Politics not Monetary Policy Rules

John Maynard Keynes, a gifted English mathematician (not either an economist or a political philosopher), developed a comprehensive set of theories during the early stages of the Great Depression that were published in his 1935 book titled The General Theory of Employment Interest, and Money. Keynes developed his theories in an attempt to explain why we had the Great Depression and how he thought we could get out of it and further to prevent like contractions from happening again. His theories of an active federal government and government spending from taxed or borrowed money are the bases that our government is using today in an attempt at getting us out of the jobs predicament that we have now which is very much like the situation that existed in the mid 1930s.

The General Theory was designed by Keynes to replace Laissez-faire (minimum government) economics as first promoted by Adam Smith in his 1776 book An Inquiry into the Nature and the Causes of the Wealth of Nations. Which was actually a follow on book to his first book The Theory of Moral Sentiments published in 1759; the two books fit well together and should be taken and studied as a set. Smith’s free market is the exact opposite of Keynes’ views that included that savings were bad and that an active government should borrow money to spend during a down turn and then (maybe) pay it off on the upside.  Although there was some good in Keynes’ work, all the politicians back then heard was that savings were bad so that gave them the economic justification to tax wealth and even worse, if that was possible, that deficit spending was “required” to promote consumption and that by doing these things it would bring the economy to full employment Combined with the activist government concept this was a license to go wild as this justified anything the politicians wanted to do as long as it was paid for with a tax, as we recently found out with the Supreme Court ruling on the Health Care and Education Reconciliation Act 0f 2010  or Obama Care as it is now known.

In the early 30’s as the economic contraction continued to deepen, the citizens decided to try new leadership and Franklin D. Roosevelt (FDR) was elected in November 1932. However, between the times he was elected in November 1932 and took office in March 1933, the worst of the three banking contractions of the Great Depression started in January 1933. Drastic action was required and during the next two years FDR’s program was known as the New Deal which actually ended up being two programs the first New Deal (One) from 1933-1934 that was not working as planned.  Then in 1935 a second and much more controversial New Deal (Two) 1935-1938 was instituted presumably this was based on Keynes’ radical new theories which gave Roosevelt the economic justification for what he was doing and what would, in time, become known as Keynesian Economics.

Technically the programs of FDR didn’t work, but the citizens saw the government doing things and they gave the government the credit for the small recovery that occurred.  Back then just as what happens today — in politics — the politician takes all the credit for any good that occurs and blame others for all the bad. The outbreak of World War II in Europe is what really got us out of the Great Depression as the United States sold war material to the allies with Lend Lease.

Then after the war the pent up demand for civilian goods that had been repressed along with the massive rebuilding efforts of Europe’s Marshal Plan and Asia’s GARIOA is actually what drove the economy for several decades. Keynes and FDR got the credit even though the theory was wrong and FDR’s policy didn’t work. However what actually caused the banking collapse in America that started this black ball rolling was never fully understood by economists and so Keynes views took hold in the economic community; it would not be until 18 years after the end of World War II before the truth would be known.

Milton Friedman along with Anna Schwartz published an almost 900 page book in 1963 titled A Monetary History of the United States, 1867-1960 which along with other works of Friedman’s got him a Nobel Prize in Economics in 1976. Friedman and Schwartz showed how the Great Depression was caused by the actions, or more properly the inactions, of the Federal Reserve, first in allowing the credit bubble that lead to the stock market collapse in 1929 (excusable with the knowledge of the times) and then in collapsing the U.S. banking system (not excusable under any circumstances) by not following the methods that were then known for preventing this very thing from happening.  Keep in mind that preventing a monetary contraction and/or a series of banking failures was the stated main purpose for creating the Federal Reserve in 1913.  This work of theirs was the first explanation of what actually caused the Great Depression and this solved the issue which had puzzled economists for almost 30 years. This work of Friedman and later works by others, as well, showed how Keynes was wrong about savings and deficit spending. This is a very critical finding as Keynes views on economics and FDR’s policies were accepted as gospel and those policies have now taken us to the very edge of word wide economic collapse.

