Sunday, May 30, 2010

Worst response to a recession since the Great Depression

Published in The Tennessean, Sunday, May 30, 2010

Worst response to a recession since the Great Depression

by Richard J. Grant

The 1970s began with the rate of price inflation over five percent. This was unusually high and of great concern to people at that time. Few could foresee that by the end of that decade, when price inflation reached 14 percent, a return to five percent would come as a relief.

When problems arise, many are too quick to assign blame. With the prices of consumer goods rising, many consumers automatically blamed businesses for raising their prices. Business owners and managers responded by blaming their increased costs of doing business, particularly the high union wages pushed upon them by the strike-threat system. But union leaders could argue that they needed wage increases to keep up with the rising cost of living.

Around the blame went. One side would claim that prices must rise because the prices of supplies and labor were rising, while the other side would claim that wages must rise because the price of consumer goods was rising. A surprisingly large number of economists were found to be on one side or the other. But these two popular explanations for inflation amounted to little more than "prices went up because prices went up."

The public argument was missing the point. As a result, government was called upon (as usual) to do something, anything. The government responded by doing what it does best, which is to treat symptoms rather than causes. President Richard Nixon introduced wide-ranging wage and price controls: they failed. President Gerald Ford’s approach was more sophisticated, but still blind to the real causes. His “Whip Inflation Now” program is remembered only for the “WIN” buttons, which caused laughter even then.

Reluctantly, mainstream economists were forced to yield to those who had been insisting all along that the cause of inflation was the government itself, specifically the Federal Reserve System. Until August 1971, the Fed's main task was to maintain the value of the dollar such that the price of gold would remain steady near its official price. But throughout the 1960s, its monetary policy was inconsistent with that goal. The Fed was inflating the dollar supply.

This episode in our history is another example of a problem being perpetuated, and made worse, by the government's failure to recognize its own ignorance while taking actions that leverage that ignorance. The 1970s – a decade of loose money, excessive government spending, and oppressive economic regulation that raised costs and made us less able to adapt – also gave us the word, “stagflation.”

Eventually, President Jimmy Carter took some positive, though ineffectual, steps toward deregulation and a tighter monetary policy. It wasn't until President Ronald Reagan made decisive and systematic strides toward deregulation, lower marginal tax rates, and monetary restraint, that the economy shrugged off the past and began to grow. Despite an obstinate, spendthrift Congress, Reagan brought renewal with a new optimism rooted in reality.

The administrations of the 1970s were not competent to handle their inheritance from the Johnson years. But they were neither the first nor the last to be in that position. President Franklin D. Roosevelt campaigned against the interventionism of the Hoover years but, once in office, embraced it and expanded it beyond all precedent. Not letting a crisis go to waste, he forbade US citizens from owning gold bullion (i.e. traditional money), oversaw new regulations, and increased government control and ownership within several sectors of the economy.

Although some understood the problem at the time, only recently has it become generally recognized that FDR was not the savior of the nation. His policies misdirected resources, reduced people’s freedom to adapt, and thwarted recovery. Roosevelt took the Hoover recession and gave it the persistence that we now call the Great Depression.

In a spooky reincarnation, the Obama administration is compounding the errors that gave us the Bush recession. Given that we know better, it is the worst response to a recession since the Great Depression.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, May 23, 2010

Political influence threatens the euro’s foundation

Published in The Tennessean, May 23, 2010

Political influence threatens the euro’s foundation

by Richard J. Grant

The currency that we now call the “euro” came into existence just over 11 years ago through the unification of the currencies of most European Union member states. The move to the single currency reduced the costs of trade and currency exchange, and eliminated exchange-rate risk from many investments and transactions.

From this perspective, the creation of the euro was a good idea and the currency is not under any threat from purely economic causes. The problem with any modern currency is its political foundations and the constant threat of political influence on its management and value.

