The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.
The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.
Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:
- ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
- are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
- impose a huge and growing regulatory burden;
- are undermined by political factors;
- fail to address major risks identified by independent experts; and
- fail to embody lessons to be learned from the failures of other regulatory stress tests.
The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.
[Editor's Note: the full document published by the Cato Institute can be found here]
Deposit insurance is one of the most misunderstood – and also most dangerous – forms of government intervention into the financial system.
Let’s start with the common misconception that deposit insurance is an industry-operated affair independent of the government.
In the UK, deposit insurance is provided by the Financial Services Compensation Scheme (FSCS). To quote from its website:
“The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means that FSCS can pay compensation to consumers if a financial services firm is unable, or likely to be unable, to pay claims against it. The FSCS is an independent body, set up under the Financial Services & Markets Act 2000 (FSMA).”
It also explains that the FSCS is funded by levies on firms authorised to operate by either of the Prudential Regulation Authority or the Financial Conduct Authority.
So the FSCS is notionally independent and the guarantees are financed by levies on participating firms.
However, this does not mean that deposit insurance is in any way a free-market phenomenon: it is explicitly the creature of legislation and participating firms are compelled not just to join, but to join on dictated terms. This is rather like having a system of compulsory car insurance and, moreover, a compulsory system that mandates the exact terms (including the pricing) of the car insurance itself – compulsory one-size-fits-all.
This should set off alarm bells that there might be something wrong with it.
And how do we know that its designers designed it properly? We don’t.
In fact, we know that they couldn’t possibly have designed it properly, as any rational insurance system would tailor the charges to the riskiness of clients, include co-insurance features and other incentives to moderate risk-taking, have charges that would evolve over time in response to changing market conditions, and so forth. This is insurance 101.
This is not how deposit insurance works, however.
Most of all, any rational system would have the product delivered by the market, not by some jerry-built contraption dreamt up by committees of legislators and regulators who have neither the knowledge nor the incentive to get it right. One also might add few if any of these people have any experience in or understanding of the industry they are meddling with, but let’s move on.
It then occurred to me that perhaps my kids are right and I am too cynical – maybe Father Christmas and the fairies do exist: one should keep an open mind – so I checked out the FSCS website to have a closer look at their system. What I found was a masterpiece of gobbledegook that I highly recommend to other connoisseurs of regulatory gibberish:
Backward ran sentences until reeled the mind. My favourite bit is the explanation of the levy calculation that does not explain how the levy is actually calculated.
All this said, the banks rather like deposit insurance because it gives them a great marketing tool: bank with us and your money is safe because we are members of the deposit guarantee scheme, and you will get your money back even if we happen to fail.
They also like it because they can game the system – taking extra risks and offering higher deposit rates than they would otherwise be able to get away with – in effect, exploiting the risk-taking subsidy created by deposit insurance and passing the extra risks to the fund itself.
But surely, if the banks like the system, they would create one themselves if the government didn’t create it for them? No. Were this true, the banks would have done exactly that many years ago, and there would have been no ‘need’ for the state to have intervened to do it for them. The fact is that they didn’t.
The reason they didn’t is because the service that deposit insurance provides to the retail customer – reassurance or confidence – is better provided in other ways, most notably, by pursuing conservative lending policies and maintaining high levels of capital. And the reason for this is simply that deposit insurance introduces an additional layer of moral hazard and governance headaches that can be avoided if the banks self-insure via moderate risk-taking and high levels of capital.
This should come as no surprise. True confidence does not come from “you can trust us if we screw up because someone else will bail you out” but from “you can trust us because it is demonstrably in our interest to make sure we don’t screw up”. Deposit insurance is an inferior confidence product – one might even say, a confidence trick.
We can also look at this another way. Suppose that a group of banks attempted to set up a scheme similar to the current one, of their own free will and with no government intervention. They would soon realise that the scheme was not viable – no bank would want to be liable for the risks the others were taking, with no means of controlling those risks. So it would never get off the ground – and the current system only got off the ground because the state imposed it.
In short, deposit insurance is not a creature of the market but a creature of the state, and a decidedly inferior one at that. It is, indeed, a classic instance of that regulatory Gresham’s Law by which state intervention causes the bad to drive out the good. Where have we seen that before?
[Editor's note: The Cato Institute will be publishing Cobden Senior Fellow Kevin Dowd's work "Competition and Finance" for free in ebook format. The following outlines the contributions of this important work.]
Originally published in 1996, Cato is proud to make available in digital format, Professor Kevin Dowd’s groundbreaking unification of financial and monetary economics, Competition and Finance: A Reinterpretation of Financial and Monetary Economics.
Dowd begins his analysis with a microeconomic examination of which financial contracts and instruments economic actors use, after which he extends this analysis to how these instruments impact a firm’s financial structure, as well as how firms manage that financial structure. After bringing the reader from individual agent to the foundations of corporate financial policy, Dowd then builds a theory of financial intermediation, or a theory of “banking”, based upon these micro-foundations. He uses these foundations to explain the role and existence of various forms of intermediaries found in financial markets, including brokers, mutual funds and of course, commercial banks.
Most scholarship in financial economics ends there, or rather examines in ever deeper detail the workings of financial intermediaries. Dowd, after having developed a theory of financial intermediation from micro-foundations, derives a theory of monetary standards, based upon his developed media of exchange and its relation to the payments system. While much of Competition and Finance breaks new theoretical ground, it is this bridge from micro-finance to macro-economics and monetary policy that constitutes the work’s most significant contribution. In doing so, Dowd also lays the theoretical groundwork for a laissez-faire system of banking and money, demonstrating how such would improve consumer welfare and financial stability.
As Competition and Finance has been out-of-print in the United States, our hope is to make this important work available to a new generation of scholars working in the fields of financial and monetary economics. If the recent financial crisis demonstrated anything, it is the need for a more unified treatment of financial and monetary economics. Competition and Finance provides such a treatment.
[Editor's note: this article was originally published by the IEA here]
I would like to thank the IEA for today publishing my monograph, New Private Monies, which examines three contemporary cases of private monetary systems.
The first is the Liberty Dollar, a private mint operated by Bernard von NotHaus, whose currency became the second most widely used in the United States. It was highly successful and its precious metallic basis ensured it rose in value over time against the inflating greenback. In 2007, however, Uncle Sam shut it down, successfully charging von NotHaus with counterfeiting and sundry other offences. In reality, the Liberty Dollar was nothing like the greenback dollar. Nor could it be, as its purpose was to provide a superior dollar in open competition, not to pass itself off as the inferior dollar it was competing against, which has lost over 95 per cent of its value since the Federal Reserve was founded a century ago. For this public service of providing superior currency, Mr. von NotHaus is now potentially facing life in the federal slammer. As he put it:
‘This is the United States government. It’s got all the guns, all the surveillance, all the tanks, it has nuclear weapons, and it’s worried about some ex-surfer guy making his own money? Give me a break!’
The second case is e-gold, a private digital gold transfer business – a kind of private gold standard – run by Dr Doug Jackson out of Nevis in the Caribbean. By 2005, e-gold had risen to become second only to PayPal in the online payments industry. Jackson correctly argued that it was not covered by any existing US financial regulation, not just because of its offshore status but also because it was a payment system rather than a money transmitter or bank as then-defined, and not least because gold was not legally ‘money’. Yet despite its efforts to clarify its evolving regulatory and tax status, and despite helping them to catch some of the biggest cyber criminals then in operation, US law enforcement turned on the company: they trumped up charges of illegal money transmission and blackmailed its principals into a plea bargain.
Both these cases illustrate that there is a strong demand for private money and that the market can meet that demand and outcompete government monetary systems. Unfortunately, they also illustrate the perils of private money issuers operating out in the open where they are vulnerable to attack by the government. Perhaps they should operate undercover instead…
This takes us to the third case study: Bitcoin, a new type of currency known as crypto-currency, a self-regulating and highly anonymous computer currency based on the use of strong cryptography.
To quote its designer, Satoshi Nakamoto:
‘The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…
‘Bitcoin’s solution is to use a peer-to-peer network to check for double-spending…the result is a distributed system with no single point of failure.’
