Thus began decades of debate over Keynesian economic policies, a disagreement as unresolvable as it is fundamental. One economic denomination believes that recessions are healthy. Like periodic forest fires or floods are necessary for a healthy ecosystem, the cleansing of a downturn strengthens the economy in the long run. The other faith, the one more aligned with Keynes’ views, believes that collective action can minimize – or even eliminate – economic hardship, and that not doing so causes needless loss and unnecessary suffering.
For example, prior to the Great Depression, housing finance was a largely local endeavor. To control risk, local banks dealt in only short-term notes – mostly three to five years – with balloon payments that needed to be refinanced when the loan matured. With capital contracting during the Great Depression, banks were less willing – sometimes not even able – to rollover loans. Many people were unable to obtain new financing when their mortgage expired and the balloon payment came due. This needlessly put them into default, and subjected them to large losses, even when they were making their payments and could afford to continue doing so.
The Federal Housing Administration (FHA) was established during the Great Depression to deal with this problem. The FHA offered mortgage insurance to entice local banks to offer longer-term loans with significantly less money required for a down payment. This allowed people to avoid default, to stay in their homes and continue to make payments. It saved banks from having to sell seized homes into a declining housing market. The FHA stabilized housing prices, which was good for nearly everyone.
The Great Depression’s housing crash is a classic deflationary spiral, where collapsing prices – in this case, homes – push otherwise solvent, productive people and businesses unnecessarily into default. This is the kind of unforeseeable event that prompts peasant farmers to spread their plots, and to forgo growth and efficiency for stability. In a modern economy, if there is an obvious case for a Keynesian intervention, this is it.
The Last Country Standing
World War II ended the Great Depression. The mobilization of millions of young men to Europe and the Pacific decreased the supply of workers. Dramatic levels of wartime manufacturing increased the demand for workers. Lowering supply while increasing demand results in increased price. In this case, the price of labor increased, a trend that would continue for the next three and a half decades.
Unlike World War I, where it was unclear until the final months who would win, it became evident sometime in early 1943 that the Allies would defeat Germany and Japan. The only real open question was the cost in lives and treasure. As Allied nations began to contemplate what a post-war international monetary system would look like, the economic trends sending wealth from Europe and Asia to North America accelerated. The United States would be the only major world power to emerge stronger from the war than they went into it.
Prior to World War II, international trade used a system that relied on gold for the settling of international accounts. Countries with trade deficits would deplete their reserves, literally giving up their gold in exchange for getting their own currency back. They now had the same amount of currency in circulation, but less gold, which is a devaluation.
To deal with this, the government would be forced to take money out of circulation, or risk losing all its gold and, by relation, the value of its currency. This is a painful constraint, one that slows the economy. A less enthusiastic economy has less demand for consumption, particularly of imports. With a weakened currency, exporters find their products more competitive internationally. This rebalancing would continue until the country was back in surplus, a point where another country would be in deficit and experience the same painful constraint.
It’s that last part – the painful constraint – that made the gold standard very inconvenient for prosperity-seeking, democratically elected governments. If one country is in surplus, another must be in deficit. The friction that reality creates forces them to not get too far out of equilibrium. It can also force them into war.
And when the entire world is at war, or is rebuilding from war, there is no surplus anywhere. The system breaks down.
The Bretton Woods agreement, negotiated in July 1944, established a new international system of fixed exchange based on a gold-backed dollar. Keynes had argued against the gold-backing – some contend to free economies from the constraints of gold-backing, others as a cynical ploy to maintain the power of the British Empire’s sterling trading block – but the American negotiators, who literally had the gold, insisted on it. One ounce of gold was set at $35.
The U.S. dollar was now as good as gold and would become the world’s reserve currency. To grasp the profound nature of this arrangement, understand that the sale of oil by the Soviet Union to communist China was done in U.S. dollars. Everyone wanting to trade needed dollars, an exorbitant privilege for the last country standing.
The Post-War Boom
Paul Samuelson, Nobel prize–winning economist and perhaps second only to Keynes in terms of influence on modern economics, wrote an essay in 1943 on employment after the war. He stated the consensus opinion among economists at the time, that there was nothing structurally different about the economy that would prevent the United States from sliding right back into depression once the war ended.
Were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties – then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.3
His brilliance notwithstanding, he was, of course, wrong. Not only did the country avoid a return to economic depression, the United States embarked on a multi-decade economic mania that is still looked at as a golden age. America took its industrial capacity and directed it toward building a new version of prosperity, a continent-wide experiment in a new living arrangement.