The current weakness of the euro, compared to other major currencies, is generally attributed to the credit crisis facing EU member-state, Greece. But the Greek debt problems are not, and cannot be, a direct cause of euro currency weakness. The European Central Bank could easily maintain the value of the euro against what would normally be a localized economic problem. The currency weakness is a reflection of worries about the political forces influencing the actions of the ECB.

The founding treaties of the EU prohibit the European Central Bank from buying the sovereign debt, or lending directly to the national treasury, of any member state. But that is exactly what the ECB is being pressed to do through its involvement in the bailout of the Greek treasury and its creditors. The issue is bigger than pedestrian politics: the ECB is being pressed to break (or reinterpret) rules that are EU constitutional provisions.

A strict interpretation and enforcement of the treaties that created the EU would treat the Greek debt problems as a local issue to be dealt with by the Greek government and its creditors. These are the parties that would, if Greece were to default, have to bear the burden and readjust their future plans and actions accordingly. They might even learn something of practical moral value. Importantly, the effects of the default would be reasonably contained and diffused.

Similar to the restrictions on the ECB, the treaties that created the EU explicitly forbid the EU or any of its member states to “be liable for or assume the commitments of” any other member state. But the EU is now clearly breaching that provision by taking on the Greek bailout.

This is the real source of any contagion effects that we now witness. The political subverts the economic. Contagion originates and then follows the path of least resistance through states where the politicians have been the least prudent.

A currency's value is in danger whenever a central bank yields to the demands of those offering inflationist solutions. A nation's treasury is weak whenever the politicians spend more than its citizens are willing to provide, or tax more than its citizens are willing to bear.

Some economists suggest that Greece would be better off if it still had its own national currency so that it could inflate its way out of its debt and other troubles. But it was precisely to remove such a temptation that the ECB was proscribed from monetizing the debt (buying bonds by issuing new money) of member states. Now that the EU has been infected by such temptation, the euro will be inflated to buy such debt.

The ECB's sole clear purpose is to maintain price stability in the euro area. With its participation in the Greek bailout, the ECB's single objective will be compromised, even though it will attempt to "sterilize" its monetization by drawing some other euros out of normal circulation.

What started as a Greek problem is now an EU and IMF problem. More specifically, it is a problem of EU taxpayers, taxpayers in the major IMF countries, and all those who would be harmed by the weakening of the euro as a currency. The EU has failed to avoid the illusory easy way out. The contagion is not economic, but political – and ultimately moral.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, May 16, 2010

Greed not the only reason for financial meltdowns

Published in The Tennessean, May 16, 2010

Greed not the only reason for financial meltdowns

by Richard J. Grant

Is Greece a derivative? Its government has certainly allowed the value of its debt to become dependent on outside events. Rather than face voters with the full cost of their demands, the Greek government has pushed off the day of reckoning by borrowing to the point of financial failure.

Few people take the trouble to learn about financial derivatives, so it is easy for demagogues to distract everyone by making derivatives the scapegoat for our financial crisis. But most derivatives are quite simple, and even the most complex ones still look like child's play when compared to the complexity of the macro-economy.

The biggest problems in our financial system have been caused, not by complex financial instruments, but by a repeated failure to observe the most basic rules of civil and commercial conduct. Mere greed is not the problem: greed has always been with us, and we have developed elaborate social means to redirect (if not transform) it toward positive goals. But all this breaks down when we fail to hold people to their word, when we forget that forgiveness should be edifying.

A century of bailouts and special protections has progressively conditioned the managers of large financial institutions to underestimate the risks that come with the pursuit of higher investment returns. The service of natural selection provided by market forces has been overridden by politicians often enough that each succeeding generation of managers has a less reliable menu from which to model best practices.

The financial industry is just one aspect of society. The perverse incentives that face politicians have encouraged a moral slothfulness that has affected all citizens. It is difficult to say “No” to a generation of voters that has been taught to believe that governments have an unlimited supply of money, immaculately conceived at no cost to society. There need not be a majority that holds such na├»ve beliefs in any society: they need hold only the balance of power to change the course of history.