Bitcoin is produced in a kind of electronic ‘mining’ process, in which successful ‘miners’ are rewarded with Bitcoin. The process is designed to ensure that the amounts produced are almost exactly known in advance. Since its inception in 2009, the demand for Bitcoin has skyrocketed, albeit in a very volatile way, forcing its price from 3 cents to (currently) just under $600. Perhaps the best-known use of Bitcoin has been on the dark web drugs market Silk Road, the ‘Amazon.com of illegal drugs’, but Bitcoin is increasingly popular for all manner of mundane legal uses as well.
Bitcoin is a wonderful innovation, but the pioneers in any industry are rarely the ones who last. Despite Bitcoin’s success to date, it is doubtful whether being the first mover is an advantage in the longer term: design flaws in the Bitcoin model are set in concrete and competitors can learn from them. The crypto-currency market is also an open one and a considerable number of competitors have since entered the field. Most of these will soon fail, but no-one can predict which will be best suited to the market and achieve long-run success. Most likely, Bitcoin will eventually be displaced by even better crypto-currencies.
Crypto-currencies have momentous ramifications. As one blogger put it:
‘As long as my encrypted [Bitcoin] wallet exists somewhere in the world, such as on an email account, I can walk across national borders with nothing on me and retrieve my wealth from anywhere in the world with an internet connection.’
This gives Bitcoin great potential as an internationally mobile store of value that offers a high degree of security against predatory governments. Bitcoin now fulfils the role once met by bank secrecy – the ability to protect one’s financial privacy.
There is no easy way in which the government can prevent the use of Bitcoin to evade its control. The combination of anonymity and independence means that governments cannot bring Bitcoin down by taking out particular individuals or organisations because the system has no single point of failure. They could shut down whatever sites they like, but the Bitcoin community would carry on.
Strong cryptography therefore offers the potential to swing the balance of power back from the state toward the individual. Censorship, prohibition, oppressive taxes and repression are being undermined as people increasingly escape into the cyphersphere where they can operate free from government harassment.
We now face the prospect of a peaceful crypto-anarchic society in which there is no longer any government role in the monetary system and, hopefully, no government at all.
Welcome to crypto-anarchy.
New Private Monies: A Bit-Part Player can be downloaded here.
Earlier today Conservative Steve Baker MP put forward a Private Member’s Bill, the Financial Institutions (Reform) Bill, which outlines a programme of radical reforms to the banking system and calls for an end to state meddling in banking. Steve is co-founder of the Cobden Centre, and has been MP for Wycombe since May 2010.
The underlying principle of his Bill is to minimize moral hazards within banking, by making those who make or preside over risk-taking as liable as possible for the consequences of that risk-taking. Since financial institutions often circumvent rules, the Bill also includes mutually reinforcing measures that minimize scope for evasion.
Within this framework, bankers would be free to do as they wished, but they would bear the consequences of their own actions.
Thus, Steve’s Bill addresses the rampant moral hazard problems within the modern banking system, and this is the central issue in putting the banking system back on its feet and restoring its integrity. Indeed, his proposals provide nothing less than a free-market solution to the current banking crisis
I would therefore ask all supporters of free markets to promote this Bill and to push for similar measures in other countries.
One key provision of the Bill is to make bank directors strictly liable for bank losses and require them to post personal bonds as additional bank capital. These measures reaffirm unlimited personal liability for bank directors, and will rule out all-too-familiar “It wasn’t my fault” excuses on their part.
The Bill also calls for bonus payments to be deferred for five years, and for the bonus pool to be first in line to cover any reported bank losses. Any reported losses would be covered first out of the bonus pool and then out of directors’ personal bonds before hitting shareholders.
These measures would provide strong incentives for key bank decision-makers to ensure responsible risk-taking, as their own wealth would now be very much at risk.
Amongst other measures, the Bill:
- Proposes a tough bank solvency standard, and would require any insolvent bank to be automatically put into receivership;
- Calls for the Government to propose a fast-track receivership regime for insolvent banks and to produce a plan and associated timetable to end all state involvement in the banking system;
- Calls for accounts to be prepared using the old UK GAAP governed by Companies Act legislation, as proposed in Steve’s previous (2011) Private Member’s Bill, the Financial Services (Regulation of Derivatives) Bill. This would put an end to the various accounting shenanigans associated with IFRS accounting standards; and
- Calls for the establishment of a Financial Crimes Investigation Unit to investigate possible crimes committed by senior bankers: this Unit would investigate all banks that have failed or received public assistance since 2007 and would replace the Financial Services Authority, which has proven to be utterly useless.
Further details of the Bill can be found on Steve’s website:
Ben’s Bubbles and the Bonfire of American Capital
Prepared by Kevin Dowd and Martin Hutchinson for the 28th Cato Institute Annual Monetary Conference Asset Prices and Monetary Policy Washington DC, November 18, 2010
In the Gospel of Matthew (Matthew 25: 14-3), Jesus recounts the Parable of the Talents: the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence. He then returns and holds them to account: the first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn’t be bothered even to put the money in the bank where it could earn interest; instead, he simply buried the money and gave his master a zero return; he is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth.
In the modern American version of the parable, the eternal truth of the original remains – good stewardship is as important as it always was – and there is still one master (the American public), albeit a master in name only, who entrusts his capital to the stewardship of his supposed servants. Instead of three, however, there are now only two (the Federal Reserve and the federal government); they are not especially wicked, but they certainly are incompetent: they run amok and manage to squander so much of their master’s capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment. For their part, the two incompetent servants deny all responsibility, as politicians always do, and – since there is no accountability (let alone Biblical justice) in the modern version – ride off into the sunset insisting that none of this was their fault.
Asset Bubbles in the U.S.: Past and Present
The story starts with the Federal Reserve. Since October 1979, under Paul Volcker’s chairmanship, the Fed’s primary monetary policy goal had been the fight against inflation, a fight he went on to win though at great cost. Given this background, many monetarists were alarmed by Fed Chairman Alan Greenspan’s formal abandonment of monetarism in July 1993, but a subsequent tightening of policy in 1994-95 had caused satisfactory amounts of distress on Wall Street and seemed to indicate that the overall thrust of policy had not in fact changed.
The great change in U.S. monetary policy, so far as it can be dated, came early in 1995: in his bi-annual Humphrey-Hawkins testimony to Congress on February 22-23, Greenspan indicated that his program of rate rises, the last to a 6% Federal Funds rate on February 1st that year, had ended. Elliptical as ever, Greenspan’s hint of easing was veiled: “There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see that underlying forces are acting ultimately to reduce price pressures.” The Dow Jones Index rose above 4,000 the following day, and was off to the races.
By December 5, 1996, the Dow was already at 6,400 and Greenspan famously expressed his doubts about the market’s “irrational exuberance”. Nonetheless, he did nothing tangible to reinforce his skepticism and pushed interest rates generally downwards over the next three years. In July 1997, he then came up with an explanation of why the high stock market might not be so excessive after all. In his usual Delphic manner, he remarked that “important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy.” The press seized on these utterances as confirming a ‘productivity miracle’ that turned out later (like its predecessors the Philips curve and the Loch Ness monster) to be a myth, but not before it gave a nice boost to tech stocks in particular, which positively boomed. Only in 1999 did Greenspan begin to take action, pushing Fed Funds upwards to an eventual peak of 6.5% in 2000, by which time tech stock prices had reached stratospheric levels and then soon crashed.
The cycle then repeated. In January 2001, Greenspan began a series of interest rate cuts that saw the Fed Funds rate fall to 1% in 2003 – its lowest since 1961. He held it at that rate for a year and short-term interest rates were to remain below inflation for almost four years. This was a much more aggressive monetary policy and the results were entirely predictable: in Steve Hanke’s memorable phrase, there was “the mother of all liquidity cycles and yet another massive demand boom,” the most notable feature of which was the real estate boom: subprime and all that. The rest is history.