A side note with relevance here is that when the Federal Reserve (FED) was formed by an act of congress (HR 7837) and signed into law as Pub. L. 63-43 on December 23, 1913 a banker named Benjamin Strong Jr. one of those that developed the concept of the FED was appointed as the Governor of the New York Federal Reserve bank at that time. From its inception and until his untimely death in October 1928 he ran the New York FED which had the lead in monetary policies since most major transactions especially international were conducted in New York City where all the main U.S. banks were located.  According to Friedman’s work   Strong did everything by the book and discounting minor ups and downs up until his death the economy ran as smoothly as could be expected as a result.

Strong besides being a very knowledgeable man had a dynamic personality and others ended up in his shadow, so after his death the FED was reorganized to prevent one person from having the power that Strong had.   His successor George L. Harrison although knowledgeable did not have the personality of Strong and with the FED operating rules being changed in March 1930 he was not able to do what he knew needed to be done, so in 1930, 1931 and 1933 there were three waves of banking failures that swept across the country each worse than the preceding one.  The result was almost the total destruction of the United States banking system and the Great Depression.  Friedman states that if Strong had lived only a few more years, he died at 55, and if he had done what he had been doing while he was the Governor of the New York Federal Reserve that the Great Depression and all it destroyed would probably never have happened. Friedman did more than state that as his opinion he showed in detail how the polices of the FED and the tools they had available to them were more than sufficient to accomplish the task of preventing the banking collapses which were the real cause of the Great Depression not the stock market collapse in 1929.

But the biggest kicker was that before the FED was established to prevent banking collapses the New York banks had come up with a method to stop these contractions on their own, and that it was used on one occasion in particular a market contraction in 1907,.  Although the method wasn’t handled perfectly the logic within it was sound. The creation of the FED stopped banks individually from doing what needed to be done and established the FED as the only agency responsible for preventing banking contractions. The policies that should have been used were well known and had been used before so there was really no excuse for the FED to not allow Governor Harrison to do what he wanted to do.  It was only the FED boards’ members not wanting Harrison to follow in Strong’s footsteps that created the Great Depression.  Sadly this is what big government always gets you ‘politics’ not what really needs to be done.

But now back to our current problems; the FED is at it again with its easy money programs and massive Quantitative Easing (QE) programs. Technically what they are doing is what needed to be done in 1930 and since it was known and not used there was no excuse for what the FED allowed to happen. But as in most things there is also to much of a good thing and since the FED is more driven by politics than sound monetary policy the QE programs have been carried out way to long and that has created some serious distortions in the economy and is one of the reasons that job growth has been so anemic. The eventual result of the current FED policies will be high inflation and all we can hope for now is that it doesn’t cause us to lose the “Reserve” currency status we now have.  If that would happen we would have “hyper” Inflation and that would bring economic destruction like never experienced in this country before.

The purpose of this post was to inform the readers of what “might” happen and that they should watch current events very closely so they can protect their assets. The current softening in the emerging economies and the resulting downward trend in the markets could be a sign that currency problems are now developing.

Comparative Disadvantage

Over the past 30 years maybe even a bit longer there has been a steady and growing shift of manufacturing based jobs out of the country and into the Pacific Rim countries for example; Japan, Korea, Indonesia, India, Vietnam and China. We were told not to worry about this as those old obsolete factory jobs were being replaced by new service jobs in accounting, finance, health care, legal services and tech related development.  We were told that this was no different then when the United States shifted labor out of agriculture into manufacturing. Therefore don’t worry about it, things will work out and be even better.  We were told that this was called globalization and the free trade between nations was the way to prosperity for all.  And according to Adam Smith in his book The Wealth of Nations this was, in fact, true and was explained by the principle of comparative advantage which we must understand first before we can understand the opposite of disadvantage which is what we have.

Comparative advantage is a result of one group, or person, doing one thing very well and another group, or person, doing something else very well.  They then strike a bargain between them to trade some of each of their product or production to the other at some ratio that they both agree to.  The result of this is that both groups, and/or both people, have more then if they had tried to make or produce everything themselves, as in jack of all trades master of none. This is a key concept and for it to work properly there must be a “free” movement of goods and services between the two groups, or people, and no “interference” between the bargaining that sets the exchange ratio.  Meaning no outside influences like government and regulation which will always distort the process either some or a lot.

