Entrepreneurs Fail not because they are Stupid but because of an Anti-Business Environment

Posted by PITHOCRATES - June 16th, 2013

Week in Review

The ‘capitalism’ we have today isn’t our Founding Father’s capitalism.  Yet critics of today’s ‘capitalism’ act as if it is.  And point to the inherent flaws of this ‘capitalism’.  As an excuse to bring in more governmental regulations to fix the problems of ‘capitalism’.  Which is the reason why today’s ‘capitalism’ isn’t capitalism.  It’s not the same economic system that made the United States the number one economic power in the world.  No.  It’s moved more towards European social democracy.  The system that gave the European nations their sovereign debt crises.  But those learned intellectuals speaking from their ivory towers still talk about fixing the problems of ‘capitalism’.  Without really understanding what the real problem is.  And it ain’t capitalism.  It’s the interference of capitalism and free markets.  This is the source of all our problems today.  And unless you address these problems you’re just wasting your time (see How to Reduce ‘Infant Entrepreneur Mortality’ by Sramana Mitra posted 6/10/2013 on the Harvard Business Review Blog).

Ever since the 2008 financial crisis, intellectuals have had to ask themselves, ‘Does Capitalism Still Work..?’

Two particular problems stand out. First, Capitalism has been hijacked by speculators. Second, the system enables amassing wealth at the tip of the pyramid, leaving most of society high and dry. Both problems have resulted in a highly unstable, volatile world order that jitters and shocks markets periodically, leaving financial carnage and mass scale human suffering.

The first problem with ‘capitalism’ today is that intellectuals are trying to fix it.  There isn’t anything wrong with capitalism.  The problems we have today have nothing to do with capitalism.  Because what we have today is state capitalism.  Crony capitalism.  European social democracy.  We have too much government in capitalism.  Who are favoring their big corporate friends in exchange for big corporate campaign donations.  And the only reason we have these speculators is because of the government.  Who is pumping so much cheap money into the economy for the speculators to speculate with.  And when their crony capitalist friends fail the government bails them out with tax dollars.  Because there is no downside to speculation when you have friends in government speculators will speculate.

People like to blame the banks and Wall Street for the subprime mortgage crisis.  But they didn’t create that crisis.  They just played their part.  The government created it.  By pumping cheap money into the economy to keep interest rates artificially low.  To encourage people to buy houses.  Even those who weren’t even considering buying a house.  Or those who simply couldn’t afford to buy a house.  These people changed their behavior based on the government’s manipulation of the interest rates.  As the government intended to do.  And they made everything worse with policies to encourage more and more home ownership.  The big one being Bill Clinton’s Policy Statement on Discrimination in Lending.  Where the government threatened lenders to lend to the unqualified or else.  So they did.  Using the subprime mortgage to qualify the unqualified.  And then the government-sponsored enterprises, Fannie May and Freddie Mac, bought those toxic subprime mortgages from these lenders, chopped and diced them into investments called collateralized debt obligations.  And sold them to unsuspecting investors as high-yield, low-risk investments.  Because they were backed by the safest investment of all time.  The home mortgage.  Only they didn’t tell these investors that these mortgages were toxic subprime mortgages being paid by people who couldn’t qualify for a conventional mortgage.  The safest investment of all time.  The conventional home mortgage.  So these lenders were able to clear these toxic mortgages off of their balance sheets.  Allowing them to issue more toxic subprime mortgages.  They were making money by writing these risky subprime mortgages.  But incurred no risk.  So they kept qualifying the unqualified for more and more mortgages.  Which was profitable.  Safe.  And kept the government off of their backs as threatened in Bill Clinton’s Policy Statement on Discrimination in Lending.

This isn’t capitalism.  This is government and their crony capitalist friends using their power, privilege and influence to game the system.  To enrich themselves.  This is what caused the mess we have today.  Where speculators and those in government get richer.  While Main Street America sees its median income fall.  And entrepreneurs struggle to stay in business.

Everybody talks about the role small businesses play in growing economies and creating jobs. However, as it stands, in America alone, 600,000 businesses die in the vine every year. This colossal infant entrepreneur mortality is a product of colossal levels of ignorance about how to build and sustain businesses.

And a myriad of governmental regulations, taxes and a litigious society.  Entrepreneurs today have to spend a lot of money and time protecting their money and time.  They need accountants and tax lawyers to help them comply with an ever growing regulatory environment.  And a boatload of insurances to keep the sharks at bay who all want a piece of their wealth and will sue if given the least opportunity.  It’s so complex that if they try to navigate their own way through these enormous burdens places on business they often make mistakes.  Or simply overlook something that they shouldn’t have.  Often times they just don’t charge enough to cover all of these costs they never expected when starting their businesses.  So when, say, a tax bill comes due they simply don’t have the cash on hand to pay it.  And then the downward death spiral begins.  This is why restaurants and construction companies are the number one and number two business to fail.  Where we have brilliant chefs and trades people who can cook or build something better than anyone else.  But are so out of their element when dealing with the business side of their trade.  The regulatory costs, taxes, insurance, etc.  And find they spend more of their time not doing what they love—cooking or building—but pushing paper through a labyrinth of red tape.  And often don’t find out they are not charging enough to cover all of the regulatory costs, taxes, insurance, etc., until it’s too late.

There is actually a method to the madness of entrepreneurship. And while the ‘character traits’ that support entrepreneurship — courage, tolerance for risk, resilience, persistence — cannot be taught, the method of building businesses can and should be taught.

In fact, it should be taught not just at elite institutions, but at every level of society, en masse.

If we can democratize the education and incubation of entrepreneurs on a global scale, I believe that it would not only check the infant entrepreneur mortality, it would create a much more stable economic system.

No.  That’s not the answer.  The reason why a lot of people remain employees instead of going into business themselves is that these people don’t want to deal with all the regulatory headaches their bosses have to deal with.  A tradesperson would rather work their 8-hour shift and go home.  They don’t want to deal with payroll taxes, workers’ compensation insurance, liability insurance, vehicular insurances, health insurance, real property taxes, personal property taxes, quarterly tax filings, business income tax, use tax, OSHA requirements, environmental requirements, city and state inspections, permits and licenses, etc.  If a tradesperson could just throw his or her tools in a truck and go into business they would.  But they can’t.  So they won’t.  Because it’s just so much easier being an employee than an employer.  Who are always guaranteed a paycheck if they work.  While an employer only gets paid after everyone, and everything, else gets paid.