With the world’s reserve currency, abundant and cheap oil, and low individual debt levels, the United States serendipitously found itself with the ingredients it needed for rapid economic growth. What happened was a generation of American growth, two and a half decades of spreading prosperity that is still broadly nostalgized.
In this period of time, Americans built the interstate highway system, the largest public works project in the history of mankind. These transportation investments broke the stifling stability of high land values, making abundant raw land available to the masses at affordable prices. Investments in infrastructure systems accelerated. Through Urban Renewal initiatives, new planning theories were put into practice, remaking entire neighborhoods.
Policymakers quickly discovered that the tools for fighting deflation in the Great Depression worked even better for expanding the economy during the post-war boom. Focusing again on housing, the FHA used the same approach of lowering down payments and insuring banks against default. This time it wasn’t fighting a deflationary spiral; it was expanding demand for housing, dramatically increasing prices.
Growing demand for new housing was a boon for the economy. Building this new version of America created millions of jobs, from carpenters and contractors to appliance manufacturers and door-to-door encyclopedia salesmen. A robust housing market created wealth in a growing middle class, a trend that became central to American self-identity. After things had been so hard for so long, everything suddenly became easy.
Of course, it wasn’t easy for everyone. The collapse of land values in urban areas resulted in systematic disinvestment – both economically and culturally – in those places left behind. The FHA, along with the government-sponsored housing finance agencies Fannie Mae and Freddie Mac, juiced housing even more by expanding the secondary market, an exchange where local banks could unload qualifying mortgages, freeing lenders up to make more loans.
Large suburban tract homes qualified for the seco
ndary market, but the frugal house with the small attached shop didn’t. Anyone who wanted a resilient housing style, one dating back to the streets of ancient Pompeii and beyond, would essentially need to pay cash, a financial handicap that made such investments largely unfeasible.
Any neighborhoods deemed “at risk” also didn’t qualify for government support, the left hand of government policy destroying urban land values while the right hand kept people trapped there – at this point, largely economically stressed minority populations – from sharing in the spoils of new growth.
By the time the United States reached the end of the first generation of the post-war boom, the first iteration of what I’ve termed the Municipal Ponzi Scheme, the bulk of the country felt so prosperous it embarked on a massive campaign to end poverty – the Great Society – as it simultaneously fought an expensive war in Vietnam.
By many economic measurements, this is the high-water mark of the twentieth century, particularly for America’s middle class. Generations of wealth incrementally built within America’s cities had been destroyed in favor of rapid growth and economic expansion, an exchange with a naturally redistributive effect. Individual Americans had experienced how national growth solved their individual problems, a narrative they would never seriously question thereafter.
Struggling with Constraints
The liabilities from this experiment would now start to come due, particularly for local governments. The infrastructure investments being induced created a lot of transactions – a lot of economic growth – but the lack of productivity meant there wasn’t enough wealth to maintain everything once the financial sugar high wore off. Cities like Ferguson, Missouri, which was an affluent suburb of St. Louis in the first generation of the post-war boom, now had to sustain all those miles of roads, sidewalks, and pipes with a stagnating tax base not up to the challenge. Ferguson would go on to become notorious for decline and blight, a distinction it shares with most of America’s immediate post-war suburbs.
These suburbs became known as “first ring” because, while they began to stagnate and struggle, a second ring of development was being created in the hinterland beyond them. In a manner similar to slash-and-burn agricultural practices, these newer cities gave the affluent a place to move when the signs of stagnation in their first-ring neighborhoods became overt.
This locked in a pattern of growth, stagnation, and decline that would become one of the defining features of the current American development pattern.
At the national level, the French were taking the United States at its word, demanding gold in exchange for dollars as promised under the Bretton Woods agreement. This was a smart move for the French as it was clear the United States was abusing its privilege as a reserve currency, creating more money than was supported by the store of bullion. In theory, declining gold reserves would prompt the government to raise interest rates, reduce the money supply, and slow growth in order to strengthen the currency. Those were painful constraints few Americans welcomed.
Instead, in August 1971, President Richard Nixon “temporarily” ended the convertibility of gold, promising to restore it once the run on gold reserves subsided. The constraining mechanism of gold-backing removed, it has never been restored. Most mainstream economists today consider the need to back the currency with gold, or any other tangible commodity for that matter, an antiquated notion.
A period of prolonged stagflation set in, something that baffled economists. All conventional economic theories suggested that prices rise and unemployment falls during economic expansions, while during recessions the opposite happens; unemployment will rise and prices will fall. Stagflation is a simultaneous rise in prices and unemployment, as if both sides of a see-saw are moving in the same direction in contradiction of the laws of physics.
