Five Questions for a Keynesian

Steven Horwitz, the Charles A. Dana Professor of Economics at St. Lawrence University, has five questions for a Keynesian:

1. Why did Keynes think savings was bad if when people save through financial intermediaries they give control over resources to the banking system, which in turn will lend that out to firms to create capital and new jobs?

2. How does government spending create jobs and wealth if the resources that government spends must ultimately come from the private sector, through taxes or reduced borrowing due to government borrowing more (or inflation), and the private sector would have spent it either on consumption directly or on investment through savings anyway?

3. If one of the problems of the housing boom is that we put too many resources into housing and finance, how will a Keynesian government spending package know where that spending should have gone instead?

4. Keynes frequently wrote about the importance of the uncertainty of the future and the way that made things difficult for private investors and for the connection between savings and investment. Why doesn’t that same uncertainty prevent governments from knowing exactly how much and where they should be spending in a recession, especially because markets have prices and profits as signals to help entrepreneurs navigate that uncertainty while government bureaucrats do not have similar signals?

5. Given the enormous role that government interventions played in causing the current recession, from the expansionary policies of the Fed to GSEs like Fannie and Freddie, to misguided regulations in housing and banking, why should anyone believe that the same government actors will know how to solve it?

For the answers to these and other questions, be sure to read Professor Horwitz’s interview with Free Market Mojo.

Inflation Worries and M2

I hold the opinion that a period of dangerously high inflation could be on the horizon. Collectivist governments (and I would certainly put our current administration in that category) have historically tended towards inflationary policies – oftentimes to a disastrous extent. The Federal Reserve’s current lack of independence and the massive amount of debt being incurred by the federal government worrying me.

Mark Perry, however, points out a possible ray of light – at least for the short term. Annual M2 money growth is at its lowest point in 14 years.

Investopedia defines M2 as:

A category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.

A decrease in the growth of savings will reduce the amount of money banks and other financial institutions are able to lend, thus reducing the money supply. So these numbers could lead to the conclusion that, at least in the short term, inflation may not be a problem. Though this decline in M2 growth could also be looked at as evidence that inflation is very likely. As inflation severely impacts savings and investments, a likely move by anyone predicting inflation would be to save less. So while a lower M2 growth is not what one would expect in an inflationary environment, it could actually be an early warning sign from the financial markets.

Inflation vs. Stock Market Gains

With stock prices rising, many commentators bandy Wall Street’s performance as an indicator of economic recovery. But these heralded returns may not live up to the hype. Unlike other economic indicators, stock market returns are not adjusted for inflation, as E.S. Browning writes in The Wall Street Journal.

Controlling for inflation takes extra work and makes stock gains look punier, so it is easy to see why stock analysts almost never do it. The media almost never do it either. But other things do get measured in real dollars. When economists report whether the economy is growing, they account for inflation. When analysts judge long-term gains in commodities such as gold or oil, they often adjust for inflation.

Because analysts almost never do the same with stocks, it leaves investors with an exaggerated view of their portfolios’ performance over time.

HT: Freakonomics

UN advisor: Drug money saved banks in global crisis

This can’t be good:

Antonio Maria Costa, head of the UN Office on Drugs and Crime, said he has seen evidence that the proceeds of organised crime were “the only liquid investment capital” available to some banks on the brink of collapse last year. He said that a majority of the $352bn (£216bn) of drugs profits was absorbed into the economic system as a result.

This will raise questions about crime’s influence on the economic system at times of crisis. It will also prompt further examination of the banking sector as world leaders, including Barack Obama and Gordon Brown, call for new International Monetary Fund regulations. Speaking from his office in Vienna, Costa said evidence that illegal money was being absorbed into the financial system was first drawn to his attention by intelligence agencies and prosecutors around 18 months ago. “In many instances, the money from drugs was the only liquid investment capital. In the second half of 2008, liquidity was the banking system’s main problem and hence liquid capital became an important factor,” he said.

Some of the evidence put before his office indicated that gang money was used to save some banks from collapse when lending seized up, he said.

“Inter-bank loans were funded by money that originated from the drugs trade and other illegal activities… There were signs that some banks were rescued that way.”

CBO: House Financial Regulatory Plan May Increase Deficit by $4.5 Billion Over Next 10 Years

In case you missed it, the Congressional Budget Office yesterday released cost estimates of the financial regulation plan that the House of Representatives will vote on this week.

