The first step is to end deficit spending. Growing the economy is the only way to increase tax revenues in the future, but revenues can never reach the levels of today’s spending, so spending must decrease. That’s where addressing the entitlements, which account for the major portion of the federal spending has to start. Without doing that, spending cuts can never reach the level needed to balance the budget. That will require great leaders who can explain to the electorate why this is necessary, who can then vote for members of Congress to carry out this reform. Remember, we are way past the point where revenues can be raised enough to balance the budget; now it’s just impossible. Adopting a gold standard to operate under is the only way we can get the discipline to enforce balanced budgets upon Congress. That’s because any deficit spending within the framework of a gold standard will lead to increased interest rates, and the pain that it will cause to be felt by the electorate ensures they will vote only for politicians who can return the country to balance.
Politicians love to promise gifts to various groups to gain popularity and to raise votes to sustain their elected office. The only way the country can maintain the discipline to reduce this tendency is via a gold standard. In the past politicians never had to worry about how their “gifts” would damage the future, and usually, deficits became “smaller” through the hidden tax of devaluating the currency via inflation. For example, say a war costs $100 billion, which was borrowed. Over time, inflation rose and prices doubled. That means dollars would only buy half as much in goods, so one had to spend twice as many dollars as before for the same goods. And similarly, tax revenues now doubled. Now, the government had $2to pay off $1 of debt. Magic! Politicians could spend with abandon, with borrowed funds to be later magically paid back with fewer dollars than borrowed. The insidiousness bamboozled the electorate into not noticing what a financial mess the political class was drawing the country into. And to make matters worse, the progressive income tax brackets unchanging with inflation, resulted in many of the electorate getting bumped up into higher tax brackets, so voila, like magic, more revenues came in later than were borrowed in the past. Politicians found this spending so much fun that they became addicted and lost all sense of value of what was stolen from the electorate. And then many of the electorates got addicted to what originally was considered a luxury, it later was thought of as a right. Think Social Security and Medicare. Except someone has to pay the bill, and that someone is us.
There’s another nuance that needs to be explained; that’s Keynesianism. John Maynard Keynes was a brilliant financial mind, and he was a great influence over Franklin D. Roosevelt, our president during the Great Depression of the 1930s. At that time, unemployment rose to 25%, and federal tax receipts plunged. Keynes thought it best to keep federal spending at the same level as before the depression started, to not be a negative influence on the already negatively dropped economy. That necessitated going into federal deficit spending mode. Keynes’s thinking was that when the recovery occurred, and revenues returned to normal, the borrowing could be repaid. That might have been a good idea if the discipline was there to eventually pay off the debt, but the recovery came after the country entered the WWII, and spending then had to be increased massively. Following the end of WWII, spending returned somewhat to balanced levels, but a new phenomenon arose. Many politicians became enchanted with Keynes’s notion that when government spends money, it flows through the economy not once, but many times. They called this the “multiplier effect.” Politicians came up with different ratios, but generally, they would say a dollar spent on such and such project runs through the economy two or three times, so its effect is just like spending two or three dollars, and that grows the economy. Thus, a big government spending program (like the recent TARP spending) is supposed to stimulate the economy so that wages would increase, and this would speed the recovery from the 2008 Great Recession. Except there was no meaningful recovery, and we were left with a massive increase in the accumulated federal debt. Of course, Keynesianism is all baloney, but this false notion took hold, and still is believed by an awful lot of people. So, when you hear a politician on the stump voicing such malarkey, tell him or her that they’re full of bull, and stop wasting your time listening to their stupidity.
14 - INFLATION
“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”
John Maynard Keynes
Inflation is the rise of prices for the same goods and services from one period of time to the next. Inflation is bad, and it makes it difficult to plan for the future. It reduces economic growth, thereby hurting job creation. It produces uncertainty in the economy. Businesses fearing loss from new ventures are hesitant to spend money on the investments needed for future growth. For household savings, they disappear over time through inflation. The only ones that benefit from inflation are those who borrow with long-term money for fixed assets that increase in inflation-induced rise in prices. This frequently is the case for real estate properties; buy with money borrowed at 5%, hold through a period of 7% inflation, sell at 7% increase in price, pay back the money at 5%, and pocket the 2% difference as “profit.” The lenders caught in this trap explains the savings and loan debacle (The S&L crisis) of the 1980s and 1990s, when 1,043 savings and loan associations out of 3,234 in the U.S. failed. The same trap was partly to blame for the housing bust climaxing in 2008 when too many people bought homes hoping that the “profit” to be made was going to be their pension plan in old age. And of course, politicians love inflation because they can run up deficits promising “free gifts” to the electorate, to be paid back with “worthless” money. Inflation is a scourge upon all that most value; to be able to work, earn a wage, save that not needed for the basics of life, and over time, accumulate wealth for future expenses foreseen and to provide for them in the years when they are no longer able to work.
