do you get it?  Profitable operations?  From sales revenue.  Sales are everything.  Have enough of them and there’s no problem you can’t solve.  Cash may be king, but sales are the life blood pumping through the king’s body.  Sales give business life.  Cash is important but it is finite.  You spend it and it’s gone.  If you don’t replenish it, you can’t spend anymore.  And that’s what sales do.  It gets you profitable operations.  Which replenishes your cash.  Which lets you pay your bills.  And service your debt.

And this is what government doesn’t understand.  When it comes to business and the economy, they think it’s all about the cash.  That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy.  The tax and spend stuff.  When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm.  Interest rates must be too high.”  Because their tax and spending sure couldn’t have crashed the economy.  That stuff is stimulative.  Because their god said so.  And that god is, of course, John Maynard Keynes.  And his demand-side Keynesian economic policies.  If it were possible, those in government would have sex with these economic policies.  Why?   Because they empower government.  It gives government control over the economy.  And us.

And that control extends to monetary policy.  Control of the money supply and interest rates.  The theory goes that you stimulate economic activity by making money easier to borrow.  So businesses borrow more.  Create more jobs.  Which creates more tax receipts.  Which the government can spend.  It’s like a magical elixir.  Interest rates.  Cheap money.  Just keep interest rates low and money cheap and plentiful and business will do what it is that they do.  They don’t understand that part.  And they don’t care.  They just know that it brings in more tax money for them to spend.  And they really like that part.  The spending.  Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’?  Especially when it gives you money and power?  And a permanent underclass who is now dependent on your spending.  Whose vote you can always count on.  And when the economy tanks a little, all you need is a little more of that magical elixir.  And it will make everything all better.  So you can spend some more.

But it doesn’t work in practice.  At least, it hasn’t yet.  Because the economy is more than monetary policy.  Yes, cash is important.  But making money cheaper to borrow doesn’t mean people will borrow money.  Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more.  Not until they feel secure in their jobs.  Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt.  But they are not going to add additional debt to expand production.  Not until they see some stability in the market and stronger sales.  A more favorable tax and regulatory environment.  That is, a favorable business climate.  And until they do, they won’t create new jobs.  No matter how cheap money is to borrow.  They’ll dig in.  Hold the line.  And try to survive until better times.

NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend.  Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans.  Instead, they’ll beef up their reserves.  Instead of lending, they’ll buy liquid financial assets.  Sit on cash.  Earn less.  Just in case.  Dig in.  Hold the line.  And try to survive until better times.

Of course, the Keynesians don’t factor these things into their little formulae and models.  They just stamp their feet and pout.  They’ve done their part.  Now it’s up to the greedy bankers and businessmen to do theirs.  To engage in lending.  To create jobs.  To build things.  That no one is buying.  Because no one is confident in keeping their job.  Because the business climate is still poor.  Despite there being cheap money to borrow.

The problem with Keynesians, of course, is that they don’t understand business.  They’re macroeconomists.  They trade in theory.  Not reality.  When their theory fails, it’s not the theory.  It’s the application of the theory.  Or a greedy businessman.  Or banker.  It’s never their own stupidity.  No matter how many times they get it wrong.

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