Greenspan’s successor Ben Bernanke then continued his predecessor’s loose monetary policy with missionary zeal. He brought the Fed Funds rate, which the Fed had belatedly pulled up to 5.25% in 2006 and held there for a year, back down to 2% by the onset of the crisis in September 2008; by then the rate of growth of MZM, the best currently available proxy for broad money, had been running into double digits for some time. Over the next six months MZM then increased at the rate of 20.4% per annum, while the monetary base doubled. Over this same period, the Fed funds rate was brought down from 2% to a mere 25 basis points, at which level it has remained ever since, and these loose money policies were supplemented with nearly $2 trillion in Quantitative Easing (QE). After March 2009, the monetary aggregates then remained flat for a year, but in April 2010 MZM started to rise again (at an annualized rate of 6.8% in the six months to October 2010) and, as we write, the Fed is embarking on QE2 – with yet another $600 billion in quantitative easing due to hit the system.
If past expansionary monetary policies led to bubbles, then we should expect the even more expansionary policies pursued since the onset of the crisis to produce new bubbles, and this is exactly what we find. Within the U.S., there are at least three very obvious bubbles currently in full swing, each fuelled by the flood of cheap money: Treasuries, financials and junk:
The Treasury bond market has seen a massive boom since 2007, fuelled by a combination of large government deficits, enormous investor demand and low interest rates pushing prices up to record levels. Treasury bond issuance totaled $350 billion in the third quarter of 2010 compared with $73 billion in the third quarter of 2007 yet the long-term composite interest rate declined from 4.81% on October 1, 2007 to 3.26% on October 1, 2010. International official purchases for the Treasury bond market, which had declined from $52 billion in net purchases in the year to August 2006 to $9 billion in the following year, have rebounded to $194 billion in the latest twelve-month period. However that is nothing compared to private net purchases, which have soared from $175 billion in the year to August 2007 to no less than $569 billion in the latest twelve month period.
The current ‘recovery’ in financial stocks is almost entirely an artificial bubble. The Fed’s interest rate policy allows the banks to borrow short-term at close to zero and invest at 3% or so in long-term Treasuries or at about 4.5% in mortgage bonds (which are now openly guaranteed by the federal government). This enables them to sit back with their 3%+ spreads, leveraged 20 times to give a comfortable 60%+ gross return: becoming a yield curve player is far more profitable and avoids all the tiresome effort and risk of lending to small business. It is therefore no wonder that lending to small and medium enterprises – on which economic recovery really depends – remains, at best, anemic, with small business loans down 25% since ’08. The result is a bizarre situation in which the banks appear to recover whilst their supposed core activity – lending – remains stuck; the reality, of course, is that lending is no longer their core business.
The banks’ true weakness is confirmed by other factors:
• Current accounting rules – so called ‘fair value’ accounting rules – artificially inflate banks’ profitability in many ways. In practice, ‘fair value’ (sometimes known as market-to-market accounting, but in reality, mark-to-model accounting) boils down to giving practitioners license to abuse financial models for their own ends. This allows them to hide true losses and loot the system: you use a model to create fictitious valuations and hence fictitious profits, and then pay yourself a handsome (and very real) bonus for the ‘profit’ you have created. Needless to add, such practices are all the more damaging because they are so hidden.
• Clever financial engineers are always finding ingenious ways to play the system and are currently very much hard at it. Many of the most lucrative of these schemes involve gaming the Basel capital rules to create fictitious profits and ‘unlock’ capital that can then be used to pay bonuses to clever financial engineers and their managers. U.K. banks seem to lead the field in this antisocial little game but one imagines that their NY colleagues must be pretty good at it too. A good example is the ingenious ‘pig on pork’ scam, introduced in the U.K. a decade ago and since widely copied; the current flavor of the month is the even more ingenious ‘failed sale’ scam, a transaction that looks like an innocent Repo, but which is really a backdoor way of hypothecating bank assets and deceiving bank counterparties who do not realize that the prime assets that appear to buttress banks’ balance sheets are in fact already furtively pledged to other parties. Such practices secretly decapitalize the banks and are of course just another form of looting.
• Underlying these, the banks are only able to continue operating because they are on state life support, propped up by repeated bailouts (including lender of last resort lending, TARP, government purchases of bank equity, repeated large-scale quantitative easing, etc) and government guarantees (including too-big-to-fail, deposit insurance, blanket guarantees of home mortgages, etc).
A third bubble is junk (sub-investment grade corporate bonds). In the year to September 15, 2010, junk bond issues raised $168.5 billion, more than the 2009 full-year record of $163 billion, and which itself represented an annual increase in total outstanding junk bonds of over 200%. Such growth is extraordinary in the deepest recession since World War II. Moreover, much of this growth takes the form of ‘covenant-lite’ bonds, which had been thought an aberration of the 2006-07 bubble. The key factor driving this growth would appear to be low interest rates: these not only reduce borrowing costs (for those able to borrow, i.e., larger firms rather than SMEs) and stimulate borrowing, itself encouraged by the tax-deductibility of debt; recent ultra-low interest rates also suppress yields on Treasuries, and this encourages yield-seeking investors to go for junk. These same causal factors have also given a big boost to the Leveraged Buy-Out (LBO) market, not least in so far as they have allowed company after company to avoid bankruptcy (and indeed prosper, temporarily) through aggressive refinancing.
Each of these bubbles was/is characterized by obvious irrationality:
• In the tech boom we had Pets.com, based on the idea that there was money to be made fedexing catfood around the country, and which could not cover the costs of sending kitty litter through the post: it made its IPO in February 2000 amid a welter of Superbowl ads and went for its final walkies a mere 288 days later. As an investment, Pets.com was a real dog.
• In the housing bubble we had NINJA and ‘no doc’ loans, and house prices in some parts of the country running at 8-10 times annual income, i.e., we had loans being made with no concern for whether they would or could ever be repaid.
• With interest rates so low, the prices of Treasuries are close to their peak and the only major change can be down; investors face a classic ‘one-way bet’ scenario reminiscent of a beleaguered currency facing a speculative attack: think of the U.K. currency crisis in September 1992, for example. In such circumstances the only rational response is to sell and yet investors’ money still pours in.
• In the current financials market, we have the irrationality of the banks apparently profitable and prospering whilst the credit system is still jammed up and most of them remain dependent on state life support to continue in operation.
• In the current junk bonds market, we have the irrationality of a major boom in lending to the riskiest corporate customers taking place in the middle of a major credit crunch and in the certain knowledge that many of these borrowers will default when interest rates rise.
We can be confident that these current bubbles will come to unpleasant ends like their predecessors, but on a potentially much grander scale. The bubbles will then burst in quick succession:
• Sooner rather than later, it will dawn on investors that Treasuries are over-valued and confidence in the Treasuries market will crack: one possibility is that rising inflation expectations or higher deficits will then push up market interest rates, causing bond prices to falter and then fall; an even more imminent prospect is that some combination of the Fed’s quantitative easing and yawning Federal budget and U.S. balance of payments deficits will cause a further decline in the dollar that makes foreign holders of Treasury bonds lose confidence in their investments. In either case, there is then likely to be a rush to the exits – a flight from Treasuries on a massive scale – forcing up interest rates in general and inflicting heavy losses on bondholders, especially on those holding long-term bonds.
• The collapse of the Treasuries market will cause the banks’ previously profitable ‘gapping’ adventure to unravel with a vengeance: the very positions that yielded them such easy returns will now suffer swingeing capital losses. Confidence in the banks – never strong since the onset of the crisis – will collapse (again) and we will enter a new (and severe) banking crisis.
• The bursting of the Treasuries and financials bubbles will then feed through to the junk bond bubble: the collapse in the Treasuries market and the renewed banking crisis will lead to sharp falls in the values of corporate bonds and sharp rises in credit spreads. Highly leveraged firms will then default in droves, the junk bond market will collapse and LBO activity will dry up.
We also have to consider the nontrivial knock-on effects: the Treasuries collapse will trigger an immediate financing crisis for governments at all levels, and especially for the federal government, and one which will likely involve the downgrading of its AAA credit rating, and so further intensify the government’s by-then already chronic financing problems. Nor should we forget that these financial tsunamis are likely to overwhelm the Federal Reserve itself: the Fed has a highly leveraged balance sheet that would do any aggressive hedge fund proud; it too will therefore suffer horrendous losses and is likely to become insolvent. The events of the last three years will then look like a picnic.
