Sound Money & Free Markets Will Spur Recovery
The primordial lesson of economic history is that sound money, low taxes on capital, and a regime of laissez-faire with respect to regulation and trade are the three necessary and sufficient conditions which guarantee long-run prosperity and economic growth. In the aftermath of the Federal Reserve’s orchestration of the Bear Stearns sale, this seminal truth is being forgotten.
Indeed, two new pieces of conventional wisdom have arisen in Washington: first, “everybody knows” that the U.S. faces its “most severe financial crisis since the Great Depression”. As a result of this, “everybody knows”, too, that the only way to avert disaster is through expansionary monetary and fiscal policies, along with increased federal regulation and intervention. The first assertion is debatable, but it is important for policymakers to understand that the latter is precisely opposite of what will engender sustainable recovery.
Casting aside where blame presently lies, the U.S. financial system certainly is challenged. Annualized foreclosure filings increased 75% last year to 1.3 million, while Economy.com estimates that 9 million homes are now negative in equity. Two million home-owners face mortgage re-sets this year, after an aggregate loss in U.S. home values approaching $3 trillion.
The above will impact the value of mortgage-backed debt, with losses and write-downs already totaling over $200 billion, and some estimates double that in 2008. Too many banks and brokerages are over-leveraged, and the ratio of risky assets to capital exceeds prudent levels at many firms (i.e., at year-end, Bear Stearns’ ratio of Level III [riskiest] assets to capital was 157%, and this was not the highest on Wall Street).
Does all this justify the unprecedented actions the Federal Reserve has taken, which have paved the path for new levels of government intervention? According to the most recent Flow of Funds Report of the Federal Reserve, U.S. household net worth was over $57 trillion at year-end 2007, and the total value of all real and financial assets in the U.S. stood at $185 trillion. Global equity market capitalization now stands at $60 trillion, while U.S. GDP is over $14 trillion. Given the dot-com collapse burst which cost U.S. equity-holders $7 trillion, sub-prime losses totaling 3-4% of GDP thus seem absorbable in this larger context. The underlying health and asset base of the U.S. economy also calls into question the “meltdown” scenario which, like Continental Illinois in 1984 and Long Term Capital Management in 1998, featured Fed and Treasury intervention as justified by an alleged “meltdown” possibility.
Additionally and importantly, credit market borrowing to all businesses is up, and bank lending of all types has increased by 8% since last August, when this sub-prime “crisis” fully emerged. The MZM money supply measure grew by $111 billion in March alone, and is now annualized at over 15% per year growth, so liquidity “seize-up” is not a problem, at least with respect to available funds. And while unemployment has increased to 5.1%, job losses are less prevalent than at the start of previous recessions, assuming we're in one now.
Regardless, panic has gripped Washington in three policy areas. First, beyond the $400 billion in new lending already committed by the Fed, the clamor for ever-easier money and lower interest rates, even to the point of monetization of commercial debt via the direct printing of banknotes, has reached consideration in respectable quarters. Second, given the rescue of “rich” Bear Stearns creditors, a comprehensive bail-out of mortgagors and various unemployment relief and assistance measures seems all but certain in concert with February’s $168 billion in “stimulus” spending. And finally, the whole sub-prime debacle has elicited calls for a new level of regulatory oversight across the financial services sector, because again, as “everybody knows” there was “not enough” oversight in the first place. The hapless U.S. tax-payer, already facing $270 billion in higher annual taxes scheduled for 2011, is now to be sacked as well with bills to pay for the mistakes of others, with higher inflation thrown in for good measure.
The moment has arrived for a return to clear thinking, which would evince the need for reversal of the current trajectory of policy response in these three areas:
(i). Monetary policy -- To generate economic recovery as rapidly as possible, the most important single policy requirement is the return of a strong dollar. Record lows for the dollar against the euro, along with $117 oil and $1000 gold confirm the Fed’s recent easy money policies begun back in 2001. Fed policy-makers, still ensnared by the framework of the Phillips curve trade-off between inflation or recession – a paradigm which has empirically been shown to be invalid for any but the shortest of timeframes – have pushed real short-term interest rates back into negative territory, and committed half the Fed’s balance sheet to new lending. Additionally the Fed is now prepared to “prop up” failing financial institutions, effectively monetizing bad debt, in the hope that liquidity will buy time for underwater firms to return to solvency.
This is an error which will have unfortunate consequences, perhaps as bad as the alleged “meltdown” which Fed experts seek to avoid. Sound money is indispensable to economic growth and sustainable prosperity – indeed, to civilization itself. The primary reason for this is straightforward: in a capital-using economy based on an extended division of labor, a medium of exchange is needed which minimizes instability in value due to the currency (“cash-induced” changes in value). In other words, shifts in value between traded goods will ideally be manifested in relative price changes which reflect only supply-and-demand (“goods-induced”) shifts, and not changes in the value of money (viz., due to inflation). Thus, in addition to maximizing the volume of trade and exchange, sound money permits investment and resources to flow to their “highest-valued uses”, according to the wishes of consumers, and avoids what Nobel economist Robert Lucas has called a “signal extraction problem” of price changes due not to supply-and-demand, but rather to false signals sent by increasing the quantity of money.