You want to reduce infant entrepreneur mortality rates?  Get the government out of the private sector.  And give these entrepreneurs a chance.  You’d be surprised at what they can do if the government just leaves them alone.  Just like Andrew Carnegie, John Rockefeller, Henry Ford, etc., did.  Who probably couldn’t do what they did today.  Not in today’s anti-business environment.

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Thales of Miletus, Olive Oil, Tulip Mania of 1636 and the Chicago Board Options Exchange

Posted by PITHOCRATES - April 30th, 2013

History 101

Thales of Miletus was able to Predict a Bumper Crop of Olives

Italian restaurants will have a bottle of olive oil on the table.  The more authentic restaurants.  That give you a taste of old Italy.  Where they give you bread to munch on while you wait for your food.  We pour a little olive oil on a plate.  And dip our bread in it.  And enjoy that Mediterranean flavor.  Something that some of us may believe the Olive Garden brought to the dining experience.  But olive oil actually predates the Olive Garden.  We probably started eating olives for the first time around the 8th millennium BC.  When our Neolithic ancestors were still using stone tools.  Someplace in ancient Greece.

Olive trees grew all around the Mediterranean Sea.  And the Mediterranean people probably started using olive oil around the 4th millennium BC.   That’s 4000 BC.  Awhile ago.  We began to produce olive oil commercially somewhere around 2500 BC.  And began trading this luxury good.  We ate it.  Used it in religious rituals.  In medicines.  And fuel for oil lamps.  Among other uses.  As demand grew we planted more trees.  And brought in large harvests at the end of the growing season.  And took the olives to the olive presses.  And waited for our turn.  To pay the pressman to press our olives into oil.  And during a good growing season you could find yourself waiting quite awhile.

But who has time to wait?  If only we could figure out some way to avoid that long line.  Well, as it turned out, if you were smart you could.  As Thales of Miletus did.  A Greek astronomer, philosopher and mathematician.  As well as a pretty good weather forecaster.  For he was able to predict a bumper crop of olives one year because of favorable weather.  Which would make those olive presses busy at the harvest.  So he went to the olive press owners and reserved time on their presses for a nominal down payment.  So when the harvest came in he would be at the front of the line.  If he was wrong about his forecast he would give up his nominal deposit.  And walk away.  As the press owners didn’t care whose olives they were pressing they were glad to take his money for this right to buy press time later.  They had nothing to lose.  And when Thales prediction proved true and there was a bumper crop of olives those options to buy time on those presses became very valuable.  Those anxious to get their olives into the presses were glad to pay him for those options.  To buy his right to be first to buy press time.  Which he did.  Getting quite wealthy in the process.  As well as proving a point.  Rational thinking had real value.  They could use philosophy to make life better.

As Tulip Prices continued their Meteoric Rise the Speculators entered the Market to Get Rich Quick

And the option was born.  You can use them to speculate about the price of something in the future to make a lot of money.  And you can use them for hedging risk.  Such as farmers do.  They enter contracts with people to sell their crops at a set price.  Which protects the farmer if there is a bumper crop and prices fall.  Those who didn’t enter an options contract will only get the market price for their crops.  And have an unprofitable season.  While those with options contracts will be able to sell their crops above the market price.  And have a profitable season.  But if there are droughts that reduce the harvest prices will rise.  Which protects the buyer.  As he is able to buy below the market price.  At the price in the options contract.  While those buyers without options contracts will have to pay the higher market price.  Thus entering a contract hedges risk for both buyer and seller.  One party may do better than the other if there is a large swing in price.  But neither party will suffer a bad loss.  So whatever happens in that growing season they will be around for the following growing season.  But the speculators, on the other hand, can suffer great losses.

Tulips were big in the 17th century.  The affluent adorned their homes with these beautiful flowers.  And they soon became a sign of affluence.  Today people go to the affluent shops on Rodeo Drive and buy the latest in high fashion to show off their wealth.  In the 17th century they planted tulips.  People were impressed with what they saw.  And soon had to have these wonderful flowers themselves.  Causing a great surge in demand for tulips.  Which tulip growers rushed in to meet.  But the supply couldn’t keep up with the demand.  So tulip prices soared.  Soon, growers (sellers) and wholesalers (buyers) start entering options contracts to hedge their risks in the volatile tulip market.  As tulip prices continued their meteoric rise the speculators entered the market to get rich quick.  This speculation grew into such a frenzy that people would even mortgage their homes to raise money to buy tulip options.  Waiting for the big payday when they could exercise those options.  And buy tulips at one price.  Then resell them at a higher price.  A much higher price.  The demand for options grew so great that an options market opened.  And people bought and sold tulip options.

All good things must come to an end, though.  As must speculative bubbles.  And that happened in the Netherlands in 1637.  For there comes a time where buyers simply refuse to buy anymore tulips at those high prices.  And when they stopped buying people with vast amounts of tulips to sell began to panic.  And started lowering their price.  As other sellers started doing.  When interest in buying tulips fell supply began to exceed demand.  Sending the tulip price into a freefall.  With falling tulip prices no one was buying options contracts.  Because the market price was falling so fast that it would fall below the price in those options contracts.  And when they did ‘fall out of the money’ those options contracts became worthless.  And all that money the speculators poured into the options market was lost.  People lost everything.  Even their homes.  Sending the Dutch economy into a nasty recession.

With the Advent of the Internet it’s Never been Easier to Buy and Sell Options

Stock options were a way to get rich quick.  And what made them so attractive to speculators was leverage.  A small investment could turn into great riches.  But that leverage worked both ways.  And it could take that small investment and turn it into a great loss.  Should the price move in the wrong direction and fall when you have a contract obligating you to buy at a higher price.  And with the tulip mania of 1636 investors were getting a little gun-shy of options in general.  Causing the volume of options trading to fall in London.  Concerned of the speculative nature of options London made options trading illegal in 1733.  A ban that remained until 1860.

