Archive for January, 2010

Hugo Chavez: Harbinger of Failure for the United States Progressive Movement

January 31, 2010

In previous columns, I have raised concerns about the economic damage imposed by progressive politics on the once widely respected United States economy.  This column clearly identifies the predictable end-point of  such progressive politics in the nightmare form of the failed economy and brutal liberal fascism of Venezuela under the presidency of  Hugo Chavez.

Hugo Chavez was elected President of Venezuela in 1998 with a successful campaign that promised to help the country’s impoverished majority.  He was re-elected in 2000, and again in 2006.  In February 2009, he won a referendum to eliminate term limits on the presidency.  Although a controversial figure –  identified by the administration of George W. Bush, for example, as a threat to democracy in Latin America – Chavez is highly regarded within the international progressive movement.  In 2005 and 2006, he was named one of  the left-leaning Time magazine’s 100 most influential people.  As a man of limited education, he has been awarded honorary doctorates by universities in South Korea, the Dominican Republic, Brazil, Russia, and China.  In a list compiled by the left-leaning  magazine New Statesman Chavez was voted eleventh in the list of  “Heroes of our Time”.

So let us scrutinize the manner in which Chavez has earned his high standing within the progressive movement, the nature of the economy that he has transformed during a decade of populist arbitrary rule. The recently published Index of Economic Freedom for 2010 provides information directly relevant to this inquiry.

In 2010, Venezuela is ranked 174th out of 179 nations in terms of the index of economic freedom.  With an overall score of 37.1 on a scale of 100 (maximum economic  freedom) to 0 (minimum economic freedom) Venezuela is categorized as a repressed state.  Venezuela is ranked 28th out of 29 countries in the South and Central America/Caribbean region.  Its economic freedom score has deteriorated throughout Chavez’s rule, declining by 2.8 points during 2009.  Despite its oil wealth, Venezuela has a per capita income of only $12,804.

The authors of the Index characterize Venezuela as follows:

“Heading a government that has abandoned all but the trimmings of democracy, President Hugo  Chavez has positioned himself as the leader of Latin America’s anti-free market forces and sought allies in China and Russia, as well as Iran and other rogue states.  He has hobbled opponents, undermined speech and property rights, pursued a military buildup, and imposed foreign exchange controls….Venezuela has Latin America’s highest inflation rate.”

Most startling of all the specific freedom indices for Venezuela is the zero awarded to property rights protection. The authors note that the judiciary is completely controlled by the executive, that politically inconvenient contracts are abrogated, and that the legal system discriminates against or in favor of investors from certain foreign countries.  A close second in the dismal rankings is the  index of 5 allocated to investment freedom.  The authors note that investment laws and bureaucracy are non-transparent and burdensome, that the legal system is corrupt, and that government expropriation of key assets – in the cement, dairy, steel, and banking industries – is increasing. 

Other very low valuations are the scores of 19 for freedom from corruption, with Venezuela ranking 158th out of 179 countries in Transparency International‘s Corruption Perceptions Index, and of 20 for financial freedom, with Venezuela’s financial system subject to growing government control and nationalization.  Capital markets are small and subject to pervasive government interventions.

The Index of Economic Freedom does not focus attention on the erosion of civil liberties under the Chavez presidency.  Private radio and television outlets have been shut down and replaced with state networks.  Political opposition has been brutally suppressed, with protesters beaten by National Guard soldiers wielding metal chains. Rumors abound that the Venezuelan military is being placed under the control of Cuban officers  as the reign of terror advances. The recent resignation of the Venezuelan Defense Minister and Vice President, Ramon Carrizales is associated with this Cuban takeover.

Ironically, the immediate cause of fermenting protest in Venezuela is a sequence of rolling power blackouts instituted by the government in January 2010 in response to an electricity shortage.  Underlining this collapse is the fact that Hugo Chavez is running out of  foreign exchange because oil production is falling.  In 1998, the privately-owned oil companies pumped 3.3 million barrels a day. In 2010, the nationalized oil industry pumps only 2.4 million barrels a day – and that is an optimistic government estimate.  Venezuela is not running short of crude.  Having expelled or seized the assets of foreign companies capable of maintaining rhe country’s fields, and firing thousands of skilled employees of the state oil company PdVSA because he did not like their politics, Chavez is now reaping the economic rewards of  liberal fascism.

Be aware, my fellow Americans of the future that awaits the United States,  if progressive populism really takes hold and destroys the cherished economic freedoms that we currently still enjoy.

The Chrysler Bankruptcy and the Rule of Law

January 30, 2010

“Did these transactions comply with the rule of law?  Were the property rights of the secured creditors fully protected in the expedited proceedings?  Will the process bring confidence to the credit markets?  No, no and no again.”