Inflation is pernicious precisely because it distorts these relative prices, causing resources to flow into investments which are not based on real demand, and thus leads to a job-destroying correction to clear inventories and re-allocate capital which was previously invested in error. Inflationary booms, in other words, carry the seed of their own busts, spreading misery and hardship in the ensuing correction. Additionally, inflation is of course an attack on real property: it hurts creditors at the expense of debtors who repay obligations in dollars with less purchasing power; impoverishes pensioners living on fixed income; and, transfers wealth from private sector taxpayers to government via what is a de facto hidden tax.
All of this leads to one final harmful effect: capital decumulation. Over time, inflation both reorients investor and consumer horizons toward the short term, and impedes entrepreneurial calculation of current and prospective profits and losses, thus inhibiting long-horizon capital investment. This of course has been manifestly demonstrated in the great hyperinflations of the past (e.g., Germany in 1923), which destroyed not only capital, but ultimately civil society.
Thus, the Fed’s argument that current inflationary policies are needed to promote employment, increase exports, and provide cheap credit now to shore up weak balance sheets is, while well-intentioned, devoid of a view to the long term. The choice is not between recession or inflation, with the intent to raise rates later, but rather between a short (and perhaps sharp) correction now, in which assets would be re-priced and balance sheets recapitalized to prudent levels of equity, and a 1970’s style era of malaise later, which may ultimately last for years.
(ii). Fiscal policy -- Senator Christopher Dodd (D-Connecticut) and Congressman Barney Frank (D-Massachusetts) are pushing legislation to provide up to $300 billion in assistance to mortgagors and housing investors, along with assorted relief for unemployed workers caught in the downturn. Again, while perhaps well-intentioned, these measures do little good. Up to one-third of underwater mortgages are presently held by speculators who do not even occupy the properties; rewarding them makes little sense. Many other home-buyers made poor decisions and will never be able to afford mortgages given their income, so payment assistance now merely delays the ultimate sale and re-pricing which needs to occur. To say this directly, many current home-owners should be renters. Ultimately, beyond the obvious moral hazard problem, such a housing bail-out will only add to federal deficits; the latter pulling capital from the private sector in favor of immediate government consumption.
Additionally, the U.S. economy is facing a massive tax increase in 2011 due to prior legislation, and now has the second highest corporate tax structure in the developed world. Democrats running for President are also uniform in their intent to raise capital gains and payroll taxes. Markets have surely factored in this portentous fiscal policy mix at the present time – none of this is helpful to economic prosperity.
(iii). Regulatory and trade policy -- Both Congress and the Administration are now deep into analysis of new regulations for U.S. financial markets and institutions, the implication being that lack of regulation has caused the present mess. This is an obfuscatory absurdity. Economist James Buchanan won a Nobel Prize by outlining the myriad examples and harmful effects of government failure, including errant regulation or bureaucratic ineptitude due to either lack of information or proper incentives. Recent events have only confirmed his insight.
The Federal Reserve’s stop-go monetary policy moves have fathered numerous boom-and-bust cycles, and induced severe recessions, from 1929 to the present. The Office of Federal Housing Enterprise Oversight (OFHEO), which is mandated to govern Fannie Mae and Freddie Mac, had 250 regulators who collectively missed Enron-era irregularities and accounting malfeasance, and up to the present moment has erred in allowing $200 billion in additional leverage on the balance sheets of the housing giants, when equitization of their capital structures is urgently needed. Many other examples could be cited from, say, the Federal Home Loan Bank Board (of S&L crisis fame), SEC, OCC, or the moral hazard-challenged FDIC, but the point is that heavier regulation of finance is hardly a panacea, and more than likely counterproductive. Regulatory burdens also send jobs and capital to other shores, ceteris paribus.
Finally, international free trade promotion may well slow, as again, political interests dominate sound economics, imperiling free trade agreements with countries such as Colombia and South Korea. The economic effects of stultifying the intensification of the international division of labor and specialization are well-known, and usually render both parties poorer than otherwise. For example, Caterpillar Inc. sells more heavy bull-dozers to Colombian coal mines than any other country in the world, but without the trade agreement, will continue to face a price disadvantage against the Japanese maker Komatsu. Colombians pay for equipment not to their maximal satisfaction, and union jobs are lost in Illinois, thanks to Congress. All of this is unhelpful in a period of looming recession.
In sum, U.S. monetary, fiscal, trade, and regulatory policies are all headed in the wrong direction given the current situation, and together may create the very economic disaster the political class in Washington says it seeks to avoid. The Fed has unleashed the twin furies of moral hazard and inflation, both of which will deliver blows in the period ahead. Congress and the Administration, meanwhile, have shown ineptitude, or at least tone-deafness, by advancing policies inimical to economic growth in the long run. In a time of significant challenge for U.S. firms and taxpayers – challenge which, by the way, the Fed and the political class themselves foisted upon the American people – a new direction is sorely needed on all policy fronts. Alas, the last member of the political class who fully understood the interconnection between these policy areas, and why they were, collectively, conditions both necessary and sufficient for economic growth, is long gone. He left Washington more than 19 years ago, flying home to California.
John L. Chapman is an NRI Fellow in Economics at the American Enterprise Institute.