How do we know what the rate of inflation is? The Federal Reserve makes a calculation or educated guess as to the rate and publishes this number, which goes out widespread. My problem with the Fed’s number is that I just don’t believe their number. Our central bank, the Federal Reserve, was created to serve as the repository of last resort to all the private commercial banks in the country when financial panics erupted, and when runs on the banks occurred, which then led to them being short of cash. That is; they didn’t have the cash on hand to redeem all the depositor’s cash on hand, because the cash was lent out to borrowers, which is how banks make their money or profit. It was also supposed to protect the value of the dollar. Later, Congress added another function; that their policies were to lead to full employment. I guess they never considered the possibility that the now dual mandate might conflict with the two functions. Today, it is considered that their mandate is full employment and price stability. For price-stability since 2012,the Fed has interpreted its mandate as a long-term inflation rate of 2%.
Martin Feldstein, who served under President Reagan and is a professor at Harvard, wrote in The Wall Street Journal, “Ending the Fed’s Inflation Fixation” on 5-18-16, has created substantial risks that could lead to another financial crisis. He says the fundamental problem is with an explicit target, it’s difficult to know if it’s been hit. The index of consumer prices that the Fed targets should,in principle, measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services they bought the year before. Estimating that would be easy if consumers bought the same thing each year, but things we buy are constantly evolving, with improvements in quality. These changes imply that our dollars buy goods and services with greater value year after year. Adjusting the price index for these changes is impossible. Thus, Feldstein says, the real value of the national income is, therefore, rising faster than the official estimates of real GDP and real income imply. For the same reason, the official measure of inflation overstates the increase in the real costs of goods and services that consum
ers buy. The true rate of inflation could be minus 1%, minus 3%, or minus 5%. There is simply no way to know. With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise target. The problem the Fed should address is avoiding a return to the rapidly rising inflation of 2% in 1965, to 5% in 1970, to more than 12% in 1980. Although we cannot know the true rate of inflation at any one time, we can see if the measured inflation rate starts rising rapidly. In this case, the Fed should be tightening monetary policy (raising interest rates).
Several follow-up letters to Feldstein’s Op-Ed came in soon after. One said the problem isn’t so much the accuracy of the inflation measure, but rather the basic underlying theory whereby 2% inflation is defined as the ideal rate for a healthy economy. Another letter states that the Fed has also been given a third mandate; a goal to maintain moderate long-term interest rates. Since historical interest rates have been about 5%, with a federal debt at the current $20 trillion, the annual interest cost would be $1 trillion. This, while current federal revenues are only $3.24 trillion. This writer then asserts that would lead to a revolution of some sort, followed by a recession or depression, then asking for Congress to revisit the Fed’s powers and duties. Amen.
What causes inflation? Mainly, too much money in circulation, so that too many dollars are chasing too few goods. It most frequently arises when the government is at war, where spending goes all out for the assured necessity of winning, but will also occur with government spending more money than they take in from tax revenues. This is called deficit spending. While everyone knows deficitspending is bad, our political system has failed to rein this in. In the past, typically Democrats loved creating new gifts for the electorate to gain votes, while Republicans abhorred deficits and forever raised, or tried to raise the money to pay for the excesses. Thus, government grew and grew, and without the market discipline present as in the private and real economy that magically matches prices to goods and services, government forever expanded and grew, and forever needed more and larger revenues, but revenues fell behind, and expenses ballooned, and inflation followed.
Nixon panicked when inflation hit 4% and caused wage and price controls be implemented on August 1, 1971. Of course, price controls never work, and as a result, we got the long gas lines back in the ‘70s when gas stations ran short, and cars lined up stuck in large numbers hoping to fill up. Nixon and his advisors failed to see that by their actions, they set off the huge price inflation of the 1970s, by ending the U.S.’s long-standing operation under the discipline of a gold standard (August 15, 1971) that went back to the founding of the country, and got caught in the financial drain of the Vietnam war (3-8-65 to 4-30-75). The inflation rate reached about 12% at its peak. Paul Volcker of the Federal Reserve then oversaw the step-by-step raise in the interest rate, until it reached just short of 20% in 1981, and broke the back of inflation. No one wishes to ever repeat this miserable experience again.
I advocate returning to the gold standard, and getting control of the federal budget, not only so that it balances, and deficits end, but a new and serious initiative must concomitantly take place to make government more efficient, cheaper, and smaller. Corral waste and corruption, rather than make overall across-the-board cuts to the budget which harm needed programs and do not end duplications and old programs.
Federal Reserve, Credit, and Interest Rates
Banks take in deposits from their customers, and loan most of the money out, and interest earned, less interest paid back to the depositors is how they earn their money. They know that usually not all customers will want to withdraw funds at the same time, but when they do, it’s called a run on the bank, and when that happens, the bank must borrow from other banks to meet the call for money. When they get caught short and have trouble borrowing enough funds, it is said the bank is illiquid. On the other hand, if the bank’s borrowers go bankrupt, and thus fail to repay funds borrowed back to the bank, it sets up the bank for failure, and it is said the bank is insolvent. Business tends to cycle through good times and bad, and in bad times, it can happen that so many bank customers need to withdraw their funds held at the banks, that a collection of banks can run short of money to refund to the customers; these times get called a “panic.” These are scary times when people fear depression and loss of their jobs and their wealth.