Richard A. Epstein, “Political Bankruptcies: How Chrysler and GM Have Changed the Rules of the Game”, The Freeman December 2009.

Richard Epstein (University of Chicago), in my judgment, is the foremost legal scholar in the United States, with a deep understanding of law and economics as well as constitutional law.  In a better world, he would be serving as  Chief Justice of the United States  Supreme Court.  I draw upon his insights in this column.

By March 2009, Chrysler was bankrupt. Its liabilities, including commitments to its pension and healthcare plans vastly exceeded the value of its assets.  There was no hope for a market recovery in the absence of bankruptcy proceedings. The Treasury had already thrown the Corporation a  TARP lifeline of $4 billion to keep it afloat. This had proved to be  taxpayer money casually  flushed down the UAW  toilet.

So the Obama administration determined that political bankruptcy was the solution.  The President had relied heavily on union support in his election campaign. A priority goal, therefore, was to preserve the UAW retiree benefits while cutting down on the dealership contracts and haircutting the secured bondholder creditors. This could not be achieved under normal bankruptcy rules.  So the rules would have to go.

There are three basic bankruptcy options: liquidation, reorganization, and sale.  A government expert witness testified that Chrysler was worth $800 million if liquidated, but could be worth as much as $2 billion if sold off intact to another firm.  Under bankruptcy law, the proceeds of that sale would be distributed according to a strict priority by claim type.  Secured creditors, including the bondholders, come ahead of unsecured creditors, including union health and retirement funds.  In the absence of a breach of the rule of law, $2 billion would leave the secured creditors a little under 30 cents on the dollar for their $6.5 billion in aggregate claims, and would wipe out all future contributions to the union retiree funds.  That was just not going to happen on President Obama’s watch.

To boost the UAW coffers,  Chrysler clearly had to be sold under very special conditions engineered by the government.  The UAW, but not the bondholders, was given a seat at the table to determine the conditions of sale.  One condition was to assume the liabilities needed to fund union health funds at sums in excess of the stated asset values of the corporation. The parties to the deal created Chrysler VEBA – the UAW Voluntary Employment Benefit Association – which received a 55 per cent equity in the New Chrysler Corporation, plus a $4.587 billion unsecured note from that company. New Chrysler was not asked to assume any liabilities for the dealers , nor would it assume liability for unsecured tort creditors (persons injured by Chrysler products).

With this reorganization in hand, the Treasury advanced a bid in the sum of $2 billion, a bid that it proudly announced to be the only bid for the company. Of course, the bid was rigged. The government was bidding $2 billion for a company that had a net worth of minus $4.2 billion.  Once the government paid off $2 billion to the secured creditors, it immediately “invested” in an “unrelated transaction” an additional $6.2 billion to keep New Chrysler afloat.  In so doing, it effectively moved the UAW into preferred creditor status over the bondholders who legally stood before it in the queue.

The crucial issue was whether the US courts would uphold such an illegal maneuver, or whether they would confront a new and popular administration,  and uphold the rule of law.  The bankruptcy court, under intense political pressure, buckled, refused to set the sale aside and to order a new sale of assets absent any prior deals.  A large majority of the secured bondholders – some 99 per cent – approved a transaction that subordinated their financial interests to unsecured creditors.  Prominent among these secured creditors, who sacrificed their bondholder interests,  were JP Morgan Chase, Citigroup, Goldman Sachs, and Morgan Stanley.  Hello! Were these not major recipients of TARP funding,  errant financial institutions now completely in the pocket of the US  Treasury.

One brave creditor withstood political pressure and appealed the judgment of the bankruptcy court.  The Indiana Police Pension Fund, with a 1 per cent interest in Chrysler’s secured debt, challenged the decision. Ultimately, two district courts and the Second Circuit Court of Appeals denied its appeal, on the ground that no taxpayer ever has standing to challenge a transaction that affects all taxpayers.

So President Obama was able to pay off,  through the taxpayer,  a significant political debt to Big Labor, while signaling to all secured bondholders in the United States that they had better watch their wallets whenever Big Government assumes a stake in a distressed company.

In the event, the US  government assigned to an Italian automobile company, Fiat, a significant stock share in New Chrysler – between 20 and 35 per cent depending on achieving specified market milestones – in exchange not for cash, but for access to small-car technology and some international markets.  Fiat is no market-leader  as an automobile company, and those milestones are unlikely to be achieved. 

So much for the rule of law, when  the  US government becomes  involved. The rule of law, remember, requires that all individuals in society, including those who govern, are subject to the same laws.  Alas!  We live under the rule of men, not under  the rule of law, despite lip-service to that latter principle.

