A Structure Is Only as Durable as Its Foundations

Almost two weeks ago I had the privilege of speaking at a supporters reception hosted by the Institute for Principle Studies (IPS). IPS is a research and educational organization analyzing public policy from a distinctly Christian world view. At the reception I briefly explained my conviction that our current economic problems are due in large part to ideologies and ethics built on faulty foundations. A building supported by a crumbling foundation will not have very long to stand. So it goes with economic society.

We see evidence of this from the mouths and pens of well-respected members of the economics profession. It was Ben Bernanke who, fearful of deflation in the middle of last decade, convinced then Fed chairman Alan Greenspan to pursue serious monetary inflation during the mid-2000s. Paul Krugman continually calls for ever greater government spending to get us out of our current economic banana. To do his part, current Fed chairman Bernanke has increased the monetary base by $1.4 trillion. Recently, Christina Romer argued that if you want to reduce the budget deficit, raising taxes would be less painful than lowering government spending, because the multiplier is smaller for taxes that it is for government spending.

The common ideology that drives all of the above is what Robert Higgs called vulgar Keynesianism. In a nut shell, this economic ideology asserts that the economy is driven by spending--especially consumer spending. Additionally, the economy is conceived as merely the sum total of various aggregate variables. The simple Keynesian system asserts that Aggregate Demand = C + I + G, where C is consumption spending, I is business investment in physical production, and G is government spending. In equilibrium, this aggregate demand is equal to output, or aggregate supply equals aggregate demand.

As Higgs notes, one of the major failings of this conception is that all spending is considered equal. $1 million spent on baseball tickets is economically equivalent to $1 million spent on desktop computers. $1 million in corporate subsidies is equivalent to $1 million spent on housing construction.

Another key part of vulgar Keynesian ideology is that the chief end of the state is to provide full employment. If there is a drop in consumption spending or business investment that is significant to push us to an equilibrium income too low to sustain full employment, the state should stand by ever ready to fix the problem. It should either increase government spending, or increase the money supply to lower interest rates, thereby increasing business investment. Both would raise incomes and therefore also increase consumer spending. Because spending is spending, there is no concern that the money is spent productively.

When weighed in the scales of sound economics and ethics, vulgar Keynesianism is found wanting. An important reason why is that this pernicious ideology dehumanizes economics. It fails to recognize that all economic phenomena is the result of actions by persons made in the image of God. Human beings are rational actors who therefore engage in purposeful behavior. They are not merely cogs in a machine.

Our contemporary policy makers act as if they think they are economic masters of the universe. It is as if Geithner can pull the spending lever in just the right way and Bernanke can raise the monetary thermostat to just the right level so that all things will be coming up roses and daffodils. The economy, however, is not a hydraulic machine made up of inanimate cogs and tubes. It is a vast network of voluntary exchange by people who have wills that are free to do what they want.

Economic policy prescriptions are truth claims. As such, they are only as good as the economic theory upon which they are founded. Because economics is the study of human action, economic theory is only as good as the conception of human action upon which it rests. Likewise, an understanding of human action will only be as good as one's understanding of the nature of man, which means that, ultimately, sound economic policy advocacy depends to a greater extent than most people realize on our philosophy and theology. If we get our anthropology wrong, our economics will be less than satisfactory, which will lead, at some level, to errors in economic policy. 

Dow Jones Index in Longest Slump Since 2002: What Gives?

Bloomberg News reports that the previous six weeks of continual stock market declines constitutes the longest slump since 2002. Longer even then anything in 2008. How is this possible? If Keynes, Bush, Obama, Romer, Paulson, Geithner and Bernkanke were right, this should not be happening. Over the past four years, the U.S. Government and its sponsored agencies have undertaken unprecidented fiscal and monetary stimulus. The media championed their moves as bold leadership made by people who were not going to sit on their laissez-faire hands while the financial system imploded. They said that government deficit spending would get the economy moving again by putting cash into hands of consumers, boosting consumer spending which supposedly makes up 70 percent of the economy. When GDP numbers increased, it was taken as a sign that the government experts were right, having saved us from financial Armageddon.

It turns out it just is not so. As I have written before, money cannot buy prosperity. Savings and investment and wise entrepreneurship? Yes. Inflation and government spending? No. We should not confuse GDP growth with economic prosperity.