Russell Sage inaugurated options trading in the United States in 1872.  These were over the counter (OTC).  There was no central stock exchange.  Or standardized options format.  Which made the trading difficult to say the least.  Brokers placed ads in financial journals for their respective buyers and sellers.  And waited.  For someone to read the ad.  And call.  Then haggled over the price a bit.  Signed a contract.  And then waited until the expiration date of the option.  Or placed another ad in some financial journal.  To find someone else to buy the option.

Then things started changing in 1935.  The SEC granted a license to the Chicago Board of Trade (CBOT) as a national securities exchange.  And in 1968, CBOT finally did something with that license.  They created the Chicago Board Options Exchange (CBOE).  Which standardized and organized options trading.  One Nobel Prize later to Fischer Black and Myron Scholes for their “The Pricing of Options and Corporate Liabilities” we had a ‘scientific’ way for valuing stock options.  And with the advent of the Internet it’s never been easier to buy and sell options.  Allowing some to hedge risks easily.  While others live dangerously.  And speculate.  Trying to score big.  Before they lose everything trying to get rich quick.

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The First Bank of the United States, the Second Bank of the United States and the Federal Reserve System

Posted by PITHOCRATES - April 2nd, 2013

History 101

Merchants raise their Prices when the Monetary Authority depreciates the Currency

What is inflation?  A depreciation of the currency.  By adding more money into the money supply each piece of currency becomes less valuable.  Let’s assume our currency is whiskey.  In bottles.  Whiskey has value because people are willing to pay for it.  And because we are willing to pay for it we are willing to accept it as legal tender.  Because we can always trade it to others.  Who can drink it.  Or they can trade it with others.

Now let’s say the monetary authority wants to stimulate economic activity.  Which they try to do by expanding the money supply.  So there is more money available to borrow.  And because there is more money available to borrow interest rates are lower.  Hence making it easy for people to borrow money.  But the monetary authority doesn’t want to make more whiskey.  Because that is costly to do.  Instead, they choose an easier way of expanding the money supply.  By watering down the bottles of whiskey.

Now pretend you are a merchant.  And people are coming in with the new watered-down whiskey.  What do you do?  You know the whiskey is watered down.  And that if you go and try to resell it you’re not going to get what you once did.  For people typically drink whiskey for that happy feeling of being drunk.  But with this water-downed whiskey it will take more drinks than it used to take to get drunk.  So what do you as a merchant do when the money is worth less?  You raise your prices.  For it will take more bottles of lesser-valued whiskey to equal the purchasing power of full-valued whiskey.   And if they water down that whiskey too much?  You just won’t accept it as legal tender.  Because it will be little different from water.  And you can get that for free from any well or creek.  Yes, water is necessary to sustain life.  But no one will pay ‘whiskey’ prices for it when they can drink it from a well or a creek for free.

It was while in the Continental Army that Alexander Hamilton began thinking about a Central Bank

During the American Revolutionary War we had a very weak central government.  The Continental Congress.  Which had no taxing authority.  Which posed a problem in fighting the Revolutionary War.  Because wars are expensive.  You need to buy arms and supplies for your army.  You have to feed your army.  And you have to pay your army.  The Continental Congress paid for the Revolution by asking states to contribute to the cause.  Those that did never gave as much as the Congress asked for.  They got a lot of money from France.  As we were fighting their long-time enemy.  And we borrowed some money from other European nations.  But it wasn’t enough.  So they turned to printing paper money.

This unleashed a brutal inflation.  Because everyone was printing money.  The central government.  And the states.  Prices soared.  Merchants didn’t want to accept it as legal tender.  Preferring specie instead.  Because you can’t print gold and silver.  So you can’t depreciate specie like you can paper money.  All of this just made life in the Continental Army worse.  For they were hungry, half-naked and unpaid.  And frustrating for men like Alexander Hamilton.  Who served on General Washington’s staff.  Hamilton, and many other officers in the Continental Army, saw how the weakness of the central government almost lost the war for them.

It was while in the army that Hamilton began thinking about a central bank.  But that’s all he did.  For there was not much support for a central government let alone a central bank.  That would change, though, after the Constitutional Convention of 1787 created the United States of America.  And America’s first president, George Washington, chose his old aide de camp as his treasury secretary.  Alexander Hamilton.  A capitalist who understood finance.

Despite the Carnage from the Subprime Mortgage Crisis the Fed is still Printing Money

At the time the new nation’s finances were in a mess.  Few could make any sense of them.  But Hamilton could.  He began by assuming the states’ war debts.  Added them to the national war debt.  Which he planned on paying off by issuing new debt.  That he planned on servicing with new excise taxes.  And he would use his bank to facilitate all of this.  The First Bank of the United States.  Which faced fierce opposition from Thomas Jefferson and James Madison.  Who opposed it for a couple of reasons.  For one they argued it wasn’t constitutional.  There was no central bank enumerated in the Constitution.  And the Tenth Amendment of the Constitution stated that any power not enumerated to the new federal government belonged to the states.  And that included banking.  A central bank would only further consolidate power in the new federal government.  By consolidating the money.  Transferring it from the local banks.  Which they feared would benefit the merchants, manufacturers and speculators in the north.  By making cheap money available for them to make money with money.  Which is the last thing people who believed America’s future was an agrarian one of yeoman farmers wanted to do.

They fought against the establishment of the bank.  But failed.  The bank got a 20 year charter.  Jefferson and Madison would later have a change of heart on a central bank.  For it helped Jefferson with the Louisiana Purchase.  And like it or not the country was changing.  It wasn’t going to be an agrarian one.  America’s future was an industrial one.  And that required credit.  Just as Alexander Hamilton thought.  So after the War of 1812, after the charter of the First Bank of the United States had expired, James Madison signed into law a 20-year charter for the Second Bank of the United States.  Which actually did some of the things Jefferson and Madison feared.  It concentrated a lot of money and power into a few hands. Allowing speculators easy access to cheap money.  Which they borrowed and invested.  Creating great asset bubbles.  And when they burst, great depressions.  Because of that paper money.  Which they printed so much of that it depreciated the dollar.  And caused asset prices to soar to artificial heights.