Ben is Back! This is No Halloween Horror Movie

January 29, 2010

On Thursday January 28, 2010,  the Senate of the United States confirmed Ben Bernanke into a second term as Chairman of the Federal Reserve.  By a vote of 77:23 Senators voted to terminate a block on his reappointment, allowing Harry Reid to bring the re-appointment to a vote.  By a vote of 70:30, the Senate voted in favor of reappointment. The vote was not along party lines.  Democrats and Republicans are to be found on both sides of the confirmation vote. 

Ultimately, the Democrats split 48 to 12 in favor of Bernanke, with 6 Democrats who are up for re-election in November 2010 voting no.  The Republicans split 22 to 18 in favor, allowing an unaccustomed aroma  of bipartizanship to float through the Senate, perhaps because Bernanke had once been an (inept) economic advisor to a Republican administration, perhaps because he  had first been nominated to the Fed and then to its  chairmanship by a Republican President. The fact that the President in question had been George W. Bush, the originator of most of  their economic  problems, conveniently was forgotten.

Unquestionably, this is a sad day for citizens of the United States.  The vote itself indicates that Bernanke is the least popular Fed chairman since the Senate started to vote on the position 32 years ago. Paul Volcker’s 1983 nomination was opposed by 16 Senators, and that was the previous record  But, there is an enormous difference in the nature of these two votes. 

Paul Volcker met with resistance because he had honored his oath of office, had imposed monetary discipline on an inflation-riddled US economy, even at the price of significant unemployment. Those Senators who opposed his second term were seriously out of line.  Ben Bernanke met with resistance because he had failed to honor his oath of office, had inflicted the US economy with house and stock market bubbles by his lack of monetary discipline, and then had breached his oath of office by taking the Federal Reserve well beyond its central bank remit in pursuit of an overt socialist financial and industrial policy agenda. The significant majority of Senators who voted in favor of Bernanke’s confirmation were seriously out of line.

The vote came after heavy lobbying by President Obama – yet another serious economic error in his deeply flawed administration – and by the Democratic leadership of the Senate. The signal that now goes out across the world is that the United States has no taste for monetary discipline, that it will surely attempt to inflate its way out of its debt once  the income velocity of circulation of money returns to normal levels, and that the Fed has been set loose from its-strait-jacket to indulge itself in progressive financial and industrial policy interventions. The signal is clear that the world should be on the look-out for another financial crisis as Bad Ben continues in his weak-minded ways. 

The People’s Republic of China most certainly will be reviewing the situation.  Expect the price of gold to rise,  and the price of the dollar to fall,  as China quietly reshuffles its asset portfolio.  This is one more small step on the road to economic ruin, one more clear signal that the Obama administration will not defend the international reserve status of the US dollar:

“Their Kings were serv’d but Knavishly

Cheated by their own Ministry;

Many, that for their Welfare slaved,

Robbing the very Crown they saved:

Pensions were small, and they liv’d high,

Yet boasted of their Honesty.

Calling, whene’er they strain’d their Right,

The slipp’ry Trick a Perquisite;

And when folks understood their Cant,

They chang’d that for Emolument;

Unwilling to be short or plain,

In any thing concerning Gain;

For there was not a Bee that would

Get more, I won’t say, than he should;”

Bernard Mandeville ‘The Grumbling  Hive’, The Fable of the Bees Volume 1, 1732.

Unlike Bernard Mandeville, I do not see such behavior as  ultimately working out for the best with respect to the economy of the United States.

The Presidential Titanic

January 28, 2010

In his State of the Union Address on January 27, 2010, President Obama responded much in the same way as the Captain of the Titanic when approaching an iceberg in the North Atlantic during  the maiden voyage of his Great Liner. Instead of sharply changing course while  fully reversing his administration’s  powerful engines, the President, like  the ship’s  fated captain,  has held  on to his chosen course, while slightly slowing his vessel’s speed; half-hearted  measures that inevitably must  fail  to avert looming disaster.

The first rule of public choice is to ignore the words of  all  politicians, while closely tracking their observable  actions, the only true barometer of  their motives.  So one should always approach a State of the Union address with a sound measure of skepticism.  In recent years few of the promises promulgated at those emotive assemblies have ever passed into law.  Most of the promises are received by the immediate audience  in the manner in which they are delivered;  as rhetoric targeted on a rationally ignorant,  emotionally vulnerable electorate. 

Clearly signaled changes in the direction of policy, however, are a different matter.  They are wake up calls to the political class.  Sadly. there was no  such wake up call in President Obama’s address. His rhetoric was surprisingly flat, his prose surprisingly poor;  but much more significant was a clear signal to the country that his policy course is set in stone,  and will not be changed.  If his ship indeed is headed for the iceberg, then he is confident that the iceberg will be destroyed,  and that  he will sail unencumbered into pacific waters.  His ship after all is unsinkable!  Has that not been the media message throughout the past 12 months?  As with the Captain of the Titanic, so with President Obama,  the ship was, and the presidency will be destroyed.