Monetary inflation via credit expansion, which is the Federal Reserve's bread and butter, was able to prop up the financial system for a couple extra years. Doug French reports, however, that there is still trouble with a capital T which rhymes with B and that stands for Banking System. Increasing statistical evidence is mounting indicating that, even according to official numbers, the economy is not functioning well enough to put people back to work.

This is because credit expansion funded by monetary inflation instead of voluntary savings does not contribute to capital accumulation, but capital consumption through malinvestment. It funds an inflationary boom which makes it look like things are better than they are. As soon as the flow of new money slows, however, economic reality reasserts itself and several projects that looked profitable are revealed to be unsustainable and must be liquidated, ushering in another recession.

Thus it appears that the stock market may be running out of steam because of perceptions that the QE2 money has run out and Bernanke is not yet willing to commit to QE3. Without the artificial stimulus, the market may be correcting itself to expectations more in line with economic reality.

In his book, Money, Bank Credit, and Economic Cycles, Jesus Heurta de Soto explains how government intervention in the money market can manipulate the stock market. He writes:

Only when the banking sector initiates a policy of credit expansion unbacked by a prior increase in voluntary saving do stock market indexes show dramatic and sustained overall growth. In fact newly-created money in the form of bank loans reaches the stock market at once, starting a purely speculative upward trend in market prices which generally affects most securities to some extent. Prices may continue to mount as long as credit expansion is maintained at an accelerated rate. Credit expansion not only causes a sharp, artificial relative drop in interest rates, along with the upward movement in market prices which inevitably follows. It also allows securities with continuously rising prices to be used as collateral for new loan requests in a vicious circle which feeds on continual, speculative stock market booms, and which does not come to an end as long as credit expansion lasts. As Fritz Machlup explains:

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.

Therefore (and this is perhaps one of the most important conclusions we can reach at this point) uninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis (pp. 461-62).

These words of Heurta de Soto are, as they say, as timely as today's headlines.

Mises Quote of the Day: Monetary Inflation is No Remedy

It seems that Tim Geithner's stock (reputational, not financial) is riding high two years after the financial crisis became impossible to recognize. The man himself claimed recently that the economy is in a "much stronger position than it was before the crisis" two years ago. Along with Bernanke, Geithner is credited by many with stabilizing our financial system via TARP and bailing out Fannie Mae and Freddie Mac so as to forestall another Great Depression. With unemployment persisting between 9 and 10 per cent, however, it seems to me that the jury is still out regarding the health of our economy. What may appear as economic health, may merely be another inflated stock market. Let us not forget that the stock market was looking pretty robust immediately before the crash of 2009.

All of this brings to mind a passage from Ludwig von Mises' Monetary Stabilization and Cyclical Policy (written in 1928) I read recently. In a section evaluating monetary inflation as a policy response to a recession once it begins, he writes:

It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course. Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still the total loss brought about by the “boom” (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. As a result, these factors of production are now lacking for more urgent uses. If intervention prevents the transfer of goods from the hands of imprudent entrepreneurs to those who would now take over because they have evidenced better foresight, this imbalance becomes neither less significant nor less perceptible.

It Takes Debt to Pay Debt?

I was quite young when I first heard the popular saying, "It takes money to make money." That statement, of course, refers to the fact that in order to invest in any profitable opportunity, one must have funds to do so.

Now it seems that it takes debt to pay debt. Both Timothy Geithner and Ben Bernanke are concerned that if Congress does not raise the federal debt ceiling and, hence, make it legally possible for the U. S. Government to borrow more money, it may default on current debt. Last month "Geithner warned that a failure to raise the debt limit would mean the government would not be able to make the payments on the current debt, which stands at $13.96 trillion." Yesterday Bernanke told the National Press Club that not raising the debt ceiling would have "catastrophic consequences" and put the United States Treasury in the possible position of defaulting on previously issued debt.

So we need to take on even more debt to pay back money we have already borrowed?!? You know things are a fiscal wreck if the government has to borrow more money merely to keep from defaulting. Bernie Madoff's Ponzi scheme worked on just the same principle, we have to keep money flowing in to pay clients who were promised phenomenal returns. 