Andrew Jackson did not like the bank.  For he saw it creating a new noble class.  A select few were getting rich and powerful.  Something the Americans fought to get away from.  When the charter for the Second Bank of the United States was set to expire Congress renewed the charter.  Because of their friends at the bank.  And their friends who profited from the bank.  But when they sent it to Andrew Jackson for his signature he vetoed the bill.  And Congress could not override it.  Sensing some blowback from the bank Jackson directed that they transfer the government’s money out of the Second Bank of the United States.  And deposited it into some state banks.  The president of the bank, Nicholas Biddle, did not give up, though.  For he could hurt those state banks.  Such as calling in loans.  Which he did. Among other things.  To try and throw the country into a depression.  So he could blame it on the president’s anti-bank policies.  And get his charter renewed.  But it didn’t work.  And the Second Bank of the United States was no more.

National banks versus local banks.  Hard money (specie) versus paper money.  Nobility versus the common people.  They’ve argued the same arguments throughout the history of the United States.  But we never learn anything.  We never learn the ultimate price of too much easy money.  Even now.  For here we are.  Suffering through the worst recession since the Great Depression.  Because our current central bank, the Federal Reserve System, likes to print paper money.  And create asset bubbles.  Their last being the one that burst into the subprime mortgage crisis.  And despite the carnage from that they’re still printing money.  Money that the rich few are borrowing to invest in the stock market.  Speculators.  Who are making a lot of money.  Buying and selling assets.  Thanks to the central bank’s inflationary policies that keep increasing prices.

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2012 Endorsements: Alexander Hamilton

Posted by PITHOCRATES - October 18th, 2012

2012 Election

When Hamilton looked out Across the Vast North American Continent he saw Great Economic Opportunity

Alexander Hamilton was born in the British West Indies.  At the age of eleven he had to get a job.  As his father abandoned his family after losing all the family money.  Young Alexander worked at Cruger and Beckman’s.  a New York trading house.  A window onto the world.  And international trade.  Where young Alexander learned about the world.  And business.  He had a gift for numbers.  He was bright.  And driven.  Born in the British West Indies he was also something else.  A Founding Father without any state lineage.  With no provincial views.  During the prelude to American independence when other patriots talked about the states going their own way he was already thinking of an American union.  And only of an American union.

The British response to the Boston Tea Party was the Intolerable Acts.  Or the Coercive Acts in Britain.  Where the British put the hurt on Boston.  And Massachusetts.  To separate it and isolate it from the rest of the colonies.  Reverend Samuel Seabury took to the papers and argued against uniting the other colonies to support Massachusetts.  That the people should support their king.  And Parliament.  And not the spoiled, trouble-making people of Boston.  Hamilton took to the papers and argued in support of union.  And Boston.  Warning the people that this was just the beginning for Britain.  More taxes would certainly follow.  Hamilton warned the people to put away their sectional differences.  As this attack on one was an attack on all.  And that if they gave up on Boston it would only be a matter of time before other colonies met the same fate.

That was all well and fine during the warm months of summer.  But the American colonies were part of the British Empire.  Which was a mercantilist empire.  Whose colonies shipped raw materials to the mother country.  And the proceeds from those sales were used to buy manufactured goods made from those raw materials in the mother country.  Making the colonists dependent on Britain for their clothing.  The lack of which would make a very cold and miserable winter.  Which led a lot of people to agree with Reverend Samuel Seabury.  But not Hamilton.  For he looked out across the American colonies and saw something else.  Economic independence.  The South had cotton.  The North could raise sheep for wool.  And they could build factories in the cities to make cloth and clothing.  Staffed by skilled immigrants from European factories.  This is what Hamilton saw when he looked out across the vast North American continent.  Great economic opportunity.  Made possible by an American union.

Hamilton spent the Winter Seasons at Valley Forge and Morristown Reading and Studying Economics and Public Finance

When the Revolutionary War came Hamilton joined the Continental Army.  Fought bravely.  Then ended up as General Washington’s aide-de-camp.  Serving in Washington’s inner circle he knew what the commanding general knew.  And he knew the sorry state of the army.  Half-naked, hungry and unpaid.  While some civilians were living the life of Riley.  Making a fortune off of hording commodities and selling them at high prices.  Which they could do with impunity as the Continental Congress was powerless to stop them.  As it was at the mercy of the states.  The national congress was broke and had little legal authority.  Which let the speculators run roughshod over it.  Leaving the people sacrificing the most for independence half-naked, hungry and unpaid.  Diminishing the fighting ability of the army.  Which greatly increased the risk of defeat.

Hamilton learned an important lesson.  The stronger the national government was, and the richer it was, the easier it was to wage war.  And the easier it was NOT to be defeated in war.  The problem here was that the national government was too weak.  While the state governments were too strong.  Which was fine for the people living normal lives in their states.  But not the soldiers in the field fighting for the nation.  Making things worse was inflation.  The Continental Congress was printing money.  As were the states.  And the more they printed the more they depreciated it.  Which led to even higher prices.  More profits for the speculators.  And even more hardship for the army.  Which had to at times take things from the local people in exchange for IOUs.  Making these people hate the army.  And the army hate the people.  As they were the ones risking life and limb for what was to them an ungrateful people.

Hamilton spent the winter seasons at Valley Forge and Morristown reading and studying economics and public finance.  And set out to solve the inflation problem.  What he learned was that a lot of people were benefiting by the rampant inflation.  Debtors loved it.  For the greater the inflation was the easier it was to repay loans in those depreciated dollars.  Especially the farmers.  They sold their produce at ever higher prices.  Borrowed money to buy land (and repaid those loans in depreciated dollars).  While escaping much of the ravages of inflation themselves.  Because they were farmers.  And were self-sufficient.  Eating what they grew.  Even making their own clothes.  For some inflation was a way to get rich quick at the detriment of others.  To help dissuade such activity Hamilton suggested high taxes in kind (if a farm grew wheat that they turned into flour they would pay a portion of their flour to the government as a tax) on those benefitting from inflation who where destroying the confidence in the dollar.