So, the President will pursue an ill-fated health care reform policy, he will pursue an ill-judged energy reform policy, he will pursue an unpopular pro-union policy, while paying lip-service to a budget freeze- -actually a freeze on only 17 per cent of the budget – over the next three years. Even that dose of medicine comes without a physician’s instructions. Congress, once again, will have to do the heavy lifting on all his policies, will have to carry the short-term electoral consequences, while the President enjoys date-trips to New York,  tours the world, and vacations in the Hawaian sunshine. 

Well, as Senator Obama should have learned – indeed did learn before his ambitions soared – that is not at all the kind of cloth from which politicians are cut.  Politicians assiduously protect their own backs; and they all  know – Democrat and Republican  alike –  that President Obama’s policies are deeply unpopular; that they do not meet the political market test.

So 2010 will be lost in an unedifying spectacle of aborted bills and divisive political battles, while the already restless American  electorate becomes increasingly dismissive of  its not-so- new President.  The end-game will be  a repeat of 1994;  and, in January  2011, no doubt,  a State of the Union address that should have been made in 2010.

By 2011, it will be too late for  President Obama. With a little bit of luck, the first green shoots will break through, harbingers of a new laissez-faire oriented  Morning in America to follow upon the 2012 Presidential elections.

A Reversal of Fortune

January 27, 2010

Just as night predictably follows day in the physical world, so nemesis predictably follows hubris in the world of human affairs.  Such is the latter case with the young presidency of Barack Obama.

Just one year ago, a young untested politician was vaulted into the highest office in the United States on a wave of media euphoria that might easily have been mistaken as recognition of a Second Coming rather than as a simple change of administration in a constitutional republic. Drenched in adulation, with impossibly high expectations pinned upon him by the electoral majority that thrust him into office,  and gifted with significant Democrat-majorities in both houses of Congress, it is not at all surprising that President Obama and his administration  over-reached, and pursued during the first year of a first-term a policy agenda designed to impact every aspect of the United States economy.

The goals were indeed all-encompassing:  a restructuring of one-sixth of the entire economy in health care reform, an empowerment of the unions, in ‘card check’ legislation, the defeat of global warming, in ‘cap and trade’ legislation, the revamping of  income distribution through the imposition of increased taxes on the well-to-do, the partial nationalization of the financial sector and the automobile industry, a shift away from free trade towards  trade protection, and the reversal of economic deregulation policies promoted by his four immediate predecessors in the White House.  Oh yes, and by the way, the administration would remove in 2009 the financial panic, and associated  economic contraction,  that was throttling jobs and wealth throughout the nation, decimating home ownership and wiping out stock market wealth.

The outcome inevitably fell far short of the goal, as the United  States Congress lost traction with the median voter in its frenzied efforts to meet impossible targets, and as an idealistic President expended all his personal political capital, and more, in promoting, in a hands-off manner, an agenda that, if successful, would change the nature of the US economy forever, via a shift from laissez-faire to state capitalism. Few individuals can relish the price that President Obama will pay tonight as he makes a State of the Union Address that will be viewed world-wide as a recognition of the failure of his economic policies and that will outline a new, and yet I fear, an equally over-ambitious course for the second year of his young presidency.

What advice can an outsider offer to a president who teeters on the precipice of policy disaster?  Specifically, what lessons from public choice might President Obama now take on board?  In this short column, I shall offer two central life-lines. 

First, and most important, reconstruct your cabinet to reflect the realities of the political market-place.  The economic team that you created in 2009 has served you badly, by offering advice that is out of line with the views of your initial electoral majority, and by suggesting a time-line that no experienced administrator ever would have attempted.  If you are now decided to adjust your agenda to a more central course, your economic team reshuffle should signal that change.  The median voter will react very favorably to the following changes: for chief of staff,  replace Rahm Emmanuel with  a seasoned apolitical administrator;  for Chairman of the Fed, replace Ben Bernanke with Paul Volcker, for Treasury Secretary, replace Timothy Geithner with Robert Rubin; for National Economic Advisor, replace Lawrence Summers with Gregory Mankiw; for Chairman of the Council of Economic Advisors, replace Christina Romer with her husband, David Romer, for Regulation Tsar, replace Cass Sunstein with Sam Peltzman.  Your new economic team would command immediate respect among  Democrats  and Independents  because it would reflect, for the most part,  a  New Keynesian rather than a hydraulic Keynesian methodology and a much more professional and experienced approach to policy promotion.