It is customary for normal people, if they have taken on too much debt, to alleviate the problem by not borrowing anymore and by reducing spending until the debt is paid down. In fact the website of the Board of Governors if the Federal Reserve includes a page devoted to helping people manage their credit. About credit cards they tell us:

To get the most from your credit card, do your homework. Review your income and expenses, estimate how much money you might have available to pay down your credit card debt, and consider cutting back on, or eliminating, optional expenses.

If you've fallen behind, are using cash advances from one credit card to pay off another, or your credit cards are maxed out--that is, at or near your credit limit--there are steps you can take to help yourself.

These steps to do not include borrowing more money from Peter to pay our existing debt to Paul. That is exactly, however, what Bernanke and Geithner say we must do to avoid catastrophe. The phrase, "Physician heal thyself" comes to mind. Alas, it seems that the government, like Nick Caraway said about the rich, are different from you and me.

Don't Polticize the Fed?

I remember from a review (having never seen the film) that at one point during Madonna's documentary Truth or Dare, she get's a telephone call from her father asking her not to be so immodest during her live concerts. She replies into the phone, "But Daddy, I have to keep my artistic integrity." When I first read that story, the first thought that came to mind was a question. In order to maintain something, doesn't one have to possess it first?

Treasury Secretary Tim Geitner recently provided a similar thought only in reverse. No doubt aware of the growing skepticism toward our central money printing machine, the Federal Reserve, Geitner has warned Congress not to remove the Fed's mandate to pursue full employment. To do so would be to politicize the Fed, which is a definite no-no.

Again a question comes to mind. Can we prevent something from happening after it has already happened? The fact is the Fed, by its very nature is politicized. It is chartered by the United States Congress, which Geitner surely understands, is filled with politicians. Whenever Ben Bernanke is asked by Ron Paul what in the Constitution gives the Fed the authority to create dollars, Bernanke appeals to the Fed's Congressional charter and says, in effect, we serve at the pleasure of Congress.

Bernanke has also recently began carrying water for the Obama Administration in criticizing China's perceived currency policy. The idea that the Fed is fiercely independent strains credulity. The Fed is already politicized up to its eyeballs. In fact, as Murray Rothbard showed over a decade ago in his Case Against the Fed, it was the product of politics from the beginning. The quickest and surest, indeed only, way to de-politicize the Fed is to end it.

Idols of Housing

One of the great books on American culture written in the 1980s (and still timely today), is Herbert Schlossberg's Idols for Destruction. Schlossberg describes and critiques various forms of contemporary idolatry in American culture from a Christian perspective. Included are chapters about idols of humanity and idols of mammon.

As Schlossberg defines it

Idolatry in its larger meaning is properly understood as any substitution of what is created for the creator. People may worship nature, money, mankind, power, history, or social and political systems instead of the God who created them all. 

In this context idolatry is the setting up of some person, place, or thing, above Jehovah God, the only being worthy of worship and obedience. Schlossberg notes, for example, that those who would make an idol out of humanity "are hostile to any notion of law that is external to the legislative organs under human control and this means that morality cannot be predicated on universal codes." Those who would make an idol out of mammon elevates obtaining material possessions, such as a house, as the end of life.

Evidence of such thinking came out of a recent Treasury Department summit about what to do with Fannie Mae and Freddie Mac, those mortgage buying leviathans. Bill Gross, for example called for the complete nationalization of housing finance in the United States. Gross said

To suggest that there’s a large place for private financing in the future of housing finance is unrealistic. . .Government is part of our future. We need a government balance sheet. To suggest that the private market come back in is simply impractical. It won’t work.

Well then. So let it be written, so let it be done. Think financing housing is not a matter for the state? Your unrealistic. Worried about constitutionality? So anachronistic. Think that full nationalization of the housing industry might be less than economically wise? Who can say before the fact what the economic outcome will be? Concerned that such a matter violates the ethic of private property? We do not discuss such things in polite company.

For his part, Treasury Secretary Timothy Geithner sounded like the conservative. He said that the Obama Administration "will not support returning Fannie and Freddie to the role they played before conservatorship, where they took market share from private competitors while enjoying the perception of government support.” Alas, it appears that Geithner is asking for something contradictory. I don't see how a government sponsored entity can participate as a supplier in a market and 1) not take market share from private companies and 2) not enjoy the perception of government support. The logical policy to take from Geithner's stated perspective is to eliminate government involvement in mortgage finance altogether, but I am confident that he does not want that.