There is also the problem of resurgent inflation. For a long time, the U.S. has been protected from much of the inflationary impact of Federal Reserve policies: developments in IT and the cost reductions attendant on the outsourcing of production to east Asia had the impact of suppressing prices and masking the domestic impact of Fed policies. Instead, these policies produced a massive buildup in global currency reserves: these have increased at 16% per annum since 1997-98 and caused soaring commodity prices and rampant inflation in countries such as India (current inflation 16%) and China (maybe 20%, judging by wage inflation, and definitely much higher than official figures acknowledge) whose currencies have been (more or less) aligned to the dollar. U.S. inflation was already rising by 2008 (annual rate 3.85%), but this rise was put into reverse when bank lending and consumer spending then fell sharply. However, there are good reasons to think that inflation will soon take off again: (1) The combination of booming commodity prices and a depreciating dollar (trade-weighted dollar exchange rate index down 15% since March ’09) means that imports will cost more in dollar terms and this must inevitably feed through to U.S. inflation. (2) Rising labor costs in the Asian economies mean that the outsourcing movement is coming to an end and even beginning to reverse itself, and with it the associated cost reductions for American firms that outsource to Asia. Most importantly, (3), there is the huge additional monetary overhang created over the last couple of years (or, to put it more pointedly, the vast recent monetizations of government debt), the impact of which has been held temporarily in check by sluggish conditions over 2009-2010, but which will must eventually flood forth – and, when it does, inflation is likely to rise sharply.
Once inflation makes a comeback, a point will eventually come where the Fed policy has to go into sharp reverse – just like the late 1970s, interest rates will be hiked upwards to slow down monetary growth. The consequences would be most unpleasant: the U.S. would experience the renewed miseries of stagflation – and a severe one at that, given the carnage of a renewed financial crisis and the large increases in money supply working through the system. Moreover, as in the early 1980s, higher interest rates would lead to major falls in asset prices and inflict further losses on financial institutions, wiping out their capital bases in the process. Thus, renewed inflation and higher interest rates would deliver yet another blow to an already gravely weakened financial system.
The Decapitalizing Effects of Repeated Bubbles
Federal Reserve monetary policy over the last fifteen years or so has produced bubble after bubble, and each bubble (or each group of contemporaneous bubbles) is bigger in aggregate and more damaging than the one that preceded it. Each bubble destroys part of the capital stock by diverting capital into economically unjustified uses – artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon. These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and ‘bubble blight’ – massive over-capacity in the sectors affected. This has happened again and again, in one sector after another: tech, real estate, Treasuries, financials, and junk – and the same policy also helps to spawn bubbles overseas, mostly notable in commodities and emerging markets right now.
We also have to consider how periods of prolonged low (and often sub-zero) real interest rates have led to sharply reduced saving and, hence, led to lower capital accumulation over time. U.S. savings rates have fallen progressively since the early 1980s, falling from nearly 12% to little more than zero in recent years.
Even without Federal budget deficits, it is manifestly obvious that U.S. savings rates over the last two decades are inadequate to provide for the maintenance, let alone growth, of the U.S. capital stock (or, for that matter, its citizens’ desires for a secure retirement): the U.S. economy is effectively eating its own seed-corn. Now add in the impact of federal budget deficits of around 10% of GDP and we see that the deficits alone take up more than the economy’s entire savings, without a penny left over for investment. It then becomes necessary to supply U.S. capital needs by foreign borrowing – hence the persistent and worrying balance of payments deficits – but even this borrowing is not enough. Hence over the long term, low interest rates are decapitalizing the U.S. economy, with damaging long-term implications for its residents’ living standards: in the long run, low interest leads to low saving and capital decline, and they in turn lead to stagnation and eventually to the prospect of declining living standards as America ceases to be a capital-rich economy.
Not to put too fine a point on it, savings have been suppressed for close on two decades, preventing the natural accumulation of capital as baby-boomers drew closer to retirement, while much of the country’s magnificent and once unmatched capital stock is being poured down a succession of ratholes.
The Federal Government is a Pretty Good Capital Destroyer Too …
We should also see these problems against the context of a vast number of other government policies that are decapitalizing the U.S. economy in myriad other ways. The wastefulness of government infrastructure projects is of course legendary. One instance is the Amtrak proposal for a Boston-Washington high speed railroad, costed at $117 billion, compared to $20 billion equivalent for similar lines in France and under $10 billion for a line recently opened in China. Even more striking is the ARC tunnel project between Manhattan and New Jersey, recently killed by Governor Christie because of its excessive cost of $8.7 billion plus likely overruns. Yet the Holland Tunnel, performing an identical function and opened by President Coolidge in November 1927, came in at $48 million, equivalent to $606 million in 2010 dollars. Even allowing for the higher real wages of today’s construction labor, and a certain amount of fiddling of the consumer price statistics by the BLS, it should have been possible to bring the ARC project in at under $1.5-2 billion, less than a quarter of the actual projected cost. The high costs of infrastructure problems boil down to the onerous regulations under which such projects are carried out, such as the 1931 Davis-Bacon mandate to use union labor on federally funded projects and a whole welter of health & safety and environmental regulations, which massively push up overheads.
We also have to consider the impact of government fiscal policy. Large government deficits reduce capital accumulation in so far as they crowd out private investments; large levels of government debt also reduce capital accumulation in so far as they imply large burdens on future taxpayers and these burdens reduce their ability (not to mention their willingness) to save. Over the three years, the government’s deficits have risen from 1.14% of GDP in 2007 to a projected 10.64% of GDP in 2010. In the process, US government official debt has grown from almost 64% of GDP in 2007 to a little over 94% of GDP in 2010. This latter figure is very high by traditional standards and the rate at which it is rising would suggest that the U.S. government’s credit rating will soon be threatened, even without the racing certainty of an imminent Treasuries collapse; indeed, this figure alone portends a rapidly approaching solvency crisis.
Yet even these grim figures are merely the tip of a much bigger iceberg. The official debt of the United States, large as it is, is dwarfed by its unofficial debt: the Social Security and other entitlements (Medicare, Medicaid, etc) to which the federal government has committed itself, but not provided for, i.e., additional debts that future taxpayers are expected to pay for. Recent estimates of the size of this debt are hair-raising. Using CBO figures, Laurence Kotlikoff recently (Aug 11, 2010) estimated that this debt was now $202 trillion. To put this into perspective, this is 15 times the ‘official’ debt and nearly 14 times annual U.S. GDP – implying that the average U.S. citizen would need to spend almost 14 years of their life (and still counting) working to pay off this debt alone: no wonder Kotlikoff matter-of-factly concluded that the US is bankrupt and we don’t even know it. This burden implies punitive tax rates on future employment income (and hence major disincentives to work or at least declare income), but will also greatly discourage future capital accumulation as investors will (rightly) fear that there is little point building up investments that will eventually be expropriated by the government.
Long-term Outlook for the U.S. Economy
The long-term effect of U.S. economic decapitalization will not necessarily be apparent in day-to-day headlines; instead, the process will be almost glacial: mostly slow but utterly devastating in its longer term impact.
For all of its history, the United States has enjoyed many advantages over most other countries: abundant wealth and capital, world-class education and technology, a highly innovative culture and, underpinning these, a freer economy. However, the US economy is now far less free than it used to be 80 or more years ago; partly because of this, but partly because of the natural ongoing processes of globalization, the U.S. is steadily losing its other advantages as well. Owing to globalization and the outsourcing and wealth transfer that has brought about, the U.S. has long lost many of its advantages of technology and education against Europe and Japan. The same process then started relative to the small ‘tiger’ economies of east Asia and, more recently, relative to the giant Asian economies of China and India, whose wage levels are still only a fraction of those of the United States. In the long run, American citizens can expect higher living standards than Chinese or Indian citizens only if they maintain some ‘edge’ over them. However, as the American capital stock gradually dissipates and their capital stocks increase, then that edge becomes increasingly tenuous and living standards will converge. Consequently, over the long term, there is no reason to expect U.S. living standards to exceed those in countries such as China, Malaysia, Thailand and Brazil that are coming to equal the U.S. in many of its factor inputs.