Second, shift your own persona from that of the fox to that of the hedgehog, in the sense defined by the great philosopher, Isaiah Berlin.  The fox knows many things, your situation in January 2009. The hedgehog knows only one thing, but it is an important thing.  That should be your position in 2010, if you wish to reverse your fortune once again, this time from disaster to success.

The one big thing that you should know is that a majority of Americans value the relatively laissez-faire economy that is the source of their economic well-being. They look to their president to nudge the economy back onto the path of the Great Moderation that your incompetent predecessor abandoned.  A policy of small changes for a better world is the public choice medicine that surely will cure your ills.  It is a tough medicine to swallow for an understandably ambitious young man.  But unlike some of your much older predecessors, you have a long life ahead in which  to enjoy the sweet fruits of  humble but steady progress.

Please Bring Back Paul Volcker as Chairman of the Fed!

January 26, 2010

2010 is a dangerous year for the economy of the United States.  The interventionist fiscal and industrial policies of the Bush and the Obama administrations have signally failed to restore the economy to good health, as I predicted would be the case one year ago.  The enormous burden of Federal debt projected onto the system by political action will serve as a drag on economic growth for decades to come.  The clear signal emanating from Washington that no large corporation will ever be allowed to fail will fire gamblers’ instincts across the nation, turning not only financial and housing,  but also manufacturing markets into gigantic casinos, in which the dice will be thrown high.  The future of the dollar as an international reserve currency is literally at stake in coming months, essentially in the unsafe hands of  a communist dictatorship.

In such circumstances, an independent Federal Reserve, capable of withstanding the overwhelming interventionist pressures of a President, and his erstwhile supporters in the House of Representatives and the Senate, many now fearful for their livelihoods in 2010 and 2012, is essential if this Great Republic is not to go the way of all past republics throughout history – to collapse from internal profligacy, recklessness and corruption.

Ben Bernanke has demonstrated in full measure that he is not up to such a task. Surely, he is an excellent economist, with a good understanding of the economic causes of the Great Depression. But understanding is insufficient, if steel is absent,  and if character and resolve are  insufficient to stand up to blind panic within the political market-place. What Americans needed most in September 2008 and beyond was an immovable monetary anchor to hold the ship of state in place through a dangerous storm.  Ben Bernanke was and is no such anchor.  He has allowed the Federal Reserve to be tossed  around like so much flotsam and jetsam, worsening the financial panic and allowing interventionist impulses full reign. By his own actions, he has debauched the balance sheet of the Fed while seriously jeopardizing  its independence by excessive meddling in political affairs. 

Our judgment of him must be harsh, because the economic  consequences of  our silence may be yet harsher for the people of the United States.  In the dreadful words of Oliver Cromwell, in his famous address to the English Parliament following its victory over the Crown in the English civil war: ‘You have been too long here for any good that you may do.  In the name of God, go.’

Fortunately, the United States has a man of proven experience and of proven steel to take Bernanke’s place, President and the Senate willing,  as Chairman of the Federal Reserve: that man is Paul Adolph Volcker. In yesterday’s column, I outlined the nature and manner of his great achievement in ending stagflation, an achievement that carries with it enormous credibility throughout the world, even some 30 years after it occurred.

For two decades after he left the Fed, Volcker’s powerful voice was silent, even as his beloved agency slowly crumbled under the more politically responsive hands of Alan Greenspan and Ben Bernanke. In an exceptionally smart move, however, President Obama returned Paul Volcker to center-stage by appointing him Chairman of a newly-formed Economic Recovery Advisory Board.  As was to be expected, the old  Lion of the Fed, in testimony before the House Financial Services Committee in late September 2009,  rediscovered his vocal chords, bared his teeth, and  roared, in an  effort to bring his errant pride to heel:

In expressing doubts about the administration’s proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure, Volcker’s words were caustically correct:

 “The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be too big to fail.

and

What all this amounts to is an unintended and unanticipated extension of the official ‘safety net’ an arrangement designed decades ago to protect the stability of the commercial banking system.  The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted.  Ultimately, the possibility of further crises – even greater crises – will increase.

and

“First, let’s make banking boring again. No bank should be too big to fail.  And, second, don’t mess with the Federal Reserve.

These are words that we do not hear from Ben Bernanke, nor ever will.  They are words that should encourage President Obama to nominate Paul Volcker for the Chairmanship of the Fed and to gamble that a sufficient majority in the Senate will consent to his appointment.  After all, he is the one hope that the Democrats may have of retaining their House majority in 2010. His appointment surely would enhance Obama’s chances in 2012. After all, in three  short years,  he put inflation back in its cage in the early 1980s. He has just three years to do the same,  in the early 2010s,  as inflationary forces re-awaken, with a long and variable lag,  in response to post-2008 monetary expansion.

Should Paul Volcker Replace Ben Bernanke as Chairman of the Fed?