The problem in Greece is at least that bad. The Greek government, despite having agreed in the treaty establishing the European Community to limit the size of its deficits and public debt, has allowed its public debt to grow to about 120% of its GDP. With increased debt comes increased leverage and risk, just as can be created with any derivative. But the question facing the Greek government is the same one that faces every mortgaged homeowner and every issuer of credit default swaps: Will you keep your promises?

The question facing lenders is just as important: What were you thinking? If your loans go bad, will you be able to keep your promises? Have you made adequate provisions, or will you come begging for bailouts?

We remember that the apostle Paul urged the Romans to refrain from doing anything that would cause their brothers to stumble. But just when Europe needed Dave Ramsey, we sent them President Barack Obama, not exactly a paragon of governmental thrift and good stewardship.

Obama spoke with French President Nicolas Sarkozy and German Chancellor Angela Merkel to urge "resolute action to build confidence in the markets." By a not so strange coincidence, the EU (and the IMF, which includes the US) has offered Greece a $1 trillion bailout. That'll teach them.

In the small consolation that world markets rose on this news, we are reminded of derivative results. The bailout money need not go directly to the lenders: a bailout of the Greek government will serve the same purpose. That'll teach them too.

The moral edification that is derived from the expectation that we live up to our promises comes from the practice of preparing ourselves to keep those promises. Each day that we prepare ourselves to live well without theft, fraud, or aggression is a day that we are able to help our fellows through trade, good works, and a good example.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, May 09, 2010

Beware government 'help' that can actually hurt

Published in The Tennessean, May 9, 2010

Beware government 'help' that can actually hurt

by Richard J. Grant

Just when Tennesseans need it most, the law of supply and demand has been suspended. In the wake of the recent flooding disaster in Middle and West Tennessee, the state attorney general was quick to issue a news release warning Tennesseans “to be aware of potential price gougers.”

There is actually a state law that makes it “illegal to set prices that are grossly in excess of the price generally charged immediately prior to the disaster.” This presumes that there is someone in the state government with the omniscience required to make such judgments. There is not, but the law is enforced and companies have been forced to make repayments in the recent past.

Governments often display a tremendous disrespect for price and believe that merely by controlling prices they can control costs. But real life doesn't work that way.

With one of the water treatment plants shut down due to the flooding, the mayor of Nashville asked residents to conserve water. In a free market, the increased scarcity of tap water would be reflected in a rise of water prices. This would encourage people naturally to cut back on their least-valued uses of tap water. The higher prices would also attract water from other sources.

In 2008, Hurricane Ike disrupted gasoline supplies to Nashville and prices rose to around five dollars a gallon. The state government interpreted such price rises as gouging. But the real economic effect of higher prices is to make it worthwhile for suppliers to bear the cost of diverting supplies to places like Nashville where people were willing and able to pay higher prices rather than to have no gasoline at all. Had the state government succeeded in keeping prices down, the fuel crisis would have lasted longer.

Government interference with prices makes crises more likely. Government flood-insurance subsidies encourage overbuilding on flood plains thereby increasing the risk of loss and social dislocation.

The Federal Reserve keeps interest rates artificially low thereby encouraging investment in inappropriate projects and in excessive amounts. This affects the decisions of all individuals and businesses, especially those whose plans include large capital requirements.

Fannie Mae and Freddie Mac, by guaranteeing home loans and underpricing their risks, have caused homebuyers (and bankers) to underestimate the risks of borrowing, and have turned all US taxpayers into property speculators with all of the risk on the downside.

The problem in the housing market is leverage and unsustainable demand: negative equity results from borrowing too much and buying too much. That is the responsibility of the homeowner, but who encouraged the owner to borrow too much – by altering the price structure through tax breaks and credits – and perhaps to buy an excessively expensive house? The trouble in the derivatives markets was just a derivative of this.