On the other hand, Mike Heid, co-president of Wells Fargo Home Mortgage, said that a government guarantee against catastrophic loss would help draw private capital into the housing finance market. Well I bet it would. As Heid correctly noted, however, the challenge would be "how to marry this government guarantee with the maximum use of private capital in a way that minimizes the risk to the taxpayer, encourages competition, and ensures no one institution is too big to fail."

In other words, how do we accomplish contradictory ends? How do we intervene to provide government guarantees in such a way that private capitalists will act accordingly while at the same time not act accordingly? If we promise them guarantees against catastrophic loss that will draw them into this market, but that same promise will also give them the incentive to take on much more risk that necessarily falls on the taxpayer, not themselves.

In his book Meltdown Tom Woods has already done a masterful job explaining how Fannie and Freddie played a large role in creating the housing bubble that helped usher in the Great Recession. Because of such government sponsorship and the perception that they were indeed too big to fail, they drew much more capital into the housing market than there would have been otherwise. This is just fine for those whose chief end is to glorify home ownership and to enjoy four bedrooms and two-and-a-half baths forever. Those who understand economic law, however, recognize that such intervention has had and will always have serious negative consequences.

Gross and company demonstrate the flight from reality, what Schlossberg refers to as pathology, of the idolatrous. Notice the implicit ethical criteria--whatever brings back the housing market trumps everything including economic law, civil law, and moral law. There was nary a suggestion that trying to reap all of the benefits of the market through government intervention cannot succeed because of economic law. There certainly was no discussion about how such policies would obliterate private property in housing finance with obvious ethical consequences. When we place anything above the law of God, however, we engage in practical idolatry and are playing with some serious fire.

How Politicians Bring Down Deficits: Geithner vs. Romer and Perhaps Romer vs. Romer

It's not by reducing government spending--the one thing that would actually help the economy. Instead, Tim Geithner, Secetary of the Treasury, says we should raise taxes by letting the Bush tax cuts die for two reasons:

1. It will not push us into a new recession.
2. It will show a commitment to cutting the deficit.

It's not clear to me that we are entirely out of the "old recession" yet. Even if we are, however, Geithner's second reason belies ignorance of the truly significant factor affecting economic prosperity. An astronomical government debt is not the main evil, per se. It is what it represents, a massive increase in spending above what is taken in as tax revenue.

There are two ways to reduce the government deficit, one is helpful to the economy and the other is not. If the government raises taxes, the government deficit may indeed be reduced, but this does not remove the drag on the economy. It merely shifts the funding of the state apparatus away from borrowing and toward taxation. Both taxation and government borrowing, however, draw resources out the private economy and result in capital consumption. Capital consumption is a recipe for economic contraction. With less capital profitably invested, labor productivity falls, putting downward pressure on wages and incomes, lowering our standard of living.

Randall Holcombe notes that an empirical study co-authored by Christina Romer, head of President Obama's Council of Economic Advisors, verifies the contractionary nature of taxation. Her paper, "The Macroeconomic Effects of Taxation," was published in the June 2010 American Economic Review and concludes that "tax increases are highly contractionary." A pre-publication working-paper version can be found here.

One interesting finding by Romer and Romer is "that tax increases designed to reduce a persistent budget deficit appear to have much smaller output costs than other exogenous tax increases." This makes sense, because of the reasons mentioned above. Raising taxes to decrease a budget deficit is merely shifting sources of funding. Capital consumption that is already occurring due to government borrowing will merely continue due to taxation, so the negative effects of taxation in this case will not appear to be as drastic a change. Note, however, that the effect is still negative. Thus economic history contradicts Geitner's hope that increasing taxes will not be a drag on the economy. It will also be interesting to see, as Holcombe asks, will Romer the political appointee listen to Romer the economist?

If Geithner and company want to point us in the direction of prosperity by way of reducing the deficit, their only option is to reduce government spending. Reducing spending will allow for less government borrowing and lower taxes. Both will keep more capital in the hands of capitalists and entrepreneurs who will invest it in productive activity instead of government consumption. Focusing on the deficit per se distracts us from government spending, the real enemy of prosperity.