Americans might also take heed from the experiences of other once wealthy countries whose economies were crippled by progressive decapitalization:
• One is Britain, which was still a wealthy country at the very frontier of technological advance in the late 1930s. However, when the War broke out the government took complete control of the economy and seized its entire capital stock, foreign investments and all. Over the next decades a bloated state sector and onerous controls deprived British industry of the capital it needed to refit, and the country went into long term economic decline. By the late 1970s, in consequence, Britain was being referred to as the new “sick man of Europe” and British living standards by the late 1970s were 30% lower than its European competitors’ and half those in the United States. By contrast, West Germany, which had suffered much more devastation in the War and the loss of most of its physical infrastructure, rebounded quickly under the free-market policies implemented by Konrad Adenauer and Ludwig Erhard from 1948, and soon rebuilt both its capital stock and its prosperity.
• Another role model to avoid is Argentina, one of the world’s wealthiest economies in 1930, with enormous foreign exchange reserves from wartime trading as late as 1945, which embarked on wildly extravagant schemes of corruption, nationalization and income redistribution. Successive governments tried to restore Argentina’s position – it was after all superbly endowed with resources and in the 1940s had a highly competitive education system – but without adequate access to capital were unable to do so. The result was progressive impoverishment, repeated debt defaults and the country’s descent into its present Socialist squalor, in which even with high commodity prices it comes between Gabon and Libya in the global table of GDP per capita.
This will therefore be the fate of a decapitalized United States: its major cities will descend through the position of Cleveland, in which decay is mixed with dilapidated old-world charm, to that of Youngstown, Ohio in which devastation is universal, with the only flourishing markets being those for chain-link fences, tattoos and rottweilers.
What Can Be Done?
Thankfully, such a dire future is not inevitable – unless current policies persist – but radical reforms will be needed if it is to be avoided. Any reforms need to be based on a diagnosis of the underlying problems, however, and one of the most important of these is, quite simply, that U.S. policy-makers place too much emphasis on the short-term and fail to take adequate account of longer-term consequences. Nor should this be any surprise: the political environment in which they operate – the fact that they are accountable over limited terms of office, etc. – encourages them to focus on the short-term, so it is only to be expected that they would respond to such incentives: what happens after their watch is not their problem.
As far as monetary policy is concerned, these short-termist incentives create an inbuilt expansionary bias that has manifested itself in repeated asset price bubbles and now the prospect of renewed inflation, and the solution is to build-in barriers to contain his bias. The key here is to reduce – or better still – eliminate their discretionary powers; this would put a stop to those who would meddle with the short term interest rate and so kill the asset bubble cycle at its root. Interest rates would then be higher (and more stable) than they have been over recent years and so provide a stronger incentive for saving.
One possible reform would be to ‘Volckerize’ the Fed and give it a single overriding objective – namely the maintenance of price stability – and reform its institutional structure to protect its independence from the federal government. Reformers could take their lead from the Bundesbank: instead of a federated central bank accountable to the federal government and headquartered in the federal capital, the American central bank could be reconstituted as a unitary central bank accountable to the States and relocated in the heartland of the nation: our recommended choice would be St. Louis, which also has the attractions of a strong monetarist tradition and of being less susceptible to the influences of Washington DC or Wall Street. The ideal Fed chairman would then be more concerned with the St. Louis Post-Dispatch than the Washington Post or the WSJ, and even the feeblest appointee would be strong enough to stand up to the badgering of east coast politicians and financiers.
However, a far better reform – and a far more appropriate one, given the Fed’s dismal record since its founding – would be to abolish the Federal Reserve altogether and re-anchor the dollar to a sound commodity standard. A natural choice would be a gold standard, with the currency issued by commercial banks but pegged to and redeemable in gold. Interest rates and money supply would no longer be determined by central bankers but by market forces subject to the discipline of the gold standard. An alternative anchor might be some broader commodity basket, which has the additional attraction of promising greater price-level stability than a gold standard.
Yet monetary reform on its own will not be enough to reverse the destruction of US capital: the federal government also needs to reform its own vast range of capital-destroying policies. Such reforms would include, among others, the following:  (1) Government should stop meddling in the financial system: it should stop giving guarantees such as mortgage guarantees or deposit insurance guarantees, and it should implement measures to prevent future bailouts and abolish government-supported enterprises such as Fannie, Freddie, etc. whose machinations have devastated the U.S. housing market. (2) Reformers should acknowledge the tendency of government to grow and be excessively short-term focused, and push for a systematic program that will cut government back and limit any future growth, the goal being to return the government back to the levels of the Coolidge Administration (motto: “The business of America is business”) in the 1920s. (3) A range of tax reforms is needed to abolish tax-based incentives to borrow, remove tax penalties from saving, investing and the transfer of capital between generations. (4) Government should tackle major budget imbalances. This requires a major reversal of current expansionary fiscal policies and, for once, the U.K. provides a positive role model: the U.K. faces similar problems, but the new Coalition Government acknowledges these problems and is in the process of implementing cutbacks to take Britain back from the brink; the U.S. needs to do the same.
The longer term fiscal prospects for both countries are of course dire but the good news is that most actuarial deficits are not so much hard and fast debt obligations as projections of what would happen if current policies persist, and there are obvious economies that can be made once the U.S government finds the courage to tackle these problems. Moreover, recent political developments – in particular, the recent Congressional elections, the rise of the Tea Party Movement and increasing dissatisfaction with the Federal Reserve, most notably the growing ‘end the Fed’ movement – suggest that the U.S. is at least beginning to move in the right direction.
Dowd, K., “An almost ideal monetary rule.” Greek Economic Review, Vol. 19, No. 2, Autumn 1999, pages 53-62.
Dowd, K., and M. Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, Wiley, 2010.
Hanke, S. H., “Greenspan’s bubbles.” Finance Asia, June 5, 2008. Available at http://www.cato.org/pub_display.php?pub_id=9448
Hanke, S. H., “Booms and busts.” Finance Asia, January 2010. Available at http://www.cato.org/pub_display.php?pub_id=11084
Hutchinson, M., “They don’t call them junk bonds for nothing.” The Bear’s Lair, September 27, 2010. Available at http://www.prudentbear.com/index.php/component/content/article/33-BearLair/10443-martin-hutchinson
Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Public debt and demography – an international comparison using generational accounting.” Research Center for Generational Contracts, Freiburg University, CESifo Dice Report 4/2009, 2009a.
Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Ehbare Staaten? Die deutsche Generationenbilanz im internationalen Vergleich.” Argumente zu Marktwirtschaft und Politik 107, Stiftung Marktwirtschaft, 2009b.
Kerr, G., “How To destroy the British banking system – regulatory arbitrage via ‘pig on pork’ derivatives.” Cobden Centre. Available at http://www.cobdencentre.org/2010/01/how-to-destroy-the-british-banking-system.
Kotlikoff, L., “U.S. is bankrupt and we don’t even know it.” Bloomberg, August 11, 2010. http://www.bloomberg.com/news/2010-08-11/u-s-is-bankrupt-and-we-don-t-even-know-commentary-by-laurence-kotlikoff.html
Norberg, J., (2009) Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis.Washington DC: Cato Institite, 2009.
O’Driscoll, G. P, Jr., “Money and the present crisis.” Cato Journal, Vol. 29, No. 1, 2009, pp. 167-186.
Woods, T. E., Jr., Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington DC: Regnery, 2009.
 Kevin Dowd is a Visiting Professor at the Pensions Institute at Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, United Kingdom and an adjunct scholar at the Cato Institute; email: email@example.com. Martin Hutchinson is a financial journalist and former banker, correspondent for Reuters BreakingViews and author of the weekly column “The Bear’s Lair”: 8307 Colby Street Vienna VA 22180, e-mail firstname.lastname@example.org. The authors thank Toby Baxendale, Steve Hanke and Gordon Kerr for helpful inputs. The usual caveat applies.
 Testimony to the House Banking Committee, February 22, 1995.
 Testimony before the Senate Banking Committee, July 23, 1997, p2. St. Louis Fed., FRASER.
 There are many excellent accounts of this story, and we particularly recommend, e.g., O’Driscoll (2008), Hanke (2008), Norberg (2009) or Woods (2009). We also had a go at it ourselves in Dowd and Hutchinson (2010).