Governments have also subsidized risk taking within financial institutions thereby encouraging excessive leverage (credit expansion) in our fractional-reserve banking system.

The FDIC, which contains the word “insurance” in its name but is not run like an insurance company, encourages carefree depositor behavior and increases the risk-taking tendencies of bankers. The FDIC does not correctly price its supposed insurance and so does not appropriately discourage risk-taking. Its main function is to give the illusion of safety while removing market discipline, and then to close failing banks when its policy side effects begin to emerge.

Just as good people do us a service by telling us the truth even when the truth hurts, good people do us a service by charging prices that reflect the truth about resource availability and the relative demand for those resources. In a time of genuine emergency, good people step in and give of themselves and of what they have. Governments, to the extent that they have policing and emergency services trained and ready, can be lifesavers. But we must always be vigilant against pushing governments inadvertently to take actions that make things worse.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2010

Sunday, May 02, 2010

Government regulations will destroy free market

Published in The Tennessean, May 2, 2010

Government regulations will destroy free market

by Richard J. Grant

Banks and labor unions have more in common than meets the eye. Both owe their current forms to the plethora of labor, corporate, and banking law that has been imposed over the decades. Both groups have been protected from the moral discipline that would be imposed upon them in truly free interactions with their associates and customers.

However sweet the intentions of early labor leaders and their supporters, the main function of labor unions has been to limit the supply of labor in order to raise the incomes of their members at the expense of everyone else. Such an endeavor always requires the use of force, with or without the complicity of government. Only by force can these groups limit the alternatives available to customers and thereby extract higher payments than the value received by those customers.

Just as labor law has created an artificial distinction between union and nonunion labor, banking law has served to treat those firms that specialize in financial intermediation as being somehow different from any other service. Governments have presumed themselves somehow to possess the knowledge necessary to predict the best framework in which financial services should be offered.

Thus we have a patchwork of not-quite-rational obstacles around which the financial industry has grown in the course of providing the services that are still allowed to be offered. Politicians have long benefited from appearing to protect their constituents by “being tough” on the bankers. But politicians and their governments have also benefited from access to those with the wherewithal to offer political support and to assist in servicing the financial needs of government activities.

In a free market, where private property and the freedom to enter into agreements are mutually respected, the first entrepreneur to offer a new and truly valued service can expect to reap a significant profit. The freedom of others to offer competing services to consumers would soon bring down prices and tend to reduce profits to normal levels.

But when regulations make entry into, and innovation within, the industry difficult, less competition is possible. This restricts the supply of services available, thereby enabling the industry to keep its profits higher than normal. The actual history of regulation offers us more examples of industries being protected from customers than the other way around. When Wal-Mart and Home Depot attempted to offer banking services, the FDIC repeatedly blocked their applications in order to protect existing banks from the competition.

We see such protectionism in other industries as well. The reasons for the stagnant uniformity of cable TV offerings should be obvious when we witness existing companies spending millions of dollars to lobby government to prevent the entry of potential competitors. Similarly, we might recognize one reason for the high cost of hospital stays when we observe existing hospitals lobby the government to deny a possible competitor a "certificate of need" thereby denying customers the alternative of a new hospital.

As long as such restrictions on our freedom to do business exist, those who blame our current troubles on the "free market" will continue to sound like buffoons. But many such critics are not so innocent. Many of the senators and congressmen now pointing fingers at investment banks like Goldman Sachs would like us to forget that it was Congress that created and protected the economically unjustifiable and morally corrupting agencies that we call Fannie Mae and Freddie Mac.

Neither of these government-created companies nor the destruction that they wrought could have come into existence in a free market. Only government interference that destroys the link between actions and personal responsibility could unleash such corruption upon us.

Instead of insulting the American public by grandstanding at the expense of Goldman Sachs executives, perhaps our senators should spend more time investigating the consequences of Fannie Mae and Freddie Mac. Then they should take a good hard look at the consequences of their own voting records.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2010