If Hamilton were Alive Today he would likely Endorse the Republican Candidates Mitt Romney and Paul Ryan

Hamilton also suggested a plan for a national bank.  To help restore the credit of the United States.  And to provide a source of credit for the national government.  The bank would be owned half by the government and half by rich investors.  By letting the rich investors make money on the bank it would, of course, encourage them to invest in the bank.  And provide capital the government could borrow.  Hamilton believed in bringing the rich people closer to the government.  So the government had access to their money.  Both would win in such a partnership.  And both would have a vested interest in seeing the government succeed.  The Continental Congress used some of Hamilton’s ideas.  But not enough to bring his vision to life.  He would get another chance, though.  When he became America’s first Secretary of the Treasury.

At the end of the Revolutionary War the United State’s finances were in a mess.  State governments and the national government owed money.  As they used that money to prosecute the war Hamilton believed the national government should assume the states’ debts and roll in into the national debt.  And, more importantly, the new national debt would help strengthen the union.  By binding the states to the national government.  These actions also helped to restore the nation’s credit.  Allowing it to borrow money to repay old debts.  As well as finance new spending.  Hamilton also got his bank.  And he produced a report on manufacturers.  A plan to use government funds to help launch American industry.  So they could catch up to Great Britain.  And even surpass the former mother country.

Hamilton pushed for these things because he wanted to use the power of government to make America strong and fiercely independent in the world of nations.  With an economic plan that would make the nation wealthy.  And allowing it to afford a military that equaled or surpassed Great Britain.  He did not want to make America wealthy to implement a massive welfare state.  His idea of partnering government with business was to make an American Empire modeled on the British Empire.  Making it a rich military superpower.  Able to project force.  Maintaining peace through strength.  Much like the British did with their Pax Britannica that he didn’t live to see.  And to protect what it had from anyone trying to take it away from them.  So based on this who would he endorse in the 2012 election?  The party that had business-friendly policies to encourage economic growth.  The party that was more anti-inflation.  The party that would best exploit the nation’s resources.  And the party that favored a strong military.  Which is NOT the Democrat Party.  No, if Alexander Hamilton were alive today he would likely endorse the Republican candidates Mitt Romney and Paul Ryan.

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Revolutionary War, Sovereign Debt, Report on Public Credit, Hamilton, Jefferson, Madison, Assumption and Residency Act

Posted by PITHOCRATES - August 16th, 2012

Politics 101

In 1792 the Outstanding Debt at all Levels of Government was 45% of GDP

Wars aren’t cheap.  Especially if they last awhile.  The American Revolutionary War lasted some 8 years until the British and Americans signed the Treaty of Paris (1782) officially ending all hostilities.  So the Revolutionary War was a very costly war.  The ‘national’ government (the Continental Congress) owed about $70 million.  The states owed another $25 million or so.  And the Continental Army had issued about $7 million in IOUs during the war.  Added up that comes to $102 million the new nation owed.  About 45% of GDP.  (Or about 35% without the state debt added in.)

To put that in perspective consider that the Civil War raised the debt to about 32% of GDP.  World War I raised it to about 35%.  World War II raised it to about 122%.  Following the war the debt fell to about 32% at its lowest point until it started rising again.  And quickly.  In large part due to the cost of the Vietnam War and LBJ’s Great Society.  Government spending being so great Nixon turned to printing money.  Depreciating the dollar’s purchasing power in every commodity but one.  Gold.  Which was pegged at $35/ounce.  Losing faith in our currency foreign governments traded their U.S. dollars for gold.  Until Nixon decoupled the dollar from gold in 1971.  Ushering in the era of Keynesian economics, deficit spending and growing national debts.  Because of increased spending for social programs governments everywhere now have debts approaching 100% of GDP.  And higher.  But I digress.

So 45% of GDP was huge in 1792.  And it continued to be huge.  Taking a devastating civil war and a devastating world war to even approach it.  It took an even more devastating world war to exceed it.  And now we’ve blown by that debt level in the era of Keynesian economics.  Without the devastation of another World War II.  This debt level has grown so great that for the first time ever in U.S. history Standard and Poor’s recently lowered the United States’ impeccable sovereign debt rating.  And restoring that debt rating at today’s spending levels will be a daunting task.  But imagine trying to establish a sovereign debt rating after just becoming a nation.  Already with a massive debt of 45% of GDP.

In Hamilton’s Report on Public Credit the New Government would Assume Outstanding Debt at all Levels of Government

There was only one choice for America’s first president.  The indispensible one.  George Washington.  Some delegates at the Philadelphia Convention in 1787 who were skeptical of the new Constitution only supported it because they had someone they could trust to be America’s first president.  George Washington.  Benjamin Franklin, John Adams, Thomas Jefferson and James Madison were indispensible at times.  But not as indispensible as Washington.  For without him the Continental Army would have ceased to exist after that winter at Valley Forge.  That same army would have mutinied (for back pay and promised pensions) after the war if he didn’t step in.  Our experiment in self-government would have ended if he did not relinquish his power after the war.  We wouldn’t have ratified the Constitution without having Washington to be America’s first president.  And our experiment in self-government would have ended if he did not relinquish his power.  Again.  After his second term as president.

With the state of the government’s finances after the war there was another Founding Father that was indispensible.  Not as indispensible as Washington.  But close.  For without him the Washington presidency may have failed.  As well as the new nation.  Because of that convoluted financial mess.  The Continental Congress borrowed money.  The states borrowed money.  Some of which went to the Continental Congress.  The army took stuff they needed to survive in exchange for IOUs.  There were bonds, loans and IOUs at every level of government in every state.  Complicating the matter is that most of the instruments they sold ended up in the hands of speculators who bought them for pennies on the dollar.  As the original holders of these instruments needed money.  And did not believe the Continental Congress would honor any of these obligations.  For before the Constitution the government was weak and had no taxing authority.  And no way to raise the funds to redeem these debt obligations.

A few tried to get their arms around this financial mess.  But couldn’t.  It was too great a task.  Until America’s first secretary of the treasury came along.  Alexander Hamilton.  Who could bring order to the chaos.  As well as fund the new federal government.  He submitted his plan in his Report on Public Credit (January 1790).  And the big thing in it was assumption.  The federal government would assume outstanding debt at all levels of government.  Including those IOUs.  At face value.  One hundred pennies on the dollar.  To whoever held these instruments.  Regardless of who bought them first.  “Unfair!” some said.  But what else could they do?  This was the 1700s.  There weren’t detailed computer records of bondholders.  Besides, this was a nation that, like the British, protected property rights.  These speculators took a risk buying these instruments.  Even if at pennies on the dollar.  They bought them for a price the seller thought was fair or else they wouldn’t have sold them.  So these bonds were now the property of the speculators.