The nontheoretical response to hardship at the local level was to seek ways to increase efficiency. For example, in my home state we experienced something that has become known as the “Minnesota Miracle.” The state government standardized local tax structures to provide one streamlined approach for businesses and individuals. Instead of each city having their own approach, the state would collect property and sales taxes and send money back to cities for essential services, all based on a single formula.
The benefits from this were immediate. Businesses looking to expand no longer had to contend with each local set of parochial regulations. Instead, large corporations were able to tap into a broad set of resources – even Wall Street capital – to make investments and drive growth in a more efficient paradigm. What cities lost in local control they gained in resources as the state, flush with money from new growth, was more generous than stingy, local taxpayers.
There were long-term consequences, however, to the increase in efficiency. Now all cities had the same local tax structure, so a mining community is forced to structure their local economy the same way as an agricultural community, which was the same for a new suburb and for a major, regional center. All local nuance and flexibility were removed, making cities unable to adapt, except in the bluntest ways, as their fortunes diverged.
And once the short-term efficiency gains were realized, the state budget came under its own set of constraints. In the ongoing debates over raising taxes and cutting services, aid to local governments has consistently been the lowest of priorities. Now that local governments’ finances are desperately fragile, so is the state government they thought was their benefactor.
Another example of short-term gains through efficiency came with women entering the workforce in increasing numbers. While there were, and still are, strong gender-equity arguments for making the workplace more welcoming to women, it wasn’t only liberation that most women were seeking by taking on additional labor outside the home. It was a paycheck, and the increased standard of living that extra income provided.
And, in another example of long-term consequences, that added income didn’t ultimately result in broader prosperity and financial stability for families. Over time, it merely increased prices for family essentials, like housing, daycare, and education. Instead of the economy having to adjust downward to meet productivity levels – a painful constraint – women entering the American workforce bailed out the economy by adding their capacity. For economists, another macro constraint avoided.
In the 1960s, a family could live comfortably in the middle class with just one wage earner. Now they need two, at least. We must applaud the empowerment aspect of expanding opportunity for women, and having women in the workplace has benefits beyond economic growth, but it’s quite a stretch to think of the person forced to clean hotel rooms, work a gas station counter, or stock shelves at a big-box store, just to make ends meet, as enjoying any meaningful form of liberation.
These actions are akin to the short-term gains from peasants consolidating their plots into a single location. If output is measured in the immediate years following the change, there is little doubt as to the progress being made. When put in the context of an infinite game, however, the increase in fragility becomes the ultimate, painful constraint.
Going All In on Debt
When you’re very fragile and you run into hard times, there are only difficult lessons to be learned. That is, unless you can make a deal with your future self.
Debt is future consumption brought forward. We borrow from our future selves with the promise that, when the time comes, there will be some sacrifice to repay the debt. In contrast, savings is consumption deferred. Money that is saved today is a sacrifice that provides opportunity to increase consumption in the future.
As America progressed through the second life cycle of the Suburban Experiment, it took a cultural shift for its citizens to embrace debt. It seems little coincidence to me that this change in attitude coincided with passing of those who were adults during the debt-fueled speculation of the 1920s. Debt increases fragility by making future growth mandatory. If all you’ve experienced in your life is growth, debt doesn’t seem nearly as risky
.
Beginning in the mid-1970s, but then accelerating dramatically thereafter, the U.S. economy shifted from one based on growth through savings and investment to growth based on debt accumulation. Government debt is an important part of this story, but perhaps more important is private-sector debt.
In 1980, U.S. households had a 63% debt-to-income ratio. For every dollar in income, a typical family had 63 cents in debt. By 2000, that had grown to 84%, and by 2008, at the start of a financial crisis, family debt was 124% of annual income.4
While debt has increased, savings have gone down. In January of 1980, the U.S. personal savings rate was 9.9%. By January of 2000, it was down to 5.4%, and by 2008, it had fallen to 3.7%.5 Over the past three decades, Americans have borrowed more and saved less.
In classic economics, it is very clear what should happen when there is a lack of savings but a high demand for borrowing: interest rates should go up. That is how the supply and demand of money reaches an equilibrium. When there is not enough savings to meet the demand for borrowing, higher interest rates entice more people to save and fewer people to borrow. Yet, the opposite happened; rates have gone down dramatically.
At the beginning of 1980, when Americans were saving more and borrowing less, the effective Federal Funds Rate of interest was at 13.8%. It would peak the next year at just over 19% and be on a steady decline through three decades of declining savings and increased borrowing. At the beginning of 2000, the rate was 5.5% and eight years later, it was at 3.9%.6
Strong Towns Page 10
