Wednesday, August 11, 2010

The Fed Gets it Wrong, Yet Again

But the Fed Doesn't Operate in a Vacuum

The Fed has recently announced that it is explicitly (as opposed to doing this anyway without a policy pronouncement) going to buy US government debt to keep interest rates low and prevent a double-dip recession. Not that we recovered from the first one, known as the Great Recession of 2007-2009, what with unemployment still above 9%, 5% unemployment being the historical average in the latter part of the 20th century and the first part of the 21st century, e.g. we are at still almost double the historical average unemployment rate, but with positive economic growth. This, just fyi, is the exact same situation as the Great Depression, albiet with a somewhat lower unemployment rate. Thank you China and India for the trade, something lacking of course in the 1930's.

The New York Times (which is of course the paper of record) had a front page article on this today and this article was very nice in capturing the fallacy of the Fed's (and, well, others who are into the business of 'demand management') thinking.

The idea of the Fed buying government bonds is to keep interest rates, and thus borrowing costs, low. The fallacy here of course is that interest rates have been near zero for banks for the last 2 if not 3 years, e.g., banks can go to the Fed for this cheap money with less than stellar collateral. The problem, and more on this later, is that the banks have no incentive to lend.

The borrowing costs for government debt are a risk-free benchmark (now is it really "risk-free" given the historically high US - almost Greek-like - debt and deficit levels ?) for more risky private sector lending, and was pushed below 4% for the 30-year government bond with this pronouncement. Of course the pronouncement was to assure the markets that the Fed would continue a low interest rate policy onward, something, it should be noted, that Japan has done for almost 20 years now, resulting in low economic growth and a devaluing Yen for Japan since this policy began.

Low interest rates mean "easy money". With easy money no one has an incentive to economize. Just ask the Holy Roman Empire (Spain and Portugual) who got all the gold coming from the Americas in the 1500's. They didn't invest this money, just spent it, those lower on the food chain of the gold coming in were the first to industrialize (England, the USA, Belgiam, France, Germany) because they had the incentive to do something useful with their scarce monetary resources. Spain and Portugual just squandered-away their easy money because it wasn't scarce.

Yet, banks aren't lending except for high collateral positions...and why is this? The answer is simple, as Robert Higgs said, "regime uncertainty".

We are having alot of investment climate uncertainty under the Obama administration, the health-care reform (e.g., central planning of same, e.g., a mega-page piece of legislation effecting between 15 and 20% of the US economy - Workers would put the link to this more than 1,600 page bill here, but it would freeze your computer to download it - that the politicians didn't even bother to read, how could they, it would take months! before passing it, well, let's say they read the parts that made sure their own speical interest groups were included and/or exempted), new financial sector rules which don't address the causes of the financial crisis in the first place - meaning Fan and Fred, the CRA, the systemic risk caused by the Basel II standards encouraging banks to load up on the government-backed mortgage bonds, and in fact the whole overt national policy of encouraging people to buy houses they can't afford - and then of course impending tax increases, not just with the expiration of the Bush II tax-cuts but the business-as-usual tax-the-rich Democrat modus operandi, and lastly an Administration which overtly states they will put their "boot on the neck" of private citizens.

[On the latter, and as an aside to this blog posting, frustration and anger over the BP "Deepwater Horizon" oil spill in the Gulf of Mexico may be undertandable, if, well, the government hadn't limited the liability of those doing business off-shore in the first place, skewing the risk-return calculations of BP, e.g., government policy underpriced the risk so BP took more risks than they would have had not the government limits been in place. BP cut safety corners because they didn't have the incentive to face-up to the full liability that their corner-cutting would have cost them given an accident. The accident occured, not surprisingly really, given the incentives BP faced due to government policy. Still, "boot on the neck" is not really a rheotoric that those with money to invest like to hear.]

Ok, back to the Fed policy....The Times states that the Fed's low interest rate policy is "to encourage consumer and corporate spending". This is fallacy number one, numero uno supremo, of "demand management", e.g. of Keynesian economics, be it on the fiscal side ("stimulus spending") or the monetary side ("low interest rates"). Economic growth comes from investment and capital accumulation, not spending. To encourage spending with easy money is a short-term fix with long-term consequences. The road to long-term prosperity is low taxes, low inflation and a solid rule of law, all of which are being ignored today. The world is small, when the USA creates regime uncertainty, capital goes elswhere.

But the bigger picture here is that the US has too much of a debt culture as it is. The last thing we need is Fed and other government policy encouraging more debt. Debt creation is prioritized in the tax code (mentioning the tax code is usually when people's eyes glaze over, but it is the crux of the problem with the US economy today), with interest on corporate debt and mortgage debt being a write-off on taxes. What we need is more equity ownership and less debt creation.

The problem is that equity is taxed twice on the tax code, first, dividends on shares are paid after a corporation pays its income taxes. Then dividends are taxed again on the personal income taxes of those that receive them. This results in what the great American social scientist Thorstein Veblen called "abstentee ownership".

Corporations are not run by those that own them, but by the managers of these corporations who make fees everytime debt is created. This is how they can pay themselves such high salaries without the owners of the companies saying "enough is enough". The tax code as is, and the Fed policy of encouraging debt creation through easy money, means that no one is watching the store. This will be even worse under the expiration of the Bush II reduction of capital gains and dividend taxes.

An increase in taxes on capital gains and share (ownership) dividends means less capital accumulation and a more leveraged (debt over equity) position for American businesses. This just enlarges the power of the managerial class over the ownership class (and more than 50% of Americans own stocks). This just inflames the rheotoric of an aritificial class divide (the managerial class who creates debt, earns fees and profits and thus bonuses from creating this debt) against those not in this class (e.g. those that work for themselves or those that work for others on an hourly wage or salary only, or, perhaps, too with some relatively small stock plan) on behalf of politicians, whose policies, in fact, have created the problem in the first place.

This populist political rheotoric, Main Street versus Wall Street or whatever, is an easy kill for the mainstream politicians, and we need to take this fear- and hate-mongering away.

The Fed indeed does not operate in a vacuum. The economy, and society, is an organic whole. Marx called those economists who did not question the underlying power relations in society "vulgar economists". This blog entry is meant to tackle the larger, institutional issues, causing the malaise in the American economy. The solutions, as gleaned from the above narrative, are plain. Allow private money (non-inflationary) competition against the Fed, reform the tax code to equalize debt and equity, and, stop the ill-conceived and long-lasting government policy of 'demand management'. Only then can we recapture an open-ended America where capital accumulation and economic growth (prosperity creation) can be our future.