The title of this essay refers to the medieval practice of drawing dragons, sea monsters or other mythological creatures on the blank areas of maps. These were areas about which the cartographer knew little or nothing and were therefore considered dangerous. Don’t go here! Here be dragons! Of course there weren’t actually dragons; the warning reflected a fear of the unknown. In the debate about how we should proceed to improve the performance of our economy, similar fears prevent us from pursuing logical policies outside the canon of accepted Keynesian dogma. Many of the policies enacted in response to the economic crisis were intended to do nothing more than prevent the economy from entering areas that have been deemed dangerous by economists, politicians and bankers with a vested interest in keeping the public in the dark about what actually happens if we enter those allegedly perilous areas. Ironically, the known areas of the economic map have been proven dangerous while we are forced to take the word of known liars (that would be the aforementioned politicians and bankers) and failed soothsayers (the economists) concerning the relative danger of exiting the temporal Keynesian edifice and entering the areas allegedly inhabited by free market dragons.
The problem facing the US economy is the same today as it was when the financial crisis started. The problem is quite simply that we have accumulated more debt than our incomes can service. The excessive debt is primarily concentrated among individuals and financial institutions but government policy over the last two years has shifted a significant portion to the balance sheet of the government. What policy has not done is reduce the amount of debt relative to the size of our income. From TARP to the stimulus bill to cash for clunkers to the home buyers tax credit, economic policy, if one can be so generous as to call it that, has been an attempt to restore aggregate demand to the status quo ante. The idea that we can solve our economic problems by convincing people to once again consume more than they produce is absurd on its face. If the economy is suffering from too much debt, the logical solution is to reduce the debt and the sooner the better. Restructuring the debt at the private level – where it was accumulated – is the proper and moral course. Using the force of government to take from the prudent to pay for the mistakes of the imprudent is not only morally suspect but perpetuates and exacerbates the problem.
The excessive debt that plagues the US economy did not just happen recently. It has taken several decades of bad policy – primarily bad monetary policy – to reach this point. It isn’t George W. Bush’s fault and it isn’t President Obama’s fault. It also isn’t Ronald Reagan, George H. W. Bush or Bill Clinton’s fault. It can’t be blamed on Jimmy Carter (although plenty of other things can) or Gerald Ford or even Richard Nixon. These politicians – not one an economist – were victims of bad policy advice. The blame is properly placed on a series of economists; a long and distinguished list that runs from John Maynard Keynes to Milton Friedman and encompasses many others along the way. The blame should also be apportioned to a series of Fed Chairmen from Arthur Burns to Paul Volcker, Alan Greenspan and Ben Bernanke. It is their hubris, what Hayek called their pretense of knowledge, that has brought us to this ignoble end.
These well intentioned – well most of them anyway – economists and politicians spent decades attempting and at times appearing to succeed at manipulating aggregate demand in such a way as to maintain nearly constant high levels of employment. These practitioners of political economy believed they had achieved a level of knowledge that allowed them to prescribe crude manipulations of monetary and fiscal policy to coordinate all the myriad factors that make up a modern economy and produce high employment and low inflation. They further believed that they could identify in advance and simply proscribe any detrimental activities or effects that result from their policies. This pseudo-scientific approach to economics uses highly complex models of the economy and some equally complex math to provide an illusion of control over events for which we cannot even identify all the potential variables. As complex and detailed as the models appear to be, they still take into account only a fraction of the real variables that effect the modern economy. Even if we could identify all the factors that affect economic output, inflation and employment, many of them are qualitative in nature and therefore not measurable in a precise manner. How does one model uncertainty or confidence or Keynes mythical “animal spirits”?
The recently passed financial regulatory reform bill ignores root causes and instead attempts to control the consequences of bad monetary and fiscal policy. Our current state of high unemployment is a result of past efforts to micromanage the economy. These efforts to dampen the business cycle – which is itself a byproduct of the monetary distortions of the Fed – the most recent of which entailed the extended period of low interest rates coupled with tax rate cuts and an explicit weak dollar policy in the early part of this decade, result in a misallocation of resources which makes high unemployment inevitable. It is impossible to ignore the large quantity of vacant houses and commercial real estate around the country that is evidence of the poor allocation of capital during the inflationary period. The employment of workers in the construction and real estate related industries was only sustainable as long as the monetary distortions persisted. Until the Fed ended the inflation, workers and policymakers were free to believe the previous distribution of employment was desirable and sustainable. The current period of high unemployment is the inevitable adjustment required to re-employ all those who were previously employed in the artificially inflated real estate related industries. Unemployment has remained high because recent policies such as the home buyers tax credit attempt to restore the previous distribution of employment, that has already proved unsustainable, rather than allowing an adjustment to a new distribution based on market forces.