According to the report, it would increase the budget deficit by $4.5 billion over the the next ten years since revenues are expected to increase by $4.9 billion while direct spending is anticipated to increase by $9.4 billion.

Ben Bernanke: Firefighter or Arsonist?

Ben Bernanke is crediting the Federal Reserve for lessening the impact of the financial “crisis”. Here are some excerpts from his recent Washington Post op-ed:

The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems.

There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks, as demonstrated by the success of the stress tests.

We have come a long way in our battle against the financial and economic crisis, but there is a long way to go. Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

Alex Epstein of the Voices for Reason blog gives a very critical response:

Thus, the Fed is a financial firefighter that simply needs more resources to put out fires set by financial arsonists in the free market—and Bernanke is Financial Firefighter in Chief.

Hardly.

The Fed is the arsonist. The Fed has command-and-control powers to dictate the money supply and baseline interest rates in our economy—fundamental factors shaping market decisions about where to invest money. As Yaron Brook explains in his thorough course on the financial crisis, the Fed’s artificially low interest rates (under the regime of Alan Greenspan and deputy Ben Bernanke) were the primary cause of the housing bubble, which combined with other government-induced phenomena (such as Fannie Mae and Freddie Mac) effectively paid people to make reckless investments in real estate. Brook explains how similar factors were at work in the dot-com boom.

In other words, the problem is not that government policies and institutions didn’t do enough to stop the fire, it is that they poured the gasoline and lit the matches.

Government Financing: Heads I win, tails you lose

In Ayn Rand’s Capitalism: The Unknown Ideal, she writes,

Every government interference in the economy consists of giving an unearned benefit, extorted by force, to some men at the expense of others. By what criterion of justice is a consensus-government to be guided? By the size of the victim’s gang.

The logic behind this statement is simple and largely self-evident, though often ignored in policy discussions. It should be noted that the article I write about below has nothing to do with the above quote – which is precisely the problem.

A November 19th article from The Economist ponders the question of how governments can best raise revenue through taxes. To the author’s credit, he states in the first paragraph:

Although spending cuts could, and should, be the preferred route to prudence, taxes are all too likely to be part of the mix—at least judging from the experience of those countries that have already acted.

Unfortunately, the article concludes that developed countries would do best to focus on “efficiency” rather than “fairness.” If a government’s goal is to pursue the utilitarian goal of the “greatest good for the greatest number,” this preference for efficiency over fairness would be correct. However, any government with such utilitarian goals is an abomination.

The author does make some important points about alternate tax systems. Taxes on consumption, including a value-added tax (VAT), are regressive; meaning the lower an individual’s income, the higher he is taxed. Consumption taxes do, as the author points out, encourage saving – but they simultaneously discourage spending. Corporate taxes, it is noted, are particularly market-distorting. The critical numbers of the article can be found in the graph below (click to enlarge).

The author also illustrates an interesting phenomenon that often goes overlooked. Very collectivist (communist, socialist, fascist, etc.) have government revenues that make up a relatively large percentage of GDP, when compared with economically liberal countries such as the U.S. Russia, for example, has government revenues equal to 47.7 percent GDP, while the U.S. has government revenues equal to 33.7 percent GDP. But these percentages do not tell the whole story. It is also important to look at the components that make up these percentages. In Russia, non-tax revenues (largely related to state-owned oil companies) make up 14.5 percent of GDP, while in the U.S. non-tax revenues comprise only 5.7 percent of GDP.

At first, this may seem to be a much more efficient way for governments to raise revenue (though, to be sure, the article never makes this claim). It is easy to understand why a person unfamiliar with the record of history may see no difference between a government-run entity earning revenues and a private firm collecting profits. Is there any real difference between the Russian government selling oil and ExxonMobil selling oil?

The answer is a definite “yes”.

History and economics  both teach us that no central body can determine the amount of goods and services needed by individuals. Only the invisible hand of market forces can provide society any degree of efficiency. So even if government raises its revenue through so-called production instead of taxation, there will still be massive transaction costs and inefficiencies on both the supply and demand side. And of course, the government has incentives that conflict with offering the best product at the best prices. Governments typically have two goals: 1) gain power, 2) create social value. Yes, these are often at odds;  and yes, the second is often a means to the first. Regardless, governments are not motivated by profits. And the profit motive is the driving force behind real economic efficiency.