Jefferson and Madison traded Hamilton’s Assumption for the Nation’s Capital

Of course to do this you needed money.  Which Hamilton wanted to raise by issuing new bonds.  To retire the old.  And to service the new.  Thus establishing good credit.  In fact, he wanted a permanent national debt.  For he said, “A national debt, if not excessive, is a national blessing.”  Because good credit would allow a nation to borrow money for economic expansion.  And it would tie the people with the money to the government.  Where the risk of a government default would harm both the nation and their creditors.  Making their interests one and the same.

That’s not how Thomas Jefferson saw it, though.  He had just returned from France where he witnessed the beginning of the French Revolution.  Brought upon by a crushing national debt.  And he didn’t want to tie the people with the money to the government.  For when they do they tend to exert influence over the government.  But Hamilton said debt was a blessing if not excessive.  He did not believe in excessive government debt.  And he wanted to pay that debt off.  As his plan called for a sinking fund to retire that debt.  Still, the Jefferson and Hamilton feud began here.  For Hamilton’s vision of the new federal government was just too big.  And too British.  Madison would join Jefferson to lead an opposition party.  Primarily in opposition to anything Hamilton.  Who used the Constitution to support his other plan.  A national bank.  Just like the British had.  Based on the “necessary and proper” clause in Article I, Section 8.  Setting a precedent that government would use again and again to expand its powers.

At the time the nation’s capital was temporarily in New York.  A final home for it, though, was a contentious issue.  Everyone wanted it in their state so they could greatly influence the national government.  Hamilton’s struggle for assumption was getting nowhere.  Until the horse-trading at the Jefferson dinner party with Hamilton and Madison.  To get the nation’s capital close to Virginia (where it is now) Jefferson offered a deal to Hamilton.  Jefferson and Madison were Virginians.  Give them the capital and they would help pass assumption.  They all agreed to the deal (though Jefferson would later regret it).  Congress passed the Residency Act putting the capital on the Potomac.  And all the good that Hamilton promised happened.  America established good credit.  Allowing it to borrow money at home and abroad.  And a decade of prosperity followed.  Hamilton even paid down the federal debt to about 17.5% of GDP near the end of America’s second president’s (John Adams) term in office (1800).  Making Hamilton indispensible in sustaining this experiment in self-government.  Keeping government small even though it was more powerful than it was ever before.  Of course his using that “necessary and proper” argument really came back to bite him in the ass.  Figuratively, of course.  As government used it time and again to expand its role into areas even Hamilton would have fought to prevent.  While Jefferson no doubt would have said with haughty contempt, “I told you so.  This is what happens when you bring money and government together.  But would you listen to me?  No.  How I hate you, Mr. Hamilton.”

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FT127: “Obamacare is a lot like the Smoot-Hawley Tariff in terms of scaring the bejesus out of businesses.” -Old Pithy

Posted by PITHOCRATES - July 20th, 2012

Fundamental Truth

The Roaring Twenties gave us Automobiles, Electric Power, Radio, Movies, Telephones and Air travel

In 1921 there were 9 million automobile registrations.  That jumped to 23 million by 1929.  An increase of 156%.  That’s a lot more cars on the roads.  In the Roaring Twenties we made cars out of steel, paint and glass.  Inside we fitted them with lumber, cotton and leather.  We put rubber tires on them.  And filled their fuel tanks with gasoline.  So this surge in car ownership created a surge in all of these industries.  Extraction of raw materials.  Factories and manufacturing plants to build the equipment to extract those raw materials.  As well as the machinery to build these automobile components.  And the moving assembly lines in assembly plants to assemble these automobiles.  The plants, warehouses and automobile dealers created a surge in the construction industry.  And all the industries that fed the construction industry.  Including the housing industry to house all these gainfully employed workers.

And this was just the auto industry.  Which wasn’t the only industry that was booming during the Roaring Twenties.  Thanks to the hands-off government policies of the administrations of Warren G. Harding and Calvin Coolidge businesses introduced us to the modern world.  Electric power came into its own.  By 1929 about 80% of all installed horsepower was electrical.  And it entered our homes.  Electric lighting and electric appliances.  Vacuum cleaners.  Washing machines.  Refrigerators.  All of this required even more raw material extraction from the ground.  More manufacturing equipment and plants.  More wholesale and retail construction.  And more housing to house all of these workers earning a healthy paycheck.

And there was more.  The Roaring Twenties gave us broadcast radio in our electric-powered homes.  Free entertainment, sports broadcasts and news.  Paid for by the new industry of advertising.  Competing with radio was another growing industry.  Motion pictures.  That by the end of the Roaring Twenties were talkies.  And speaking of talking there was a lot of that on the new telephone.  In our homes.  Interconnecting all of these industries was ship, rail and truck transportation.  Even air travel took off during the Twenties.  More raw material extraction.  More equipment.  More manufacturing.  More construction.  And jobs.  More and more jobs.  The hands-off government policies of the Harding and Coolidge administrations created the great Bull Market of the Twenties.  Explosive economic activity.  Real economic growth.  Creating low-cost consumer goods to modernize America.  Increase her productivity.  Making her the dominant economic power in the world.  The Europeans were so worried about America’s economic prowess that they met in 1927 at the International Economic Conference in Geneva to discuss the American problem.  And how they were going to compete with the American economic juggernaut.  Because the free market capitalism of the New World was leaving the Old World in the dust.

Herbert Hoover was a Republican in Name Only that FDR once Admired but Calvin Coolidge Despised

This was real economic growth.  It was not speculation.  This wasn’t artificially low interest rates creating an asset bubble.  Working Americans bought homes and cars.  And furnishings.  Businesses produced these to meet that demand.  They had growing sales.  And growing profits.  Which increased their stock prices.  Investors wanted to own their stocks because these companies were making money.  And with the world modernizing these stock prices weren’t going anywhere but up in the foreseeable future.  Unless something changed the business environment.  Well, something did.

