Common Cents

by Michael Harrington

  4. Capital is the lifeblood of a free market society. Economic policies should promote capital accumulation and widespread participation in capital ownership.[61]

  The ‘democratization’ of capital can open up capital markets through microfinance, giving wider access to competitive sources of investment capital. This is historically how poor immigrant communities have bootstrapped their way to wealth. Since participation in the wealth-creating potential of a market economy would be more widely shared by all, an increase in capital investment combined with available labor can drive that potential higher.

  We cannot ignore the fact that widespread accumulation of capital also demands widespread risk-sharing, which is the basis for spreading returns. One might think more risk-sharing places too much of a burden on the working class, but workers and wage-earners already bear the risks of business failures and economic downturns through unemployment—they just don’t get paid for it. Most wage contracts, such as those negotiated by unions, do not reduce risk but merely transfer it, usually from the politically strongest to the weakest. We see this trend in two-tier union wage contracts where senior members retain benefits that new members will not receive. In a fluid capitalist economy, it is becoming apparent that wage contracts are low-risk, low-return strategies that reduce the ability of workers to get paid for risk and to share in the returns to success. The specter of wage competition from the expanding international supply of labor should be warning enough that the rules of the game have changed.

  There is one last principle of policy design that we must add:

  5. As uncertainty reduces the level of economic risk-taking, our public policies should strive to reduce the uncertainty associated with economic decisions. This means that government policy directives should be clear, transparent, consistent, and far-sighted. A firm commitment to first principles helps insure this outcome.

  The essential action of life in a free market economy in an uncertain world is risk-taking. Our strategies to survive in this world involve managing the inherent risks we face in order to take additional risks of our choosing. If someone has several million dollars in the bank, he or she may then feel comfortable to pursue the financially precarious life of an artist or intellectual. If someone has a broad job skill set, he or she may be more inclined to start up a new business in a chosen field. These strategies we pursue at the individual, or microeconomic, level should be enhanced, not constrained or hampered, by our public policies. A good example of how policy constrains risk-taking is linking health insurance to places of employment, with the result that many people stay in a job merely because they fear losing affordable insurance. This fear greatly impairs entrepreneurial risk-taking. In an uncertain world, we should strive to make sure our policies do not increase that uncertainty unnecessarily.

  To summarize, let us restate the preceding five principles of policy design:

  1. Economic policy and politics should serve the principles of freedom; in the realm of public policy this translates into maximizing freedom of choice and freedom of action.

  2. Policies should facilitate the flexibility of the economy, improving its adaptability to unpredictable change. Thus, policies should facilitate the fluid reallocation of resources. This requires accurate price signals provided by competitive markets.

  3. To facilitate change, public policies should primarily focus on managing risk, either through helping citizens manage their own risks, establishing laws that ensure competitive private insurance markets, or providing social insurance.

  i. The preferred policy for risk management is self-insurance through increased savings and diversified asset holdings;

  ii. The next policy priority should be to support efficient private insurance markets;

  iii. In cases of insurance market incompleteness or failure, policy should resort to universal social insurance systems funded by taxed contributions; ideally, these contributions can be based on expected losses as determined by actuarial data.

  4. Capital is the lifeblood of a free market society. Economic and tax policies should promote capital accumulation and widespread participation in capital ownership.

  5. Because uncertainty reduces the level of economic risk-taking, our public policies should strive to reduce the uncertainty associated with economic decisions. This means government policy directives should be clear, transparent, consistent and far-sighted.

  Guided by these policy principles, we will apply our understanding of the economy to several of our most challenging policy issues.

  Chapter Five

  The Main Policy Challenges

  We could spend an entire book analyzing all the ways we fall short of first principles in formulating economic and social policy. Instead, I will focus on the main challenges we face today. These are Federal Reserve policy and banking reform, fiscal reform, tax reform, entitlement reform, and the principal-agent problem.

  5.1 Federal Reserve Policy

  The Federal Reserve was established in 1913 in order to manage the private banking system and avoid panics that were common to the 19th century. The 1913 Act has been amended over the years, expanding the Fed’s original purpose and mandate. Currently, the two principal functions that concern our policy discussion are:

  Managing the nation's money supply to achieve the sometimes-conflicting goals of

  Stable prices, including prevention of either inflation or deflation

  Maximum employment

  Moderate long-term interest rates

  Maintain the stability of the financial system and contain systemic risk in financial markets by regulating member banks.