January 25, 2010

Studies clearly demonstrate that countries secure enormous economic benefits when control over the supply of money is firewalled from the political process.  Long-term price stability (or rather long-term minimal inflation to avoid the Irving Fisher fear of deflation) provides the keystone for economic growth under conditions of laissez-faire capitalism.  Politicians, however, only rarely share such a goal. For price stability removes from the political market-place the short-term advantage of a seigniorage tax, that simultaneously floods their coffers with federal revenues and reduces the  real value of the public debt.  The political pressure is always to inflate above the minimal rate.

The Federal Reserve Board, in principle, is firewalled from the political process, is mandated to pursue the goal of price stability appropriately defined. The Chairman of the Board, by tradition and through agenda control, dominates the behavior of the Fed. In the first 100 years of the Board’s existence, however, with only a single exception, the Fed chairmen have proved to be normal human beings, who succumb to the pressures of politics, and the adulation or hatred of the general public, by oiling the monetary wheels too generously.

The cost of such personal weakness, such a failure to honor their oaths of office, has been high, as the run-up to the Great Depression, the stagflation of the 1970s, and the run-up to 2008 clearly show. When monetary policy has been disastrously too tight, as was the case throughout the period 1929 to 1932, the reason was not deliberate policy but an absence of leadership, indeed an absence of any policy whatsoever.

At this moment in time, monetary policy in the United States is critically important for the future of the United States economy. Under the successive chairmanships of Alan Greenspan and Ben Bernanke, between 2001 and January 2010, the Fed has performed far from well, fueling a monetary furnace that spilled over into stock market and housing market bubbles, that burst as soon as monetary sanity was restored, followed by a dangerous policy of balance sheet debasement as the Fed has correctly flooded the money supply, but foolishly by a process of purchasing, not Treasury Notes, but largely worthless toxic mortgage securities as a means of creating a second, politically-desired bubble in the housing market.

 The medium-term risk is significant inflation, with the Fed handicapped by a lack of valuable assets to sell back to the public as a means of mopping up an excessive supply of money, once the income velocity of circulation of money returns to normal levels.  Ben Bernanke, sadly, is a well-meaning chairman who, nevertheless,  has been center-stage throughout this ill-fated sequence of events.

In the history of the Fed, one chairman alone towers above the rest as super-hero, stalwart in pursuit of his mandate, incorruptible in his defense of Fed independence against powerful pressures from the White House and the US Congress, to say nothing of  the construction  and farming industry special interests that clogged up C  Street, NW and blockaded the Eccles Building with stalled tractors and other such vehicles in an attempt to intimidate him into monetary expansion.

That man is Paul Volcker, the 12th Chairman of the Federal Reserve (August 6, 1979 – August 11, 1987), who almost  single-handledly pulled the United States economy out from a decade-long stagflation and who paved the way for some 17 years of The Great Moderation.

Volcker honored his oath of office from his first day in office, asserting that his policy was to remove the curse of high inflationary-expectations from the United States economy.  For the most part, his statement was dismissed as hyperbole, which was unfortunate because that error of judgment  exacerbated  the depth of the economic downturn that his policies created. The federal funds rate had averaged 11.2 per cent in 1979.  It was increased to a peak of 20 per cent  in June 1981.  The prime rate rose to 21.5 per cent in June 1981, the 30-year mortgage rate to 18.5 per cent and the 48-month car loan rate to 17.4 per cent.

The impact on economic activity was pronounced, with unemployment peaking at 10.8 per cent in December 1982 and remaining above 8 per cent until January 1984, an election year.  Volcker came up for renewal in 1983, and under most circumstances, he would have been political toast.  Fortunately for the country, another super-hero was in high office, and President Reagan burned up significant political capital to ensure that Paul Volcker (a registered Democrat)  was re-appointed to a second term. Volcker repaid his debt to Reagan by correctly refusing ever to meet with him, either in the White House or at the Federal Reserve, to discuss monetary policy.  Paul Volcker knew exactly the true nature of good policy with respect to the money supply.  That was his job, not the President’s. 

By mid-1983, inflation had been squeezed out of the system, as the inflation rate dropped dramatically to 3.2 per cent on an annualized basis. Ronald Reagan was re-elected by a landslide into a second term of office  in November 1984, not least because Paul Volcker had put inflation back into its cage.

Should President Obama learn from history, remove his support for Bernanke’s second term, and throw his full political weight behind the Lion of the Fed, promoting a newly-minted Paul Volcker candidacy?  Evidently, that should be a tempting prospect for a beleaguered president.  I shall address that question directly, not least from a public choice perspective,  in tomorrow’s column.