Despite the roaring economy Calvin Coolidge did not run for a second term.  Which was a pity.  For his successor, Herbert Hoover, was a Republican in name only.  He was a big time progressive.  Who wanted to use the power of government to make the world perfect.  A devout believer in the benevolence of Big Government.  He added about 2,000 bureaucrats to the Department of Commerce.  FDR at one time admired him (before he ran against him for president).  Coolidge despised him.  Under Hoover the federal government intruded into the private sector.  His economics were Keynesian.  He, too, worshipped at the altar of demand.  He believed high wages were the key to prosperity.  For people with more money buy more.  And all that buying created demand for businesses to meet.  Even during a recession he believed wages should not fall.  Despite the fact that’s what recessions do on the back side of the business cycle.  Lower prices and wages.  And lay off people.

By the Twenties American farmers were mechanizing their farms.  Allowing them to grow more food than ever before.  Agriculture prices fell.  At first this wasn’t a problem as there were export markets for their bumper crops.  Thanks to a war-devastated Europe.  But eventually the European soldiers returned to the farm.  And the Europeans didn’t need the American food anymore.  Even places tariffs on U.S. imports to their countries to help their farmers get back on their feet.  Add in a bad winter that killed livestock.  Some bad insect infestation in the summer.  Add all this together and you had the beginning of the great farm crisis.  Debt defaults.  Bank failures.  And the contraction of the money supply.  Which the Federal Reserve (the Fed) did not step in to compensate for by expanding the money supply.  Which was sort of their purpose for being in existence.  As there was less money to borrow business could longer borrow to continue their growth.  Because of the time factor in the stages of production to expand production required borrowing money.  To make matters worse the Fed was actually pulling more money out of circulation.  Because they looked at the rising stock prices and concluded that speculators were borrowing money to invest in the stock market.  Thus inflating stock prices.  But it wasn’t speculators running up those prices.  It was an economic boom that was running up those stock prices.  Until the government put a stop to that, at least.

Bad Government Policy didn’t Create the Roaring Twenties but Bad Government Policy ended Them

The Smoot-Hawley Tariff was close to becoming law in the fall of 1929.  It was moving through committees on its way to becoming law.  This tariff would raise the tax on all imports by about 30%.  The idea was to protect domestic supplies and manufacturers.  But even in 1929 it was a global economy.  A lot of imports entered the stages of production.  Which meant costs would be increasing throughout the stages of productions.  Greatly increasing the input costs of all those businesses enjoying those high stock prices.  Which would raise their prices (to cover those higher input costs).  Reducing their sales.  And slashing their profits.  Add this to the contracting money supply and it painted a very bleak picture for business.

With demand sure to fall due to a massive new tariff that was about to become law businesses cut back.  To get rid of what was about to become excess capacity.  For they were smart.  And understood what affected their businesses.  And you know who else were smart?  Investors.  Who looked at this tariff and saw a locomotive engineer about to slam on the brakes.  And if Congress passed this into law after 1928 Coolidge wasn’t going to be there to veto the law.  So they all came to the same conclusions.  The bull market was coming to an end.  And they wanted to sell their stock to lock in their stock gains.  Which caused the great sell-off of 1929.  And the stock market crash.  Starting the Great Depression.

People still debate the cause of the Great Depression.  A popular argument is that greedy investors caused it by speculating in the stock market.  Or that greedy businesses out-produced demand.  But the economics of the Roaring Twenties don’t support this.  This wasn’t people buying big houses because interest rates were low.  This was the electrification of America.  Cars.  Telephones.  Radio.  Movies.  Air travel.  This was broad and real economic growth.  Bad government policy didn’t create it.  But bad government policy ended them.  And it was the expectations of even worse government policies that yanked the rug out from underneath the economy.  By causing a business contraction and stock market sell-off.  Much like Obamacare is doing to businesses today.  Scaring the bejesus out of them.  For they have no idea what their future costs will be under Obamacare.  So they are doing their best to prepare for it.  By not expanding their businesses.  By not hiring anyone.  And sitting on their cash.  To prepare for the worst.  Much like businesses did in 1928.  Which explains why the Great Recession lingers on.

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Price Controls make Scarce things Scarcer

Posted by PITHOCRATES - October 23rd, 2011

Week in Review

If there’s anything that tells us not to take mainstream economists or the United Nations or the International Monetary Fund or other global organizations seriously it’s this (see Economists Call for Crop-Trading Limits to Curb Volatility by Alan Bjerga posted 10/10/2011 on Bloomberg Businessweek).

Hundreds of economists including scholars from Oxford University and the University of California, Berkeley, are asking the Group of 20 nations to impose limits on speculative positions in food commodities to curb volatility in crop prices…

Research sponsored by the United Nations, International Monetary Fund and other global organizations suggest speculation in crop futures by index funds and large banks may cause price spikes that can put grocery costs out of reach for poorer people. Global regulation of speculators has been a goal of French President Nicolas Sarkozy during his term as leader of the G-20 this year.

What’s the common thread in all these organizations?  They’re all Keynesian tax and spend big world government.  And, surprise, surprise, they want more control over the world’s economies.

Have we learned nothing from the Nixon’s price controls of the Seventies?  Price controls make scarce things scarcer.  Did rent control make more low-income housing available?  No.  Did price controls make gasoline more available?  No.  Why?  Because market prices match supply to demand.  And when you mess with the market price mechanism, you mess with supply and demand.  Resulting in shortages.  Such as low-income housing and gasoline during the Seventies.

Messing with prices doesn’t make scarce things less scarce.  So why do it?  Because that’s what Keynesian tax and spend big world government does.  It’s not about the economy.  It’s about power.  Their power.  And they want more.

The 2008 spike in gasoline prices is an example of this pricing mechanism.  The run up that peaked in July 2008 was due to a fall in OPEC production, not speculation (see Federal Reserve Bank of Dallas Clearly Explains Why Speculation Didn’t Drive Oil Prices in 2008 by Kay McDonald posted 10/14/2011 on big agriculture picture).  The high gas prices in 2008 just made sure that a scarce resource was available for those who really needed it.  People drove less over the summer.  Which made a scarce resource available for those who really needed it.  The result?  No gas shortages.  And no gas lines.  Like in the Seventies.