  We already discussed how the money supply is manipulated through credit creation by the fractional-reserve banking system under the imperfect control of the Fed. In 1946, the Full Employment Act introduced an additional policy objective of promoting full employment for the Federal Reserve. Today, the twin goals of price stability and full employment (1.a and 1.b above) are referred to as the Fed’s “dual mandate.” These goals conflict, however, when the choice is between lowering interest rates to stimulate investment and employment versus raising interest rates to tighten the money supply and dampen inflation pressures. The conflict is easily politicized because politicians facing re-election favor short-term stimulus spending to increase employment over long term price stability. Excessive public and private debts have also tilted the balance between inflation and deflation in favor of inflation. Knowledge of these policy biases has fostered uncertainty and investor anxiety over the future value of the dollar, as well as the policy direction of a Fed faced with conflicting goals.

  Recent results of monetary policy, combined with the logic of our model, suggests policymakers may be pursuing a false trade-off between employment and price stability with wrong-headed policies that deliver neither. Let’s investigate this possibility.

  We must remember that neither the Federal Reserve nor the government directly ‘creates’ employment and production. It is the private economy that creates jobs through business expansion and entrepreneurial start-ups. In order for the private economy to expand, businesses need to understand their own financial risks relative to the future value of the dollar and government policies that may affect the expected future value of their investments.

  We often hear from the politicians that their main priority is “jobs, jobs, and jobs,” but what does that really mean in practice? Public spending can be employed toward this goal by creating positive externalities that help the private sector become more productive. For example, Congress can authorize to build a road as a public good, paid for with taxpayer money. The government does not collect any revenue from the road, which is used by private parties to reduce transportation costs and broaden markets. Thus, the private sector expands as a result of this public spending externality. (This assumes that the road would not be provided by the for-profit, private sector. If it was, there would be no need for the government to step in.)

  However, if the gove
rnment spends money on activities that either create no positive externalities or that substitute for private sector businesses, the spending represents a mere substitution of public for private investment. No gain in production or employment results and the administrative costs represent a welfare loss to the economy. Let us consider another example to demonstrate. The government decides to hire one crew of workers to dig a ditch and then another crew to fill in the ditch. All are fully employed digging and filling in ditches and everybody gets paid a decent wage, say $20/hour plus benefits. There is no real production to show for all this effort, but each worker now has more money to buy food, clothing, etc. Is this a positive externality? Probably not. Let’s imagine a private developer wished to employ these same workers to build low cost housing, but could only pay $15/hour with fewer benefits. But the labor resources he needs are unavailable, soaked up by the non-productive government sector. The net effect to the economy is a loss of productive jobs and income growth.

  This example illustrates how public investment, absorbing labor and capital resources, can “crowd out” private sector activity that would lead to greater job growth and production. Perhaps this sounds theoretical, but what exactly was “Cash for Clunkers”? It was a policy that destroyed assets (older cars) in order to subsidize the purchase of newer, more expensive assets (fuel-efficient cars). All this did was subsidize car purchases that would have occurred but were moved forward in time to take advantage of the price break. The policy also removed used cars from the market that many buyers who could not afford a new car would have liked to purchase and use. If one wants to grow an economy, this policy makes little sense. (Of course, we should realize this was a political gambit to save jobs in the auto industry – jobs that eventually may disappear anyway.)

  In Chapters Two and Three we discussed the importance of the interest rate and predictable currency values for stable, sustainable economic growth. Unfortunately, the dual mandate forces the Fed to manipulate interest rates, compromising its mission of price stability and distorting crucial price signals that guide consumers, savers, borrowers, and investors. All sorts of sleights of hand have been employed to try to obscure this fact with rosier headline economic statistics (see previous discussion on government statistics). We should also raise questions about the actual results of such policies. The president’s Council of Economic Advisors recently calculated that only 2.4 million new jobs could be directly attributed to $666 billion of government stimulus spending. The cost to taxpayers comes to $278,000 per job! Due to generous rules for counting new jobs, that figure is probably vastly understated. It’s difficult to defend this sort of public investment policy.

  Given the obvious limitations of government to affect employment directly, it would probably be better policy if the Fed focused solely on ensuring the purchasing power of the dollar so the private economy could adjust to stable, undistorted prices. The less uncertainty businesses face, the more confidence they will have to make risk-taking investments in the future. The alternative, which we are experiencing now, has burdened us with idle capital and underinvestment, asset speculation, underemployment, undercapacity, and anemic real growth, to say nothing of the future implications of exploding public debt.

  The next issue on the Fed’s policy agenda is the problem of managing the banking system and controlling systemic risk. The root of this challenge can be found in a financial system dominated by credit creation and debt. Debt, as opposed to equity (or stock), increases and concentrates risk. It does this through financial leverage and legal contractual obligations. When a business issues stock, the investors assume the risk of loss to the limit of the investment, without any guarantees. When business obtains a loan from a bank, or issues a bond, it assumes a legal contract under the loan terms specifying the right of the lenders to be repaid ahead of other claimants, such as equity investors. Lenders also have first claim on the salvage value of any assets owned by the business, such as plant and machinery, real estate, or inventory. The finance term for this priority is seniority, so debt finance is senior to equity finance. This is why equity investors are often called residual claimants, meaning they can claim any profit residuals only after every other liability of the business is paid off. Technically, they are also the owners of the business, which is why they are called shareholders and stocks are called shares.