United States Ranks ‘Mostly Free’ in 2010 Index of Economic Freedom

January 24, 2010

Each year, the Heritage Foundation and the Wall Street Journal jointly publish a carefully researched Index of Economic Freedom that ranks 179 nations in terms of ten components of economic freedom: business, freedom, trade freedom, fiscal freedom, government spending, monetary freedom, investment freedom, financial freedom, property rights, freedom from corruption, and labor freedom. Each of these components is measured on a scale from 0 to 100, where 100 represents the maximum freedom. The ten component scores are then averaged to provide an overall economic freedom score for each country.

Countries that score between 100 and 80 are characterized as Free, those that score between 79.9 and 70 are characterized as Mostly Free, those between 69.9 and 60 as Moderately Free, those between 59.9 and 50 as Mostly Unfree, and those between 49.9 and 0 as Repressed.

The 2010 Index of Economic Freedom was published on January 20, 2010.  The United States economic score was 78.0, with its economy ranked Number 8 in the total Index (falling from Number 6 in 2009), and characterized now as only Mostly Free. Its score was 2.7 points lower than in 2009, reflecting the most precipitous drop in economic freedom among the world’s top 20 countries (measured in terms of gross domestic product).  Canada, with an overall score of 80.4, is the only country in North America now ranked as Free.

For reference, the top ten ranked nations are: 1. Hong Kong (89.7), 2. Singapore (86.1), 3. Australia (82.6), 4. New Zealand (82.1), 5. Ireland (81.3), 6. Switzerland (81.1), 7. Canada (80.4), 8. United States (78.0), 9. Denmark (77.9) and 10. Chile (77.2).  The United States is now bracketed with such nations as the United Kingdom, Germany, Japan, Sweden, Georgia, Botswana and South Korea, nations that are not usually highly regarded as bastions of economic freedom. Well, at least there is still some distance from North Korea (1.0)!

So what went wrong?  The answer is unequivocal: the interventionist 2009 responses by the Obama administration,  the US Congress, and the Federal Reserve to the financial crisis and economic contraction.  Economic freedom declined in 7 of the 10 categories measured in the Index.  The score, category by category, is as follows, in a descending order of economic freedom:

Labor Freedom (94.8) Free; Business Freedom (91.3) Free; Trade Freedom (86.9) Free; Property Rights (85.0) Free; Monetary Freedom (78.1) Mostly Free; Investment Freedom (75.0) Mostly Free; Freedom From Corruption (73.0) Mostly Free; Financial Freedom (70.0) Mostly Free; Fiscal Freedom (67.5) Moderately Free, Government Spending (58.0) Mostly Unfree.

For a nation that once proudly claimed to be The Land of the Free, this is a wretched Report Card, not one that any child would be proud to show to his parents. Worse still, there are no signs as yet that the child has learned its lesson. The Report Card in 2011 shows every sign of yet further deterioration. “Please don’t show it to Dad, Mom. He might take off his belt.”

Why Demand Stimulation Has Failed: New Keynesian Insights

January 23, 2010

I have explained in recent columns how hydraulic Keynesians promoted the case for fiscal intervention, through increased public expenditure and rising budget deficits, as a response to under-full-employment equilibrium under conditions of price stability.  Once inflation raised its ugly head during the 1950s,  as a consequence of excessive expansion of the money supply designed to accommodate rising budget deficits, these same Keynesians  honed in on another exploitable opportunity: governments should exploit nominal wage rigidities to purchase a lower rate of unemployment at the price of (in their minds a tolerable) increase in the rate of price inflation.  In essence, government should take advantage of a gullible work-force that would fail to recognize  inflation-induced reductions  in the real wage that would encourage firms to increase output.

Governments – always eager to take advantage of a free political lunch – fired up both the monetary and the fiscal furnaces to drive their economies beyond the natural rate of unemployment.  For a time the strategy seemed to work.  In the United States, however, the policy ran into serious headwinds when President Johnson simultaneously pursued war in Vietnam with a Great Society program.  Inflation appeared to take on a momentum of its own and, by the end of the 1960s, it was out of control.  Milton Friedman and Edmund Phelps explained the nature of the problem in terms of adaptive expectations models.  Expectations, henceforth, would move center stage as an era of stagflation dampened the efficient functioning of macroeconomies world-wide. The days of the hydraulic Keynesians were over – at least that is what almost every major economist believed;  until September 2008.

Adaptive expectations just would not cut the mustard, as economists now rushed to investigate the micro-foundations of macroeconomic theory.  Drawing on an idea advanced earlier by John Muth, Robert Lucas and Thomas Sargent re-wrote macroeconomics in rational expectations new cloth:  individuals in society optimally use all available information, including information about current government policies, to forecast the future.  Because monetary and fiscal policies influence inflation, expected inflation depends on such policies. 