 There are also major bubbles overseas, most notably those in the Chinese and Indian real estate markets, and which (given the reserve currency status of the dollar and the huge expansions in these countries’ dollar holdings over a long period) are also due, in part, to the same expansionary Federal Reserve policies.
 We also mention two others in passing. (1) Stock prices are in a moderate bubble: analysis of stock fundamentals suggests that stocks (up 60%+ since the lows of March 2009) are now somewhat overpriced, though low interest rates are pushing up profits, especially for highly leveraged businesses. (2) Commodity prices are already approaching and in some cases surpassing their 2008 highs: e.g., since early ’09, gold is up nearly 60%, silver is up 100%, copper up 350% and crude oil up nearly 250%. Commodity prices are driven partly by rapidly growing demand in emerging markets and partly by continuing ultra-cheap money.
 There is also a large boom in fast/insider trading that illustrates, if not the irrationality, then at least the economic pointlessness of much of what the financial system currently does. High-frequency trading using fast computers and automated algorithms has grown enormously and now accounts for 70% or more of trading volume, up from very small amounts a few years ago. Its defenders claim it promotes market liquidity, but we would argue that their impact on market liquidity is at best minimal as markets are already liquid for the most part and the machines are switched off when markets become unstable. We would also argue that they are potentially destabilizing (as evidenced by the May 2010 ‘flash’ in the Dow Jones when the market fell 10% after a rogue machine went on a rampage) and in some cases their activities are fraudulent (e.g., when they program their computers to “ping” markets with orders that are instantaneously retracted). We would argue that most high-frequency trading is rent-seeking activity that has no place in a truly rational system and really needs to be shut down: this is where a Tobin tax would come in useful as a stop-gap, pending more radical reforms (free banking, extended liability, etc.) that would restore such a system.
 We thank Gordon Kerr for this information; further details on ‘pig on pork’ are provided by Kerr (2010).
 See also Hutchinson (2010).
 To give a simple illustration, take a Treasury bond with a duration (average time to cash flow) equal to say 25 years: using conventional duration analysis, a rise in interest rates of just 1% would lead to a capital loss of 25%; at the same time, with interest rates so low and the government flooding the market with more, thanks to its gaping borrowing requirements, the bond has little chance of going up in price.
 A free investment tip, guys: cash out and try the mattress – at least there is no danger of a capital loss when interest rates rise. Alternatively, you might take a leaf from the wicked servant in the Parable and bury the cash in the garden: that strategy is not as bad as it is cracked up to be – so long as you don’t just bury paper money in a damp garden.
As an example, recent stories in the U.S. press report that Indian helpdesk companies are now finding that they can operate more cheaply in the rural U.S. than in India itself: the fall in rural U.S. wage rates due to the recession has combined with the rise in Indian costs to produce an astonishing reversal of the original outsourcing driver.
 See also, e.g., Hanke (2010). We can illustrate this impact by applying duration analysis familiar from bond market analysis: if an investment with given expected future cashflows has a duration (or average time to cashflows) of T years, then a fall in interest rates of 1% will lead the value of the investment to rise by (approximately) T%. The impact on asset values will be ameliorated if longer term rates do not fall so much, but the essential story still holds.
 We gloss over various knock-on effects. One such is how the lowering of short-term interest rates depresses yields: this encourages investors to look for higher-yielding, investment outlets which, in turn, reduces credit spreads and diverts capital from ‘safe’ investments into higher risk investments such as junk bonds or emerging markets. If Vietnam, for example, can then raise money almost as easily as Ohio, then capital will be diverted to lower cost Vietnam and US manufacturing jobs will migrate with them.
 We gloss over here but take as read the vast amount of wastage and loss (much of it not even estimable) in recent federal government spending programs: TARP (cost said to be only about $30 billion) and other bank bailouts, the AIG rescue (which will be much higher than that), the rescue of Fannie and Freddie (currently worst case about $360 billion), the $1 trillion or so FHA loans made since it stepped in during the crash (and no one yet knows how many are bad), cash for clunkers and the auto bailouts, the over-hyped American Recovery and Reinvestment Act and quantitative easing, the costs of all of which are still unknown.
 See Kotlikoff (2010). Other scholars come up with different estimates, though still very alarming ones: for example, Hagist et al. (2009, 2010) suggest that the ratio of unofficial U.S. debt to GDP was 350.8% in 2004 and an update for 2009 gave an estimate of 567.4%. This suggests the problem is growing rather rapidly. The same study also provided an international comparison of the U.S. against selected European economies, and their results suggest that the U.S. has now displaced the U.K. as the country with the shakiest long-term public finances, a not inconsiderable achievement.
 Indeed, it would appear that the U.S. government is already laying the groundwork: the recently passed Foreign Account Tax Compliance Act requires U.S. taxpayers to inform the IRS of their foreign investments, and also requires foreign funds to name their U.S. investors on pain of a flat 30% confiscation tax each year. As one (non-U.S.) institutional investor informed us in private correspondence, “Naturally, we are divesting ourselves of all U.S. holdings.” This does not augur well for the future of the U.S. as a magnet for foreign investors; it also raises specter of the seizure of private gold holdings in 1934.
 An example of such a scheme is the ‘almost ideal monetary rule’ suggested by Dowd (1999). The idea is to create a monetary rule that stabilizes the CPI without the central bank having to buy and sell the CPI ‘basket’ of goods and services itself, which would obviously not be feasible. Instead, the Fed creates a new form of CPI-based financial derivative – in this particular case, this derivative would be a perpetual American put option on the U.S. CPI, the term ‘American’ here being used in the sense of standard options language to refer to an option with unrestricted early exercise rights. The Fed would then buy and sell these contracts on demand at a fixed price, and the system is so designed that its only zero-arbitrage equilibrium is one in which the expected change in the future CPI is zero; this would ensure that the system delivers price-level stability. In our (preferred) free-banking version of the scheme, commercial banks would be allowed to issue dollar-money on this same basis, and the Fed itself could then be abolished.
 For more on these reform proposals, we refer the reader to Dowd and Hutchinson (2010).
In a recent video interview in the Daily Telegraph (October 7, 2010), Keynes’s biographer, the noted historian Professor Lord Skidelsky, gives us the benefits of his views on what Keynes would have thought of current economic policies.
His main point is that Keynes would have been appalled at the “economic illiteracy” of the current government and in particular by its concern with the deficit. The view that the government deficit could be compared to the credit card spending of an ordinary household was, to paraphrase his argument, to show a level of economic illiteracy that would get “0 out of 10 in any economics paper”.
He then went on to argue for more deficit spending along standard Keynesian lines, whilst criticising those who wanted deficit cuts as coming from some inflexible nostrum that did not take account of the current state of the economy.
This is unreconstructed Keynesianism at its very worst.
- Let’s leave aside the awkward facts that textbook Keynesian policies didn’t work in the 1930s, in this country or in the US, that they created a stagflationary nightmare in the early 1970s that took this country to the brink of collapse, and were repudiated after much soul-searching by Labour PM Jim Callaghan in 1976, after which the economy began to recover.
- Let’s leave aside the fact that Geoffrey Howe in his famous 1981 budget courageously decided to cut the deficit in the middle of a deep recession; the Keynesian establishment howled and warned that this would produce disaster, but the economy recovered strongly.
- Let’s leave aside the fact that the policies that many Keynesians now advocate were tried for the best part of two decades in Japan and failed.
- Let’s leave aside the fact that high government spending, high taxes and an insouciance about the deficit were key factors in the creating the macroeconomic backdrop to the current crisis.
Yet despite this dismal record the followers of Keynes still push the tired old policies of deficit spending like a broken record. The analysis and remedy is always the same: demand is too low, so expand government spending and increase the deficit.
And still Skidelsky criticises others for having an inflexible nostrum! When did they ever say, “Well guys, we have had enough deficit spending for now”? (Apologies in advance: if any of them did, I missed it.) Of course, why would they ever oppose deficits, as they have a blinkered view of deficits that tells them that deficits can only ever be good?