But all of this talk of efficiency misses the point. I’ll return now to the point of the quote I began with.

When reading such articles, it’s easy  to get wrapped up in the author’s arguments and lose the ability to distinguish the forest from the trees. Though the free market is far more efficient than a centrally-planned market, is that really a concern when so many tax systems and government sources of revenue violate individual rights? ExxonMobil has vast resources at its disposable to best its competition. But the one thing it does not have is the ability to coerce by force. Only by offering its customers the greatest value at the lowest price can it win in a free market. While the Russian government (or any other government) only has to pass laws – backed, of course, by men with guns – to maintain its supremacy. Take the U.S. Post Office, for example. If FedEx and UPS were allowed to carry mail, would the USPS have any chance at remaining viable? Of course not. Only by regulation and force can the USPS continue to provide income for the U.S. government.

So whether you are concerned with efficiency or freedom, the property confiscated by government should be reserved only for the protection of our individual rights.

One final thought from Ayn Rand on the subject:

There can be no compromise between freedom and government controls; to accept “just a few controls” is to surrender the principle of inalienable individual rights and to substitute for it the principle of the government’s unlimited, arbitrary power, thus delivering oneself into gradual enslavement. As an example of this process, observe the present domestic policy of the United States.

No such thing as a bad tax cut… is there?

Don Boudreaux of Cafe Hayek points out an interesting paragraph from a 2005 CBO study:

The resulting [tax] rate on equity-financed corporate capital income is 36.1 percent and that on debt-financed corporate capital income is -6.4 percent, a difference of 42.5 percentage points. The rate on equity-financed corporate capital income is higher than the statutory corporate tax rate because of the extra tax imposed on dividends and capital gains at the individual level.

Obviously, this will steer corporations towards debt financing over equity financing. Some quick definitions: equity financing is financing by issuing stock, i.e. financing from your shareholders; while debt financing is done by borrowing. Firms typically use a mix based on their individual needs. The important point is that the tax code is quite probably influencing corporate decision-making for the worse and distorting capital markets.

So is this a case of a tax cut with negative consequences? Milton Friedman once said:

I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.

My preferred solution is to cut all tax rates drastically. But assuming we have some situation where our only choice is a 36.1% tax rate for both debt and equity financing, or 36.1% for equity and -6.4% for debt; is the best solution to have both at 36.1%, as this probably causes less severe market distortions?

As always, we welcome your thoughts.

Stockholders vs. Stakeholders

Critics of capitalism (and therefore freedom in general) are ever quick to hold up cases of consumers and employees exploited by greedy corporations. These attacks often have negative consequences for the stockholders of corporations.  Stockholders of GM and Chrysler were sacrificed in order to serve the “greater good” (a term that, as I’ve stated before, is so idiotic it is depraved in its purported meaning).  David Friedman recently penned an excellent blog post on the ways in which stockholders are actually more vulnerable to corporate mismanagement than consumers or employees.

…my situation as customer and employee is very much better in this respect than my situation as a stockholder. It is true that, as a stockholder, I have the option of selling my shares of stock, which at first glance looks rather like my option as a consumer of not buying a product or as a worker of quitting a job. But the apparent similarity is an illusion.

If I choose not to spend twenty thousand dollars buying a car from Ford, Ford has one more unsold car and twenty thousand dollars less money. If I choose to sell twenty thousand dollars of Ford stock, on the other hand, the money I get is not coming at Ford’s expense. Another investor has paid me the money and now owns the stock, leaving Ford itself unaffected.

If the firm is being run in a way that fails to maximize stockholder value, he cannot escape that cost by selling his share, since the price he can sell it for will reflect the reduction in future profits and dividends, insofar as it can be estimated by other stockholders.

It follows that the stockholder is dependent, very much more than the other stakeholders, on other mechanisms for controlling a firm to make it act in his interest. That is a strong argument in favor of the current mechanism for corporate control and the current legal rules defining the fiduciary obligation of the directors.

Indeed, it is an argument for more than that. It is an argument for strengthening stockholder control in order to provide more protection to the most vulnerable party in the network of relationships that makes up a corporation. One way of doing so would be by removing current legal barriers that make takeover bids more difficult, and so protect managers and directors from the consequences of serving their own interests at the expense of the stockholders whose interests they are supposed to be serving.