Today we find that the manufacturing jobs are gone but we also find that the service jobs are gone as well, in fact some of the service jobs left faster then the manufacturing jobs.  Try calling for any tech support or customer service and you will, in many cases, end up talking to someone in India.  Although it must be said that there has been some blowback on this as it was very hard to get someone to understand you. So what happened — what went wrong? Was it evil greedy business men looking to make a few cents more on a product because labor was cheaper someplace else?  Was it labor unions driving up the cost of labor?  Was in Health Care being to expense?  Was it Wall Street financiers finding ways to manipulate markets?  Was it the evil Oil companies ripping us off?

Actuality the answer is none of those! The question can be best answered by using a line from an old comic strip “Pogo” created by Walt Kelly from comments he first made in 1953 where he said, “We have met the Enemy and he is us!” So the answer is that we the citizens are the problem!

That is actually a parody of a message sent in 1813 from U.S. Navy Commodore Oliver Hazard Perry to General William Henry Harrison after the Battle of Lake Erie, stating, “We have met the enemy, and they are ours.” Kelly was a master of satire and parody and produced Pogo in syndicated form from 1949 to 1973 when he died from complications from diabetes. The strip was carried on by Kelly’s wife and son for two more years before it was stopped.

The reason that we the “Citizens” is the answer to why this happened is that we the “Citizens” let the politicians convince us that what was going on with globalization was OK and we should not worry.  We believed them even though it didn’t sound quite right to us. But they told us they were the “best and the brightest so we believed them. And there were some good times originally until the dot com bust and then 9/11 and Enron after that the cancer took hold with a vengeance and the jobs were soon almost all gone.  But there were signs early on like Billy Joel saw in his song Allen Town from a 1982 Album ‘The Nylon Curtain’.  Then there was the 1987 movie Wall Street Directed by Oliver Stone starting Michael Douglas, Charlie Sheen and Daryl Hannah, with its warnings about breaking up companies for profits.  And we can throw in Disclosure a 1994 movie also starting Michael Douglas which is about the games being played in Silicon Valley with all the production (a side issue) in Indonesia.

While the country was being dismembered one company and one job at a time we the Citizens were worried about all the really important things in life like; gay rights, abortion rights, civil rights, the environment, women’s rights, animal rights, handicapped peoples rights, emigration rights, affordable housing, breaking the glass ceiling, not offending anyone (Political Correctness), taking God out of everything, and not teaching anything of substance in our schools so that no one would feel bad because they couldn’t learn.  So today we have all those rights in spades but no jobs. Which was really more important?

Having lived through the 1980’s as a businessman in production related industries in a senior management position the effects of the political policies of the 1980’s were very apparent.  No one seemed to care about what was happening to business their focus was solely on all those issues listed in the previous paragraph which by the way is not a complete listing it’s just a sample.  But why would these social issues matter to businesses and job creation? And what does any of this have to do with comparative disadvantage?

First we need to discuss business and its purpose which is to make a profit so that the investors can be paid back for making their investment in time and/or money.  If a business can not make a profit that it can “keep” then the investors will either not invest or they will sell their position (at a loss) and the business will close. Therefore no business can stay in business without making a profit. So by simple extrapolation profits are good not bad.

They are the reward for doing a good job

The lack of them is the penalty for doing a bad job

So how does a business make a profit?  Well there is really only one way and that is to sell a product for more then what it costs to make the product and in addition cover all the costs of being in business.  A key point here that most people do not appreciate is that the only thing that matters to an investor is the net cash left after the deduction of all expenses; which includes production costs, operating costs and all business taxes.  So it’s easy to see that to have anything left over to pay the investors, the price of the product or service has to be greater then all the costs of providing that product or service, including taxes.

Anything that raises any part of the cost of doing business “must” be passed on to the consumer in the form of “higher” prices.  Even Adam Smith knew this, it’s in his book.

Therefore if society determines that businesses must include social costs as for example in complying with OSHA, EPA, NLRB rules and providing HEALTH CARE (a complete listing of rules and regulations would fill this entire paper) as well as property taxes and income taxes the costs of doing business are by definition driven up.  And therefore as the costs are driven up the businesses must raise their prices or go out of business. Their revenue must always be greater then their costs, to stay in business. Or one other is by government subsidies (additional revenue) but then the government needs higher taxes to do that. And the government also gets the right to participate in that business.