  From the point of view of the business, debt obligations concentrate the risks of the business onto the owners of the business, while equity finance spreads the business risk by creating new ownership rights. Since equity investors assume more risk, they also expect higher returns if the business is successful. With business success, equity finance can be quite expensive to the business owner, or entrepreneur, because he or she had to give up ownership rights and residual claims to profits. These higher returns demanded by equity investors are the business owner’s trade-off for more financial flexibility. If the business suffers losses, equity investors share those losses, whereas lenders and debt holders still have legal recourse to interest and principal payments. If debts are not serviced or repaid, the business can be forced into bankruptcy where its assets are liquidated to pay off as much debt as possible. This means a business funded by debt has less flexibility to adapt to unexpected market shocks.

  An entire financial system that depends primarily on debt finance is going to present greater risks of a systemic collapse. Fundamentally, this is why the losses of the dot-com crash were more easily absorbed by the economy than the losses of the housing crash. When dot-com companies’ stocks crashed, unsecured equity, or “funny money,” disappeared. Dot.com bubble gains felt surreal, like Monopoly money, with the mere illusion of value. In contrast, when the housing market crashed and house prices fell, mortgages still have to be paid in full, putting a crushing burden on those who borrowed excessively with the expectation that prices always go up. With the integration of credit through securitized collateralized debt obligations, the chain reaction of defaults spread far and wide. The U.S. crisis of subprime mortgages quickly became a crisis that threatened the entire worldwide financial system.

  The Federal Reserve’s mandate to regulate and stabilize the banking system to contain systemic risk is severely compromised by the rise of a worldwide shadow banking system. The expansion of finance, worldwide integration of financial markets, and the lack of sovereign government control over multinational banking means that many of the tools that governments use to regulate the banking system are obsolete and ineffective. Leading up to the crisis, unregulated, non-banking entities such as investment banks (Bear Stearns, Lehman, Goldman Sachs, Morgan Stanley), hedge funds, foreign banks, and private companies like AIG issued billions of dollars of highly leveraged credit. The potential failure of these 'shadow banks' led to cries of "too big to fail" and the eventual TARP[62] bailouts.

  The Fed has embraced its easy credit policy in a desperate attempt to get the economy back on track. But it’s still the wrong track. Subsidized interest rates have hurt savers and creditors, and rewarded marginal borrowers, asset speculators, and consumers. One former hedge fund manager, assessing the Fed’s management of the crisis, commented: “Just don't forget that zero interest rates are not real—they are a construct of the Fed, not the market, and they are dangerously distorting the crucial capital-allocation process.”

  In order to get monetary policy back on track, we should narrow the mission of the monetary authorities and enforce some stability into the policymaking process through transparency and accountability. Instead we have gone in the opposite direction by granting the Federal Reserve and the U.S. Treasury extraordinary discretion over our economic future. This should not have been necessary. Consider these statements made by our present Federal Reserve chairman Ben Bernanke in the run-up to the worst financial crisis since the 1930s:

  "We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize" (July 1, 2005).

&
nbsp; "…the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained" (March 28, 2007).

  [Freddie Mac and Fannie Mae] "will make it through the storm" [and are] "adequately capitalized" (July 16, 2008).

  As one policy wag put it, Bernanke has been wrong with his financial predictions more often than the weatherman! But this is no laughing matter. Our credit-driven monetary management over the past twenty-five years has turned the relationship between the financial service sector and the real economy on its head. We have essentially created a financial market casino, where the banking industry lays bets on price movements of financial and real assets instead of making long-term loans to businesses. Price volatility is a Wall Street gambler’s best friend and easy credit policies have grossly distorted prices of everything—from houses, to securities, to gold and commodities, to final goods and services.

  The subsequent loss of confidence in the U.S. financial system and the Federal Reserve's mismanagement of the banking system imposes real costs on the domestic economy. These real costs lie behind the price bubbles and busts that have misinformed our economic decisions, causing us to make the wrong consumption, saving, and investment decisions, misallocating the deployment of scarce resources that ensures the long run sustainability of the economy. Our savings have been inadequate, our borrowing excessive, and our investment and production misdirected. In simple terms, we've spent too much money on houses, automobiles, and other discretionary goods sold at the mall, and spent too little on food, pensions, energy production, and other necessities.