Whatever Keynes would have said now — who really knows? and more importantly, does it really matter? — it beggars belief to suggest that the deficit does not matter, especially in the current economic environment. The UK is already in an insolvency crisis and big international investors are already very nervous. Ignoring the deficit (with explicit government debt now about 70% of GDP and rising fast) will soon lead to the erosion of the country’s credit rating which will make the Government’s financial problems very much worse and, potentially, lead to a Greek-style crisis. This looming fiscal crisis is already crippling government finances and the financial burden and uncertainty it creates are key factors undermining economic confidence and holding the economy back.
Furthermore, the long-term prognosis for the UK is much worse than the 70% debt/GDP ratio would suggest, as this ignores the vastly greater ‘hidden’ debt that the government has already accumulated off-balance sheet.
There is also a huge intergenerational issue here: youngsters coming onto the job market face the prospect working all their life to pay off enormous debts already incurred for them, often before they were born, to pay for the pensions, medical and other benefits to be received by their elders, in the full knowledge that there will be nothing left for them when they get old themselves. The pension system is, in effect, a massive Ponzi scheme, and they are the ones being ripped off. You try telling them that a debt of perhaps £200,000 over a lifetime doesn’t matter, especially when they have to pay it and that debt is incurred merely by virtue of entering the labour force – a kind of entry tax to the labour market, as if they had the choice not to enter it!
In the long-term, economic prosperity depends on the old verities of the Children’s Copybook: hard work, trust, integrity, prudence, and the importance of capital accumulation and saving. These are the pillars on which the economy depends, and yet Keynes and his followers systematically attacked each of these as if they were useless relics from an earlier age:
- They undermined hard work by oppressive taxation, ludicrous welfare systems and, more generally, state intervention into the economy, gravely weakening the link between work and reward, and turning the capitalist system into an ugly and corrupt form of crony capitalism in which hard work is penalised and what really matters is political influence.
- They undermined integrity and trust in our economic institutions, not least in the banks and government itself, and they undermined the currency by abandoning the discipline of the gold standard. But we should not be so surprised: Keynes was a self-confessed immoralist who had no time for conventional systems of morality: the idea that governments should keep their word, and so forth, was old hat, another Victorian hang-up; governments could and should do whatever they wanted … provided they took his advice.
- They mounted a sustained attack on saving: they undermined saving by low interest rates, inflation and oppressive taxation. They constantly preached the message – and still do – that saving was a social evil and should be discouraged. However, in the longer term, lower saving means low capital accumulation, and lower capital accumulation means low growth and stagnation, and lower living standards. (But never mind this: in the long-term, as the Great Man said, we are all dead anyway.)
Part of the reason for the continued influence of Keynesian ideas is that his followers managed to establish an iron grip on academia that remains to this day. One only has to look through the standard economics course syllabi and associated textbooks to see this: students are taught a “Cowboys and Indians” Keynes vs Friedman debate that is, in essence, still strongly Keynesian in its underlying assumptions. Pre-Keynesian schools of thought are represented by a largely fictional ‘classical economics’ that serves as a useful straw man. The key issues of the role of the state in the economy are rarely addressed; economics students no longer get a sense of the broader social, moral and philosophical issues on which economic questions ultimately depend, and have little or no sense of economic history. Economics is relegated to mere technical analysis (and bad technical analysis at that), devoid of any meaningful context.
Amongst all of this, the (largely unspoken) message is all too successfully conveyed: that there is only one way to think about these issues – their way. A student can go all the way through University, even up to PhD level, and still have no sense of there being any reasonable alternatives. Other schools of thought – especially pre-Keynesians and the Austrian school – don’t get a look-in. Thus, we continue to produce thousands of economics graduates – educated idiots, in effect – who are blinkered by their models and have little grasp of true economic problems, especially macroeconomic ones.
With “experts” like these, I would prefer to take my chance with the gut instincts of the man on the street … and on that front there is hope yet: almost all the comments in the discussion thread following the Telegraph video were highly critical and rightly so. When it comes to economics vs. common sense, the latter wins hands down: I will happily settle for my 0/10 on Professor Skidelsky’s economic literacy course.
Towards the end of his General Theory Keynes warned that the power of vested interests was vastly overrated compared to the power of ideas: “Practical men … are usually the slaves of some defunct economist,” he wrote. In this he was surely right. It is high time that his followers woke up to the fact that it is Keynes himself who is now the “defunct economist”.”
There are alternatives and we must look at them: Keynesianism is washed up.
Although few people yet realise it, the UK is bankrupt: the Government cannot pay its debts.
This might sound a little pessimistic. After all, the UK debt to GDP ratio is still under 70%, and the debt to GDP ratio for some other countries is much higher.
However, for peacetime the current UK debt to GDP ratio is high and rising fast. Furthermore, observers of the UK economy have been sounding warnings for some time: one major bond investor early in the year warned his clients that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine”.
Unfortunately, the Government’s official debt is not the real problem: the Government’s ‘official’ debt is only a small percentage of its true debt exposure. The official debt is merely the tip of a very large hidden iceberg.
The Government’s true debt is the present value of all the commitments it has entered into, on the expectation that these commitments will be paid for by future taxpayers. Some prominent examples are the commitments implied by the public sector pension system, the state pension system, the health system and PFI. The costs of these commitments are staggering.
One recent Institute of Economic Affairs study by Nick Silver put this figure at 333% of GDP. Another, by Christian Hagist and his colleagues at Freiburg University, put the figure at 530% of GDP. Two different methodologies by reputable researchers, both painting a very bleak picture. The latter study also carries out an international comparison – and, relative to other countries, the UK comes out as a basket case along with the US: the US is bankrupt too.
Let’s take the first figure. This means that a typical UK citizen will be expected to pay well over three times’ their annual income just to cover this debt. If we go with the larger figure, then he or she will be expected to pay well over five times their annual income.
With an average income of about £22,000 for per person, these figures suggest a future tax bill in the range between approximately £73,000 and almost £117,000 for each man, woman and child in the country.
Yet even these figures are over-optimistic, in so far as they refer only to the unfunded tax burden that has already been incurred, whereas the reality is that this burden has been rising rapidly before the current crisis, and is rising even more rapidly now. So we are looking at an obligation on the future taxpayer that is not only very large, but still rising sharply.
The problem is made worse still because of the way the tax burden will be distributed. For some older people – such as those in retirement – there isn’t much problem at all. They benefit from the government’s commitments, but are unlikely to have to pay much towards their cost. For young people, it is the other way round: they are expected to pay large amounts into the system and get little back in return; and the younger the person, the worse the deal.
So we have an average, per person, tax burden of £73,000 if we are feeling optimistic and nearly £117,000 if we are feeling pessimistic – but in either case possibly much higher, and certainly rising – that is distributed very unevenly across the population: younger people paying much more, and older people less, if anything at all.
One recent estimate suggested that a UK citizen born in 2011 will inherit, on birth, a debt of perhaps £200,000, and it could easily be much more.
It is simply inconceivable that debts on this scale will be paid off in full.
Nor should they. These were not debts that youngsters freely took on, but obligations incurred on their behalf in many cases before they were even born.
The uncomfortable moral question then naturally arises: at what point does the debt become so large that our future children will be born into a new form of slavery, entering the world shackled by the debts of their forbears?
This highlights the underlying moral as well as fiscal bankruptcy of the system. For years, politicians yielded to the temptation to increase spending commitments and put off the costs of those decisions into the future, when it would be someone else’s problem. The political system itself encouraged them to do so – handing out goodies is so much easier to sell politically than handing out pain. Even the voters themselves were complicit, because they voted in governments committed to ‘spend now, [someone else] pay later’ policies, instead of penalising governments for long-term fiscal irresponsibility. Most of those who will pay the burden did not yet have the vote, so they didn’t count. No-one took responsibility for the long-term.
In so doing, our political system created a huge intergenerational Ponzi scheme, passing the buck from one generation to the next, until the whole rotten system inevitably collapses under its accumulated weight.
The long-term, even medium-term, outlook is therefore deeply unpleasant. Taxes will rise, sharply, but these rises will not be enough, and will leave younger people with little incentive to work or to save. Benefits across the board will be cut, massively: the government will renege big-time on many of its commitments, breaking its health, pensions and other promises on a huge scale. The social and economic consequences don’t bear thinking about. And of course there is the very real danger that even these draconian measures will not be enough: that the government will lose all control of its finances and end up printing money to pay off its debts, so leading to hyperinflation and economic collapse.