Now we get to comparative disadvantage for we in America do not have a closed society we allow others to sell goods and provide services in this country.  Discounting transportation cost which are minimized by huge cargo container ships we have goods coming into this country from countries that do not have the same social cost structure that companies here have.  American companies are therefore at a comparative disadvantage.  And to be honest the actual direct labor component, even with unions, maybe the smallest element in their high cost structure.

For example the hard push today to “Green Energy” which costs more to produce as any technical person will agree to.  According to the International Energy Agency (IEA) in 2005 the average cost of electricity in the United States was $.052 per kWh and in China it was $.032 per kWh. This is before the big push to renewable sources which will drive up the cost of electricity here even higher. For example, according to the U.S. Energy Information Administration (EIA) in their report of H.R. 2454 (the clean energy act) electric rates $ per kWh could easily double during the time frame of the report if that law was ever enacted.  If the business in China were paying on average only 55.2% of those of their U.S. competitors now, that is a major Comparative Advantage that they have.  Further it would seem that that advantage will get bigger as the EPA pushes to implement its clean energy agenda. This is being done through rules and regulation by the EPA even without the passage of any carbon reduction legislation being passed.

If we add to that all the other social costs of doing business here (we are not considering the social merit here only the costs) from say worker safety and pollution for example we quickly find that it would be almost impossible for any U.S. company to produce anything in our country that could not be produced and delivered here cheaper from a foreign source.  It does not require a degree in economics or finance to see that this is just not going to work. Common Sense alone tells us that the system our current leaders have put in, because we told them we wanted these social benefits, welfare programs and regulations, and this will continue to drive production related business out of this county.

Walt Kelly, “We have met the Enemy and he is us!”

However our politicians, although they gave us the rules and regulation we asked them for, didn’t explain to us the consequences of those rules and regulations as they became apparent. As we saw in the songs and movies of the 1980’s even the entertainment industry saw what was happening.  So why didn’t the politicians do something — well it was really very simple.  As the trade imbalance increased and cheap goods poured in, through Wall-Mart initially, the countries that were flooding the U.S. with cheap products elected to buy U.S. treasures bonds (T-Bills) rather then products and services that were too expense to buy from the U.S.

So what most of us would say?  Well as it turns out this is the most critical element of the predicament that we are now in.  Our elected officials being from the best schools and being very educated (that’s what they tell us and is the reason we are supposed to listen to them) knew what was happening but since the countries that were giving us the cheap goods were buying T-Bills the politicians had more money to play with and so to them having those extra funds meant they could pay for things that they otherwise could not provide (to us).  This made them look good and got them re-elected. And they could always blame the job losses on the evil businesses that just didn’t care.

There has been a lot of talk by economists that claim this is of no concern as eventually those countries will have to move out of T-Bills so it doesn’t matter.  Although technically that may be true in “economics,” in the real world its nothing but farm pollution.  For example we are told that foreign purchases of T-Bills hold down the rate of interest which is good.  True yes, but rather then use that low interest rate to build infrastructure and promote business investment we used it to finance our social programs. The problem with that was that the social transformations increased the cost of doing business which made the situation worse.

It was an absolutely perfect positive feed back situation working like this: as the foreign purchases increased the government had more funds to make social changes which then raised the cost of doing business, which drove more business out, which then resulted in more imports, which then result in more money for the government to play with. There was just no incentive to stop this from happening in the government; it would have stopped the money flow to them.

In addition as the businesses closed or moved operations out of the country there were both fewer businesses to pay taxes and fewer employees to pay them as a result.  So with fewer and fewer workers the tax burden per worker was forced higher and higher. Fewer workers meant the government needed to provide more services and therefore the government needed more funds and the resulting growing deficit was financed increasingly by foreigners.

In simple terms the foreign purchases of T-Bills represents the hidden social cost of U.S. policies compared to those in the rest of the world that is bringing us our products.

In the study of economics one quickly learns that in the “long run” most everything works out.  The artificially induced distortions by governments and rulers are never sustainable for very long.  Look what happened to the workers paradise the U.S.S.R. it only lasted 70 some years before collapsing. China lasted even a shorter time maybe only about 50 years before making a major change and letting a private sector develop there. Although to be fair they did see what happened to the Russians and so making a change was the only way to avoid a similar collapse for them. They did stay in power which was the really important part to them.