The debt built up in the economy over the last few decades is a consequence of the periodic inflations during that time. Starting in 1971 when the US left the Bretton Woods currency system and severed the last link of the dollar to gold, inflation has been the primary tool to expand aggregate demand in times of recession. One side effect of these periods of inflation is the accumulation of debt that culminated in the crisis of 2008. Inflation favors debtors over creditors so it is not only predictable but rational for individuals, corporations and governments to take on more debt – as long as the inflation persists. All of the problems the regulatory reform bill is intended to address are actually just symptoms of decades of periodic inflation. The growth of the finance sector and the resulting too big to fail banks could not have happened without inflation. The excessive leverage and risk taking by the brokerage firms and banks was a direct result of the moral hazard created by the policy of inflating in response to any “crisis”. From the Mexican debt crisis in the early 80s to the S&L mess to the LTCM debacle to the Asian contagion to the dot com bust to the housing crash every dip in aggregate demand has been met with another dose of inflation and credit creation by the Federal Reserve. What we are experiencing now is the end of this cycle of repeated inflations as the most recent one has -so far – failed to trigger the expected expansion of credit and recovery of aggregate demand.
The growth of the derivatives industry that so many fear and that the reform bill allegedly addresses is one of the major consequences of using an inaccurate price index measure of inflation to set monetary policy while allowing the more important monetary factor – the value of the dollar – to be controlled by political forces. The large quantity of outstanding derivatives contracts is a consequence of the increased volatility of the dollar and the subsequent volatility of commodities and financial asset prices. Companies faced with volatility in variables outside their area of expertise must hedge those risks or tempt failure. Derivatives are the most efficient use of capital to accomplish this vital task made necessary by the policies of the Federal Reserve and the Treasury Department. Companies would naturally reduce the use of derivatives if the value of the dollar – and therefore commodities and interest rates – was more stable.
Increased speculation and reduced savings (and the trade deficits that are the flip side of a low savings rate) are also a consequence of volatile monetary policy. When the monetary authorities periodically and unexpectedly change the value of money it punishes individuals who attempt to accumulate cash or near cash savings. Those who in the past depended on saving to fund their retirement are forced by the Fed’s practice of suppressing interest rates for the benefit of the financial sector to pursue returns in more risky financial markets. It should also be noted that this often requires individuals to employ intermediaries to effect these more complex investment strategies. Many have discovered recently that a poor choice of intermediary can have devastating consequences. Congress now seeks to create a regulatory regime to protect investors from these intermediaries who are only necessary because of the policies of the Federal Reserve.
Real economic growth requires a stable monetary environment, low taxes, adherence to the rule of law and minimal government intervention. It is previous government intervention that makes more government intervention appear necessary and desirable. The government bailouts over the course of the current crisis – by both the Bush and Obama administrations – were taken for the benefit of the managers, shareholders and bondholders of the major financial institutions. Policies intended to prop up the housing market and badly managed auto makers were wastes of precious capital that could have been used to fund more productive activities. So called systemic risk, where failure of one or several large institutions results in a failure of the entire system, suffers from the same lack of evidence that plagues those who believe in dragons. It is the beneficiaries of taxpayer funded political largesse who were the real cause of the crisis by issuing false warnings about the consequences of wandering into the areas of the financial map labeled, “Here be dragons”.
Unfortunately, I see little reason to believe that real economic or monetary reform is on the horizon. The recent reforms labeled as comprehensive would not have even prevented the last crisis much less the next one. It was a political exercise designed to allow politicians to claim the mantle of reform and lobbyists to further entrench the policies that protect their clients from the vagaries of the marketplace. The Fed is a powerful political institution that will always have the support of a Congress that benefits from its flexible policies. Even Ron Paul’s popular bill to audit the activities of the supposedly independent Fed was eventually defeated. One cannot help but marvel at their ability to gain power through the Finreg reform when they are potentially more culpable for the crisis than any other government agency. Only in government does complete failure lead to increased responsibilities.
Recently there has been a great deal of uncertainty concerning the health of the developed economies of the world, particularly the US. The fear of a new recession has manifested itself in various markets. Treasury yields have fallen, TIPS spreads have narrowed indicating reduced inflation expectations, commodity prices, with the exception of gold, have fallen and stock prices, despite relatively low valuations and good earnings, have corrected over 10% from their recent highs. It should not be surprising, but apparently is, that these fears started to increase at the same time the Federal Reserve ended its experiment in quantitative easing, i.e. inflation. Inflation distorts perception of the economic landscape as surely as a fun house mirror. When the mirror is broken, what remains is the real condition of the economy. What we discovered after the financial crisis of 2008 is that we didn’t much like the real state of things. The Fed was able to prop up the mirror for a while by purchasing huge quantities of poorly collateralized debt but now we are back to reality and again, we don’t much like it. And neither does the Fed. Here’s what Bernanke had to say in his testimony before Congress last week:
We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.
What possible policy action could the Fed take? The only variable over which they have control is money supply so whatever Bernanke might want to do – cut corporate taxes for instance – his lone, real policy option is inflation. How exactly a renewed effort at inflation affects the markets will depend on the timing and the specific actions the Fed takes but what we do know is that it will result in a another misallocation of capital. It is quite possible that the new misallocation will restore, at least for a while, the illusion of growth. More importantly for the economists, politicians and bankers we will remain on the known parts of the economic landscape while true recovery lies just out of reach beyond the warning signs. What the US economy needs right now are leaders willing to boldly plot a new course through dragon territory. Unfortunately, our monetary sorcerers shake in their boots at the mythical dangers of the free market dragons while blithely ignoring the very real dangers on the safe path of conventional wisdom where the real dragons hide in plain sight.
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