With such knowledge in the hands of the people, governments seemingly cannot exploit a Phillips Curve.  In the New Classical macroeconomics, governments are impotent to influence the level of macroeconomic activity through sysematic policy interventions. Only by surprise can they make an impact. Ironically, this pits the government against the people in an ongoing strategic battle that was never supposed to reflect the nature of democracy!  The New Classical macroeconomics had launched a new Star Wars in the unending battle between mercantilism and free markets.

Initially, the Keynesians ceded the battle-field to the New Classicals, acknowledging, as economists must always  be tempted to do, that rational expectations was the only game in town.  But not for long.  By the late 1970s, the Empire struck back, as Keynesians rose like Phoenix from the ashes in a New Keynesian form. A new brand of Keynesian, now immersed in rational expectations, searched high and low for any nominal rigidity that might arguably survive in the Brave New World.  Larry Summers and Christina Romer were right there, with other leaders such as Gregory Mankiw, David Romer and John Taylor. And my, how contemptuous these New Keynesians were of the old-fashioned hydraulic Keynesians who struggled valiantly to compete with them in separate sessions at the annual conventions of the American Economic Association!

Well, the New Keynesians were quite successful. The Empire restored its rightful position, and the New Classical Jedi failed to take revenge. By the mid-1990s, governments once again pursued active monetary and fiscal policies as tools of macroeconomic stabilization policy.  But they did so on a reduced scale.  For even the most ardent New Keynesians recognized the fragile nature of their new nominal rigidities: staggered wage contracts that exposed workers to a modicum of real wage reduction, efficiency wages whereby firms attempted to hold on to superior labor by paying it above market rates, and menu price rigidities that exposed firms to a modicum of inflation-induced sales expansion, as government surprised the system with accelerated inflation. But policy leverage  through this mechanism must be limited, and transient, since  workers and the firms would eventually catch on to the government’s game, with labor shortening  the duration of labor contracts, and with firms revisiting their efficiency wages and menu prices more frequently,  in response to government manipulation of the macroeconomy. 

The proof of the pudding, of course, is in the eating. The year 2009 has left the Obama administration and the Democrats in Congress with severe indigestion and acute intestinal discomfort.  The temporary tax cuts have been pocketed, not spent, by debt-burdened households. Federal stimulus monies have been absorbed by the states  in reductions in their own projected outlays, and by firms who have replaced privately-funded with federally- funded labor. Stated goals of unemployment reduction have  proved worthless. Reckless Federal Reserve outlays in purchasing toxic mortgage securities have served only to promote the issuing of ever more volumes of such instruments by agencies of the government. Increases in the money supply have been hoarded by the banks, while good entrepreneurial initiatives are starved of funding. 

Now dear reader, think just how useless demand stimulation by government is in a post-2008 environment where inflation is all but non-existent, where market pressures are such that wages and prices are only too evidently downwardly flexible as workers scramble to hold on to their jobs  and as firms scramble to hang on to their markets in a severely recessed economy. If not before the recession, certainly now, we live, at least temporarily, in a New Classical environment.  

Do you believe that once leading New Keynesians such as Larry Summers and Christina Romer experienced a limited attack of Alzheimer’s,  forgetting their own scholarship,  and retreating  into a hydraulic Keynesian fantasy, when advising President Obama and Chairman Ben Bernanke to engage in reckless, wasteful and essentially impotent monetary and fiscal outlays?  Or do you believe that they were acting not as economic, but as political, advisors to a President and a Congress desperate to exploit a financial crisis as a means of expanding the  power of the state?

In Praise of President Obama

January 22, 2010

I am breaking my unwritten rule to post just one new column each day to Charles Rowley’s Blog.  The reason is that yesterday President Obama announced the first economic policy of his administration that I consider to be  constructive for the well-being of the United States economy. 

The President’s  proposal to return, at least somewhat, to the Glass-Steagall  Act of 1933  that governed financial institutions until its ill-advised  final repeal in 1999,  is well-justified.  In our book  Economic Contractions in the United States: A Failure of Government  Nathanael Smith and I outline an economic case for separating  FDIC-insured clearing banks from casino investment banks,  strictly regulating the former, while allowing caveat emptor rules to govern the latter. Copies of our book were forwarded to the President’s economic advisors and also to Paul Volcker.  We should like to think that the book played a minor role in the President’s policy thinking.  In any event, his proposals are remarkably similar to those that we formulated, though his populist rhetoric was absent from our book.

I congratulate the President for good thinking on this important issue.  I have not been slow to criticize him in these columns when,  in my judgment, he has pursued poor policies.  I do not intend to be  slow in  praising him when he defines excellent policy.

When the dust settles on his initiative, I shall  return to discuss it in greater depth.


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