We can not by law or regulation overrule these three things: human nature, the laws of physics and engineering or the principles of economics.  An economics professor of mine one told us in class that the only thing any government can do is to create “shortages” or “surpluses” and he was 100% right.

We have the Department of Energy and a shortage of energy

We have the Department of Heath and Human Services and we have a surplus of poor

We have the Department of Labor and a shortage of jobs

We have the Federal Reserve and that has given us both a shortage of and a surplus of money.

Neither the shortage of energy nor the surplus of poor nor the shortage of jobs nor the swings in money existed as a major problem prior to the creation of these agencies.  Each of these government departments was created to fix a problem that at the time was a short term problem not a structural problem.  And each time this happened we lost a little bit of our Comparative Advantage for each of these changes added more rules and regulation that had to be followed.

So now these and many other government actions and social issues have eliminated most all of the Comparative Advantage that the U.S. once had.  The options for getting it back are slim to none unless we take drastic action — and very soon.

So where has this taken us then what have all these really smart and educated politicians given us with their politics?   Well it a very easy thing to answer — no jobs!  Americans want to work and take care of themselves and their families they don’t want some big government telling them what they can or can not do.  The Citizens can develop a feeling in them collectively when major shifts occur;.how this occurs is not the subject of this post but the facts are that the public, the Citizens, know that things are not right.  They may not know the details because they have been hidden but they do know that the country is in deep trouble.

One last comment in this post is that there is a fix for at least a part of this.  The process of other countries buying U.S. Treasurers in lieu of buy things here is the main reason we have lost so many jobs. In a free market this would not have happened but since there is no true free market we need some way to compensate for this.

There are two ways this could be done although neither would never be done, and it’s relatively simple.  The first method would be that Congress could pass a law that would state: Starting immediately U.S. Treasuries will no long be sold to anyone that is not a U.S. citizen or a U.S. corporation.  And if a Corporation then it must be at least three fourths’ owned by U.S. Citizens.  All Treasuries that are now held by non qualifying entities will be held to maturity but will not be refinanced.  This will force the money into product services or other non government equities of some kind.

This will raise the interest rate for government securities but that will only put the cost of this kind of borrowing in line with where it should be to begin with.   The effect of this will be to raise stock prices and force the government to be more realistic with its expenditures.  Obviously the change will be traumatic but it will be better then other alternatives as described elsewhere in the book.

The second method would be somewhat easier to implement but it would be just as confrontational.  This method is one of tariffs but not as we presently know or think of them; we add a different twist to them.  If we agree that the various social costs in the United States are in fact driving up business costs and if we agree that the corollary to that is many of the countries that import to us do not have those same costs then there is a way to fix this.

We would set up two tariffs the first being a Social tariff and the second an Environmental tariff.  A task force would be set up consisting of the countries Business and Unions but no politicians.  They would determine what those two non business (not related to producing the product or service) related costs are.  They would also look at the various countries that ship goods here and estimate what each of those counties costs are.  Once that has been accomplished a comparison can be developed between them and two tariffs established one for social costs and one for environmental costs.  A particular country could have none, one or both applied and they would be administered separately.

It would not be reasonable to implement something like this all at once and so it would be phased in over time, say ten years, at 10% of the total differential added each year.  Offsetting this would be an annual review of the tariffs such that if a country got worse of better vis-a-vis the United States the numbers would be adjusted up or down.  A system like this would force countries doing business with us to either clean up their countries or pay the penalty through the tariffs. Over time the comparative disadvantage would be reduced and that would allow some of the lost jobs to be brought back here. The offset to this is that the costs of goods would go up and that must be understood itf we are going to protect our jobs.

Neither of these solutions is desirable in themselves but the alternative of continuing the present system is much worse.  We must have jobs in this country commensurate with the abilities of the citizens and that means there must be a range of jobs available that encompass the full range from manual labor to university professors. Obviously those are the extremes and the bulk must fall in the middle such that the average person can hold a full time job that pays a decent rate.  If we as a society do not provide that then we have failed both as a society and as people.