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Falling Oil Prices will lower Gas Prices, if the Fed stops Printing Money

Posted by PITHOCRATES - May 9th, 2011

Falling Oil Prices and you at the Gas Pump

Here’s something you don’t see every day.  Oil prices have fallen (see Special report: What really triggered oil’s greatest rout by Matthew Goldstein, Svea Herbst, Jennifer Ablan, Emma Farge, David Sheppard, Claire Milhench, Zaida Espana, Robert Campbell and Josh Schneyer posted 5/9/2011 on Reuters).

Never before had crude oil plummeted so deeply during the course of a day. At one point, prices were off by nearly $13 a barrel, dipping below $110 a barrel for the first time since March.

Apparently the speculators aren’t all that eager to buy and hold oil right now.  Something must have spooked them.  Because it’s May and the summer driving season is about to ramp up.  People driving around to enjoy their summers.  Some 3-day holiday weekends.  And a vacation or too.  Demand for oil should be up.  Not down.  So what happened?

A routine report on U.S. weekly claims for unemployment benefits spooked investors, showing the labor market in worse shape than expected. That fed a growing pessimism about the resilience of the global economy after industrial orders slumped in Germany and the massive U.S. and European service sectors slowed. Then the European Central Bank surprised with a more dovish statement on interest rates than expected, signaling its wariness about the euro zone outlook. The dollar rose sharply.

Oh.  So that’s what spooked them.  Recession.  Which is another name for continued high unemployment.  Looks like people will be taking more ‘staycations‘ this year.  Just like last year.  Which means people won’t be gassing up the family car for those long trips.  Instead of gas they’ll be buying more expensive groceries.  So the speculators don’t want to buy oil.  Demand for oil will drop.  And something with low demand has a low price.

A range of factors, both economic and political, were also at play. The recent rise in raw goods has been fueled in part by the U.S. Fed pumping cash into the markets by purchasing $600 billion in bonds. This program has pushed interest rates extraordinarily low, making borrowing essentially free once adjusted for inflation. Investors have been using the super-cheap money to buy into commodity markets. But the Fed’s program is slated to end on June 30.

The U.S. Fed in their infinite wisdom printed more money to entice business owners to expand business and hire more people.  Unfortunately, this also created inflation.  Made our money worth less.  And this raised prices.  So we bought less.  And if we’re buying less, businesses aren’t going to expand.  They’re going to contract.  To reflect the falling consumer demand.  So where did all that printed money go?  Wall Street.  Investors borrowed the money ‘for free’ and invested in commodities.  Which drove the prices up.  And oil is a commodity.  Now that the Fed is shutting off the ‘free money’ spigot, they’re not buying anymore.  They’re selling.  Hence the fall in oil prices.

China, the world’s fastest-growing consumer of commodities, also is tightening monetary policy to tamp growth rates and control inflation, raising the prospect of a slowdown in demand for oil.

And one of the big things that triggered the huge run up in oil prices back in 2008, an explosion of Chinese demand, is reversing itself.  They are trying to control inflation.  By slowing their economic growth.  And, of course, slower growth requires less energy.  And less gasoline for cars.

Put all of this together and it explains why oil prices are falling.  Which is typically what happens in a recession.

Recession and Tight Monetary Policy always lowers Gas Prices

The greatest factor in the cost of gasoline is the cost of oil.  Oil goes up and gas soon follows.  Oil goes down and gas follows.  Eventually (see Just say no to $5 gasoline by Myra P. Saefong posted 5/6/2011 on MarketWatch).

Despite Thursday’s drop, crude futures are still more than 9% higher, year to date. Crude oil makes up 68% of the price of gasoline at the pump, according to the EIA.

Overall weakness in the dollar is also to blame for rising gasoline prices. “The U.S. dollar has an inflationary impact on U.S. buyers, while also triggering increased buying in equities and commodities to stave off lost currency value,” said Telvent DTN’s Milne.

And there’s an “overlap” between refinery maintenance and a cluster of bad luck for Gulf Coast and Midwestern refineries, including electrical outages and storm-induced shutdowns, said Kloza. “This is the catalyst for the last leg [of the gasoline-price rise], which may take us to $4-$4.11, but also should soon stall.”

So we’re not going to see a corresponding fall in gasoline prices right away.  But it’s coming.

Still, gasoline prices may hold a $5 average in California, where a strict gasoline formula makes the state more susceptible to higher prices, and in New York, due to tax issues, he said.

Of course, there’s always concern over the start of the Atlantic hurricane season, which begins on June 1, given the potential for disruptions to oil production and refineries in the Gulf of Mexico.

Be grateful you don’t live in California or New York.  At least, when you’re buying gas.  The environmentalists have added about $1 a gallon to the price of gas in California.  And New York is just tax-happy.  Add that to the recent storm damage, heavy rains and Mississippi flooding, prices won’t be coming down anytime soon.  But they’ll be coming down.  Because they always do during a recession.  As long as the Fed stops printing money (which was President Carter‘s problem.  Prices stayed stubbornly high in the Seventies despite recession until Paul Volcker finally tightened monetary policy).

Drill Baby Drill

Supply and demand determines the price at the pump.  That’s why prices go up during the summer driving season.  And down when much of the world is shoveling snow.  Oil is the biggest factor in the price of gas (68%).  Therefore, the less oil on the market the higher gas prices go.  And the more oil on the market the lower gas prices go.  Simple supply and demand.  Which provides a very easy solution to bring gas prices down.  Drill, baby, drill.  The next best thing we could do to keep prices down is to increase refinery capacity.  The more capacities available to refine crude oil the less storm damage will affect the price at the pump.  Finally, roll back environmental regulations and cut taxes.  Californians could easily see a drop of a dollar a gallon.  Even with current oil production and refining capacities.

Energy policy can be very easy if only you can separate the politics from it.  But when your political base is defined by those politics, that ain’t going to happen.  So get use to high gas prices.  Because they’re being kept artificially high for political reasons.  And enjoy your staycation this year.  And next year.

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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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