Friday, June 21, 2013

The Multiple Roots of Our Misery

As Director of the Office of Management and Budget (OMB) from January 1981 to August 1985, David Stockman learned first-hand the workings of the federal government at the highest levels. Educated at Harvard, his firm belief was that free market capitalism will create more prosperity for the population than “crony capitalism” - the latter being a system in which markets are nudged by the government into various patterns, rather than allowing patterns to emerge organically as free individuals make decisions about buying and selling.

In addition to favoring free markets over regulated markets, Stockman also understood that in order to get the full benefit of tax cuts, such cuts must be accompanied by roughly corresponding cuts in the federal budget. When the Reagan administration opted to take tax cuts despite congressional unwillingness to make any spending cuts, Stockman declared that the “Reagan Revolution” had failed. Only when taxes and federal spending are simultaneously reduced can a country hope to make progress against both debt and deficit. Stockman saw that clear economic prescriptions were corrupted by the political process. Disillusioned, he resigned from the OMB and never returned to politics.

From his private-sector perch, he continues to offer explanations about economic events, illuminated always by the distinction between free markets on the one side, and crony capitalism on the other side.

It requires a great deal of self-discipline for a government to oversee a truly free market: the temptation to intervene is omnipresent. While it may seem catastrophic for one or more large enterprises to fail, and seem negligent for a government to stand back and allow large businesses to go bankrupt, such events are necessary, and in the long run beneficial, to the national economy.

The specter of factories closing, workers being laid off, and large unemployment numbers appearing in reports can instill fear in the stoutest hearts. But oftentimes, enduring such short-term pain paves the way for long-term gain. Enduring a few months of unemployment often leads workers to new jobs at even higher wages, if they are working in a truly free market.

Sadly, most elected political leaders - Democrat or Republican, liberal or conservative - do not have the stomach to stand back and simply let major industries collapse. Although this crash would pave the way for an economic boom, the temptation is to intervene. Stockman writes:

By the time of the September 2008 crisis, however, these long-standing rules of free market capitalism had undergone fateful erosion: traditional rules of market discipline had been steadily superseded by the doctrine of Too Big To Fail (TBTF). The latter arose, in turn, from the notion that the threat of “systemic risk” and a cascading contagion of losses from the failure of any big Wall Street institution would be so calamitous that it warranted an exemption from free market discipline.

While a political leader can sound very confident as he labels this or that concern as “too big to fail,” there is in fact no theoretical construct which clearly defines such a category of businesses. In fact, some theoretical models of free markets predict that every firm will eventually fail, and that such a failure is not only a necessary part of the business cycle, but it is a beneficial part of the cycle - such failures create the next round of opportunities.

But there was no proof of this novel doctrine whatsoever. It implied that capitalism was actually a self-destroying doomsday machine which would first foster giant institutions with wide-ranging linkages, but would then become vulnerable to catastrophe owing to the one thing that happens to every enterprise on the free market - they eventually fail.

Even if one were to grant, for argument’s sake, the TBTF hypothesis, then one would expect, as a logical consequence, that governments would simply regulate the economy so that no corporation ever grew so large that it was TBTF. While wrong-headed, that would at least be internally consistent from a theoretical point of view. But instead, the nation’s central bank chose to simply tinker with the market place.

In fact, if TBTF implied an eventual catastrophe for the system, there was an obvious solution: a “safe” size limit for banks needed to be determined, and then followed by a 1930s-style Glass-Steagall event in which banking institutions exceeding the limit would be required to be broken up or to make conforming divestitures. Yet while the TBTF debate had gone on for the better part of two decades, this obvious “too big to exist” solution was never seriously put on the table, and for a decisive reason: the nation’s central bank during the Greenspan era had become the sponsor and patron of the TBTF doctrine.

President Ronald Reagan had appointed both David Stockman to the OMB and Alan Greenspan as Chairman of the Federal Reserve. While Stockman remained true to his economic training and worked for truly unregulated markets and for spending reductions to match tax cuts, until he resigned after seeing “the triumph of politics” over rational economics, Alan Greenspan, on the other hand, seemed to shed his free market ideology upon taking office. Whether Greenspan was truly a die-hard laissez-faire advocate, or whether Reagan merely mistakenly thought he was one, is open to debate. Reagan thought that, in appointing Stockman and Greenspan, he was appointing two ideological soulmates; that hope was quickly shattered, as was the hope that Congress would see the wisdom in cutting spending as it cut taxes. When Congress refused to cut spending, Reagan took the tax cuts as a political compromise. In politics, one can take “half a deal” as a compromise; but in economics, one cannot take half an equation and get half the results.

This was an astonishing development because it meant that Alan Greenspan, former Ayn Rand disciple and advocate of pure free market capitalism, had gone native upon ascending to the second most powerful job in Washington. In fact, within five months of Greenspan’s appointment by Ronald Reagan, who had mistakenly thought Greenspan was a hard-money gold standard advocate, the Fed panicked after the stock market crash in October 1987 and flooded Wall Street with money.

Abandoning the basis of the free market, Greenspan saw his objective as the stabilization and maintenance of certain market levels. This was one of many steps which led the nation toward economic disaster.

For the first time in its history, therefore, the Fed embraced the level of the S&P 500 as an objective monetary policy. Worst still, as the massive Greenspan stock market bubble gathered force during the 1990s it had gone even further, embracing the dangerous notion that the central bank could spur economic growth through the “wealth effect” of rising stock prices.