Alexander Hamilton sensed the country’s need for a national or head bank to facilitate commerce and this was created in the Washington administration. Over the years, different political views dominated, and the national bank was ended, then later another national bank started, and again ended. In 1900, banks had been operating on their own and there was no national bank. Panics weren’t infrequent, but the Panic of 1907 was particularly severe. Ron Chernow writes about this in his award-winning book on the financier, J.P. Morgan in The House of Morgan: an American Banking Dynasty and the Rise of Modern Finance.
“The folk wisdom of Wall Street says that if a crash is widely expected, it won’t occur, for a saving fear will filter through the marketplace. This was refuted in 1907, when Wall Street spent a cliff-hanging year awaiting the crash that came. On March 25, panic selling roiled the Stock Exchange. The financial powers—Henry Clay Frick, Edward H. Harriman, William Rockefeller, and Jacob Schiff—assembled at the Corner for a secret meeting. They wanted a $25 million pool to steady prices. Jack cabled Pierpont (J. P. Morgan) in London, saying Schiff “thought the amount of money really needed would be very small, as moral effect of concerted action on the part of large interests heretofore antagonistic would be sufficient without actual purchases.” While Jack favored cooperation, Pierpont fired back a hostile cable, saying such an action “would be unwise, entirely at variance with all the policies we have ever adopted being the head of a declared Stock Exchange manipulation.” The next day the market rallied—partly on the basis of incorrect reports that Pierpont had joined the relief efforts—and the plan was scrapped. All spring, as Pierpont cruised around Europe, his partners wired him that a serious autumn drop appeared likely.
At age seventy, Pierpont was often in low spirits. In photographs, his eyes look slightly unfocused, as if telling of inner turmoil. The October 1907 panic found him at the Episcopal Convention in Richmond, Virginia. As a lay delegate from New York, he would attend these conventions in opulent style, bringing bishops down by private railroad car and throwing parties catered by Louis Sherry. Nothing pleased him more than recondite controversies over prayer-book revisions and other matters remote from the material world.
As the Richmond convention progressed, emergency telegrams came in thick and fast from 23 Wall Street (Morgan’s bank address). Morgan’s friend Bishop William Lawrence noted in his diary how Morgan would study the telegrams, place his palms on the table, then stare fixedly ahead. Though Pierpont was needed on Wall Street, his partners feared a premature return might itself touch off a panic. By Saturday, October 19, he decided to rush back by private railroad car to deal with a spreading banking crisis. “They are in trouble in New York,” he told Bishop Lawrence. “They do not know what to do, and I don’t know what to do, but I am going back.”
The 1907 panic was Pierpont’s last hurrah. Although semiretired reporting worked periodically for an hour or two, he suddenly functioned as America’s central bank. Within two weeks’ time, he saved several trust companies and a leading brokerage house, bailed out New York City and rescued the Stock Exchange. His victory was Pyrrhic, however, as America decided that never again would one man wield such power. The 1907 panic would be the last time that bankers loomed so much larger than regulators in a crisis. Afterward, the pendulum would swing decidedly toward government financial management.
[Chernow then relates a lot of details about how the crisis unfolded, but I now insert how Morgan actually managed the impossible.]
Like an impresario creating his theatrical masterpiece, Pierpont gathered the city’s bankers at his library. He settled commercial bankers in the East Room, beneath signs
of the zodiac and a tapestry of the seven deadly sins, while in the West Room trust-company presidents sank into deep red couches and armchairs beneath the gaze of saints and Madonna. In between, like Lupiter above the fray, Pierpont played solitaire in Belle Greene’s office.
One spectator was Tom Lamont, now vice-president of Bankers Trust. Then only an “experienced errand boy,” as he said, he was entranced by the pageantry. Of Pierpont’s successors, only Lamont would possess the flair to stage such events. He recalled: “A more incongruous meeting place for anxious bankers could hardly be imagined. In one room were lofty, magnificent tapestries hanging on the walls, rare Bibles and illuminated manuscripts of the Middle Ages filling the cases; in another, that collection of the Early Renaissance masters—Castagno, Ghirlandaio, Perugino, to mention only a few—the huge open fire, the door just ajar to the holy of holies where the original manuscripts were guarded.”
To save Moore and Schley, Pierpont wanted some payoff for himself. With his usual sense of martyrdom, he felt it was his due. With his peculiar bifocal vision, he saw the panic as a time for both statesmanship and personal gain. At this point, he told friends that he had done enough and wanted some quid pro quo. He now took an appropriately big fee.
Pierpont hatched a scheme that would save Moore & Schley, avert its need to sell the Tennessee Coal and Iron block in the open market, and benefit his favorite creation, U.S. Steel. He knew U.S. Steel could profit from Tennessee Coal’s huge iron ore and coal holdings in Tennessee, Alabama, and Georgia. For antitrust reasons, it was a prize unattainable under ordinary circumstances. So, he struck a deal: U.S. Steel would buy Tennessee Coal stock from Moore and Schley if the hesitant trust-company president assembled a $25-million pool to protect the weaker trusts. What a characteristic mix of high and low motives!
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