Make no mistake about it: the country is bankrupt.
In today’s Telegraph Ambrose Evans-Pritchard gives a splendid analysis of the dire fiscal problems facing the developed economies, but a dreadful analysis of their monetary problems.
With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice. The Government is indeed very fortunate to have kept its credit rating – even at the beginning of the year, one big bond investor was warning that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine” – but this cannot last unless the Government provides a credible plan to map the country back towards solvency.
We must also keep in mind that the ‘visible debt’, the debt on the Government’s balance sheets, is just the tip of the iceberg: when one takes into account all the hidden commitments the Government has entered into – PFI, public sector pensions, state pensions, etc. – the situation is far far worse: we are looking at debt to GDP ratios in the range of perhaps 350% to 500%.
The true fiscal situation is, thus, even more dire than Mr. Evans-Pritchard makes out. Nonetheless, he is absolutely right that fiscal expansion is not an option. Instead, the Government is drinking in last-chance saloon and it is a choice between painful spending cuts now and much more more painful cuts later.
However, Mr. Evans-Pritchard also tells us that “ultra-loose monetary is the only option for Europe, the US and Japan”. He suggests that in the US, M3 has fallen at a 10pc pace for much of this year, telling us that this was the “Great Depression rate” and so the economy hit the buffers with the “usual lag” along textbook Quantity Theory lines. The clear implication is that this needs to be reversed to get the US economy going again.
This analysis is nonsense. First off, there is no “usual lag” – Milton Friedman spoke spoke of “long and variable lags”, but most economists interpret this in the region of perhaps 12-24 months – so it is pushing it to blame very recent falls in M3 for the decline in the US economy. But in any case, the Fed discontinued publishing M3 statistics back in 2006 – one suspects, because they painted an embarrassingly expansionary picture about the true stance of US monetary policy in the bubble years.
Instead, we need to take a broader picture and look at how the monetary aggregates over a much longer period. If we do so – and lets look at the official statistics published by the St. Louis Fed on its Federal Reserve Economic Data site – we get a picture of seriously expanding monetary aggregates over a sustained period of time. Even if we look at the most recent year-on-year data we find:
- St. Louis adjusted monetary base up by about 15% (though having fallen in recent months a little to $2 trillion, itself up from about $800 billion before the crisis – a big expansion in my book!);
- M1 up about 5%;
- M2 up about 2%;
- MZM (the closest now to M3), down about 2 to 3%.
By contrast, in the early 1930s, US monetary aggregates fell by about a third.
And one should never look at monetary aggregates alone; we also need to look at real interest rates, and in this respect the difference between recent years and the early 1930s is again very pronounced. In recent years, real interest rates have been strongly negative – this of course has been a key problem, repeatedly fuelling boom-bust cycles; by contrast, in the US in the early 1930s, real interest rates were VERY highly positive, sometimes in double digits.
So the overall monetary policy stance in recent years is anything but contractionary, and there is no comparison to the 1930s.
Monetary expansion has merely created an inflation time bomb and fuelled repeated speculative cycles, the latest one being in the banking sector itself, by allowing the banks one last lending binge at negative real interest rates subsidised by the long-suffering taxpayer. Further monetary expansion would merely give the patient more of the poison that is already doing much to kill him.
Fortunately, there are solutions, but one has to think outside the washed up Keynesian macroeconomic toolbox. The reason the economy is doing so badly is because the banking system is still broken, and the economy will continue to do badly until the banking system is properly fixed. Some of us have been hammering on about this for years.
This is, I would suggest, also a matter of some urgency: the Bank of England’s latest Inflation Report suggests that CDS spreads on UK banks are rising very sharply, and are nearly as high now (200 basis points) as they were at the height of the crisis (almost 240 basis points, as opposed to a mere 10 basis points before the crisis hit). The storm clouds are gathering again for everyone to see, and no expansionist ‘solutions’ are going to help.
This article is an expanded version of the Second Chris R. Tame Memorial Lecture delivered by Professor Dowd at the National Liberal Club, London, March 17th 2009. A recording of the original Lecture, with an introduction by Dr Tim Evans, President of the Libertarian Alliance and CEO of The Cobden Centre, can be found here. The original paper is available here: please see that paper for appendices and endnotes.
Good evening everyone. I would like to start by thanking my friends at the Libertarian Alliance for inviting me to give this lecture. It’s good to see so many other friends here as well. I would like to thank you all for coming.
For those of us who were fortunate to know him, Chris Tame was an inspiring mentor and a loyal friend; he showed remarkable dignity and courage in the face of the illness that ultimately cost him his life, and his death was a massive loss. I owe him an immense personal debt myself, so it’s a very special honour to speak at his memorial lecture.
Chris was a central figure in the rebirth of Classical Liberalism in this country and it is very appropriate that we meet here in the National Liberal Club. But the Liberalism that Chris espoused was not the watered down ‘liberalism’ of the 20th Liberal Party—the liberalism of Lloyd George or Jeremy Thorpe—but the Classical Liberalism of an earlier age—the Liberalism of Gladstone, and earlier still, the Classical Liberalism of the great moral philosophers of the 18th century Enlightenment.
My topic this evening is the current financial crisis. My theme is that the Classical Liberal perspective can help us both to understand the crisis and to find a way of out it.
I always like to begin with a nice quote, and we are spoilt for choice when it comes to quotes about the financial crisis. Amongst those I can quote in mixed company, my favourite one is a comment by a Wall Street passer-by when asked his thoughts about the bank bailouts: “Its like not being invited to a party and then being given the bill for it”, he said.
This comment goes right to the heart of the matter—the widespread perception amongst the public that there is something wrong with the current financial system, i.e., that it lacks legitimacy. I agree with this view entirely: the current system does lack legitimacy and I am sure every right-thinking person would agree with me that it is manifestly indefensible.
Though correct, however, this perception is also dangerous, as it provides fodder for interventionists who argue that the current crisis is due to unconstrained market forces. Free markets have failed, they argue, so let’s have more state control instead.
Such arguments are mistaken in every respect. The current system involves limited competition within the constraints of a large variety of state-mandated parameters – a managed (or rather, mismanaged) economy, but not nothing like laissez-faire. And it is this ‘managed’ economy that has failed us all so badly.
The roots of this managed economy back a very long way:
- We had the establishment of the Bank of England in 1694 and the subsequent development of centralbanking.
- We had the establishment of the limited liability statutes in the 1850s, passed against bitter opposition by those who claimed—rightly—that they were a recipe for irresponsible risk-taking at other people’s expense.2 This might sound familiar.
- We had the stage-by-stage destruction of the commodity monetary standard. The pound, which was originally—and literally—‘as good as gold’, was replaced with the current inconvertible pound, which is intrinsically worthless. One consequence of this was the horrendous inflation of the 1970s and 1980s, not to mention the danger that inflation will return again if current monetary policies persist.
- We had the development and widespread adoption of Keynesian macroeconomics from the 1930s on. Keynesianism was discredited and then abandoned in this country in 1976, but the Keynesian legacy—in essence, the belief in a managed economy—still survives and poses a grave threat to our future.
- In the late 20th century, we had the establishment of state-mandated deposit insurance.
- And, over this same period, we had the growth of vast systems of financial regulation: these included the establishment of the Financial Services Authority and the growth of international bank capital adequacy regulation. Contrary to what one
- often hears, banking is not the epitome of laissez faire, but a heavily regulated industry.
My point here is each of these pillars of the current system—central banking, limited liability, inconvertible currency, the managed economy, deposit insurance and financial regulation—represents a major and profound state intervention into the economy, i.e., the opposite of a free market.
What I would like to do this evening is give my own view of the crisis as a Classical Liberal economist. Naturally, I can’t pretend to have all the answers, but I think there is a way out: we can put together a workable reform package. We then need to be confident in it and advocate it with all the powers of persuasion that we can muster. Above all, as Chris always maintained, we need to win the battle of ideas against those who would argue that we need even more of the interventionist medicine (or rather, poison) that has already caused so much damage—and threatens to do so much more.
The stakes haven’t this high since at least the 1930s.
Continue reading “Lessons from the financial crisis: a libertarian perspective”