I would like to add two points to this already outstanding argument. First: regardless of the practical effects on stockholders and stakeholders; the fact of the matter is that the corporation belongs to the stockholders. It is their property. As property is gained by money, as money is gained by production, as production is performed at the expense of an individual’s time, and as an individual’s time is an individual’s life, the right to property is inseparable from the right to life – which is an inalienable possession of every human being. So, practical considerations aside, the stockholders’ interests should still be protected over the interests of the stakeholders (note that “interests” are not synonymous with “rights” – the protection of the rights of one individual cannot necessitate the violation of the rights of another).

Second: the stakeholders rely on stockholders for their lives. Stockholders are not pirates scouring the market for plunder – they are the enablers of production. It is only by the productive energies and subsequent investments of stockholders that capital is raised to improve the quality of life for the masses (the beauty of capitalism is that society’s betterment is in no way a necessary motivation of the investors).

For all of the reasons discussed above, stockholders should be lauded for their contributions to society and not branded as blackguards of “corporate greed”.

Kenneth Feinberg: “Pay Czar”

The Wall Street Journal reports on Kenneth Feinberg, President Obama’s new “pay czar”:

In the annals of what used to be known as American capitalism, yesterday will go down as a sorry day: The Treasury and Federal Reserve announced wage controls on private American companies. So once again our politicians are blaming bankers, rather than addressing the incentives the politicians themselves created for bankers to take excessive risks.

President Obama cheered the pay reductions as “an important step forward” and urged Congress to “continue moving forward on financial reform to help prevent the crisis we saw last fall from happening again.” The pay curbs are intended to feed the official political narrative that the bankers caused the entire crisis, and that cutting their future pay will prevent the next one. Only a politician could really believe this, or at least pretend to.

We certainly have no sympathy for bankers who’ve been bailed out, and the most defensible of yesterday’s pay curbs are those announced by Treasury “pay czar” Ken Feinberg. He was handed the task of determining compensation for 175 executives at seven companies that are still using money from the Troubled Asset Relief Program: Citigroup, AIG, Bank of America, General Motors, Chrysler, GMAC and Chrysler Financial. These companies—and executives—owe their survival to political intervention, and the price of such taxpayer help is inevitably some populist retribution.

Far more dangerous is yesterday’s announcement that the Fed plans to impose new pay guidelines on all of the banks it regulates. While the Fed imposed no pay cap, and it was at pains to say it didn’t want to impose a “one size fits all” standard, the implication is that any large single-year payouts will be frowned upon by regulators. The Fed wants what it refers to as more “balanced” pay standards, which in practice is likely to mean smaller bonuses up front and longer time frames to see if “risks” pay off over several years.

The irony is that judgments about what constitutes “excessive risk” at banks will presumably be made by the same Fed regulators who let Citigroup put hundreds of billions in SIVs off its balance sheet. That certainly looks “excessive” now, though apparently it didn’t amid the credit mania. The point is that Fed officials aren’t likely to have a clue what kind of risks warrant tighter compensation rules. And these new guidelines may also drive the best and brightest out of the banks and into less regulated institutions.

Meanwhile, the Administration still hasn’t done anything to change the incentives for excessive risk-taking that are embedded in its own “too big to fail” doctrine. As long as bankers and their creditors believe they have a federal safety net, they will have a cheaper cost of capital that will encourage them to take greater risks. New pay rules will quickly be worked around or through.

The most profound mistake in these rules is the terrible precedent they set for wage controls across the economy. The Obama Administration will say that banks are a special case, and that is true. But once politicians feel free to regulate executive pay for one industry, it is no great leap to do it for everyone. Our guess is that these pay rules will prove to be both ineffectual and destructive—a perfect Washington combination.

Capitalism creates a greater amount of prosperity than any other economic system because individuals are incentivized to work in their own self-interest. A move towards regulating executive pay is an attack on the very foundation of our country’s economic success.  Furthermore, a simple supply and demand graph can show that any price ceiling – provided it is set below the market equilibrium – will cause a supply shortage. In the case of executives (who play a role so vital that most of us cannot comprehend its importance) this supply shortage could materialize in any number of ways. Talented executives could expatriate in greater numbers, retire earlier, or simply cease to invest as much energy in their jobs as they previously had. Again, these are merely some suggestions as to how a price ceiling on executive wages could stifle the supply of competent executives. The central point is that further regulation (of which price controls are a particularly vicious brand) will only dampen, if not destroy, any hope of an economic recovery.