Greenspan found justification in the writings of Milton Friedman. Friedman, a Nobel Prize winner in economics, while propounding an orthodox version of the free market, introduced another error. Friedman endorsed the notion of floating exchange rates for currencies, even after President Richard Nixon cut the final loose connections between the US dollar and the price of gold. Friedman’s vision of floating exchange rates paved the way, perhaps unwittingly, for an entire industry of currency speculation. The worst effects of that industry would take decades to emerge after Nixon’s disastrous 1971 decision.

It thus happened that Leo Melamed, a small-time pork-belly (i.e., bacon) trader who kept his modest office near the Chicago Mercantile Exchange trading floor stocked with generous supplies of Tums and Camels, found his opening and hired Professor Friedman. Even as several dozen traders at the Merc labored in obscurity to ping-pong a thousand or so futures contracts per day covering eggs, onions, shrimp, cattle and pork bellies, Melamed was busy plotting the launch of new futures contracts in the major currencies. In so doing, he inadvertently demonstrated how radically unprepared the financial world had been for the Friedmanite coup at Camp David.

The Chicago Mercantile Exchange - known simply as the ‘Merc’ - is an institution which facilitates the trading of futures and options, two types of financial instrument. A “future” is a contract to buy or sell a given quantity of a given commodity at a given price at some specified future time. For example, we can write a “future” to sell one ton of steel for $50 three months from now, or to buy one ton of wheat for $75 two months from now. Originally designed for industries which used these commodities, they eventually began to be used for pure speculation. An “option” is a document which gives its owner the right to buy or sell a quantity of a commodity at a given price at a specified future time, but does not oblige him to do so. The trading of futures and options requires complex calculation, involves great risk, but can yield great profits. Traditionally, the commodities involved were wheat, steel, copper, cotton, corn, beef, pork bellies, and a few other agricultural and mining products. Now, that would change. Because of floating exchange rates for major world currencies, and finally because of floating exchange rates for the US dollar, futures and options would be traded, not for wheat or steel, but for currencies. This would change the world’s exchange dynamic in ways which were unpredictable and which took years to manifest themselves.

Leo Melamed was the genius founder of the financial futures market and presided over its explosive growth on the Chicago “Merc” during the last three decades of the twentieth century. He understandably ended up exceedingly wealthy for his troubles, but on Friday afternoon of August 13, 1971, it would not have been evident to most observers that either of these outcomes was in the cards.

While the speculative trading of currencies was quietly starting - the world didn’t seem to notice at the time - other harmful changes to the nation’s economy were underway. Greenspan managed interest rates and managed the money supply with an eye to keeping equities markets at certain levels.

This should have been a shocking wake-up call to friends of the free market. It implied that the state could create prosperity by tricking the people into thinking they were wealthier, thereby inducing them to borrow and consume more. Indeed, the Greenspan “wealth effects” doctrine was just a gussied-up version of Keynesian stimulus, only targeted at the prosperous classes rather than the government’s client classes. Yet it went largely unheralded because Greenspan claimed to be prudently managing the nation’s monetary system in a manner consistent with the profoundly erroneous floating-rate money doctrines of Milton Friedman.

Allegedly different from each other, both President George W. Bush and President Barack Hussein Obama would find themselves in the financial turmoil of 2008, more than 25 years after Nixon’s currency rate decision, and both would seek advice from Greenspan’s successor, Ben Bernancke, who insisted on comparing the situation in 2008 to the situation in 1929.

The great contraction of 1929-1933 was rooted in the bubble of debt and financial speculation that built up in the years before October 1929, not from mistakes made by the Fed after the bubble collapsed. In the fall of 2008, the American economy was facing a different boom-and-bust cycle, but its central bank was now led by an academic zealot who had gotten cause and effect upside-down.

If the situation in 2008 was misdiagnosed, inasmuch as Bernancke saw it as parallel to 1929, then the misdiagnosis led to incorrect prescriptions.

The panic that gripped officialdom in September 2008, therefore, did not arise from a clear-eyed assessment of the facts on the ground. Instead, it was heavily colored and charged by Bernancke’s erroneous take on a historical episode that bore almost no relationship to the current reality.

The prescription for the problems of 2008 were not appropriate for that situation, or indeed for any situation. They helped not at all, but rather created two additional problems: further distortion of the market’s natural trend, and further undermining of currency’s credibility. Yet these bad prescriptions were delicious to those business leaders who did not want to operate in a free market. Cronyism had a heyday. Instead of exposing all businesses to the hurricane of market fluctuations and seeing which of them could weather the storm, markets were warped to create safe havens for those businesses which abandoned their laissez-faire ethics and would sell their honor for a government handout.

Nevertheless, the bailouts hemorrhaged into a multitrillion-dollar assault on the rules of sound money and free market capitalism. Moreover, once the feeding frenzy was catalyzed by these errors of doctrine, it was thereafter fueled by the overwhelming political muscle of the financial institutions which benefitted from it.

From Stockman’s viewpoint, 2008 was 1985 all over again. Theoretical purity was negotiated away to political pragmatism. Such damage, once done, is not quickly or easily undone.

These developments gave rise to a great irony. Milton Friedman had been the foremost modern apostle of free market capitalism, but now a misguided disciple of his great monetary error had unleashed statist forces which would devour it. Indeed, by the end of 2008 it could no longer be gainsaid. During a few short weeks in September and October, American political democracy had been fatally corrupted by a resounding display of expediency and raw power in Washington. Every rule of free markets was suspended and any regard for the deliberative requirements of democracy was cast to the winds.

In David Stockman’s view, then, a series of bad decisions led to the nation’s economic decline: Nixon’s free floating currency, the Fed attempting to manage the stock markets via interest rates, speculation on currency exchange rates, Congress’s refusal to cut spending, and more. The lingering question remains: can it be undone?