The Frame of Mind of American Economic Policymakers

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I seldom become
depressed, but when I consider that prosperity is created by “peace,
easy taxes and a tolerable administration of justice” I really
think that the U.S. and other Western governments are doing their
very best to impoverish their countries.

A friend of
mine, Michael Berry, whose missives I always read, could not have
phrased this better than in “Importance of the Individual,”
a recent report in which he quotes Milton Friedman (whose views
I fully share in this particular instance) in an interview with
Phil Donohue.

According to
Berry, “On February 11, 1979 Milton Friedman took 2-1/2 minutes
to explain the critical importance of the individual and choice
in the free enterprise system to a doubting Phil Donohue. I wonder
what Dr. Friedman would say 30 years later about our current predicament
and the role government is assuming in our lives? The individual’s
freedom and ability to choose and take risks to create value are,
of course, all important life elements and a cornerstone of our

ability to choose and take risk is being suppressed. It is increasingly
evident that it is the government that is defining risk and the
taking of risk. The sanctity of Moral Hazard has now been repeatedly
breached by both recent administrations. We must guard these life
elements jealously. Please take time to ponder the Friedman interview.

in the current partisan atmosphere in Washington the role of the
individual and that of individual risk taking is being suppressed.
When the President of the United States uses the ‘Bully Pulpit’
to criticize institutions for not ‘playing ball’ (Chrysler
debt holders) and forces a CEO to resign (GM’s Wagoner), when
a Treasury Secretary and Chairman of the President’s Economic
Council team up to run an auto company (General Motors), and when
no institution is too large to fail (the other side of individual
risk taking) something is seriously amiss. Under the guise of saving
the economy, there is a not so stealthy encroachment on the rights
of the individual. No one is noticing.

is not, ‘Change We Can Believe In.’ It is ‘change
we must be wary of.’ Where is Milton Friedman when we really
need him? Think carefully about the following interview which was
conducted 30 years ago. Another read of Friedman’s Free
to Choose
is in order for all. We pray that Washington will
not stray too far.”

Phil Donohue:
When you see around the globe the maldistribution of wealth, the
desperate plight of millions of people in underdeveloped countries.
When you see so few haves and so many have-nots. When you see
the greed and the concentration of power. Did you ever have a
moment of doubt about capitalism? And whether greed is a good
idea to run on?

: Well first of all tell me, is there some society
you know that doesn’t run on greed? You think Russia doesn’t
run on greed? You think China doesn’t run on greed? What
is greed? Of course none of us are greedy. It’s only the
other fella that’s greedy. The world runs on individuals
pursuing their separate interests. The greatest achievements of
civilization have not come from government bureaus. Einstein didn’t
construct his theory under order from a bureaucrat. Henry Ford
didn’t revolutionize the automobile industry that way. In
the only cases in which the masses have escaped from the kind
of grinding poverty that you are talking about, the only cases
in recorded history are where they have had capitalism and largely
free trade. If you want to know where the masses are worst off,
it’s exactly in the kind of societies that depart from that.

So that the
record of history is absolutely crystal clear, there is no alternative
way, so far discovered, of improving the lot of the ordinary people
that can hold a candle to the productive activities that are unleashed
by a free enterprise system.

Phil Donohue:
Seems to reward not virtue as much as the ability to manipulate
the system.

: And what does reward virtue? You think the Communist
commissar rewards virtue? You think a Hitler rewards virtue? Do
you think… American presidents reward virtue? Do they choose
their appointees on the basis of the virtue of the people appointed
or on the basis of political clout? Is it really true that political
self-interest is nobler somehow than economic self-interest? You
know I think you are taking a lot of things for granted. And just
tell me where in the world you find these angels that are going
to organize society for us? Well, I don’t even trust you
to do that.

Well, for sure
you won’t find any angels at central banks around the world
and in the economics faculties of universities. I needed quite a
stiff drink after reading a Wall Street Journal article by Harvard
Professor Gregory Mankiw, who advocates creating negative real interest
rates through inflation and seems to have great sympathy for the
outright expropriation of savers. Professor Mankiw needs no introduction.
His great intellect was revealed on February 1, 2000, dead ahead
of the NASDAQ collapse, when he expressed the view in the Wall Street
Journal that “when you look at the mistakes of the 1920s and
1930s, they were clearly amateurish. It is hard to imagine that
happening again – we understand the business cycle much better.”

The mindset
of the US Federal Reserve and of a very large number of economists
is perfectly reflected in the views of Mankiw, according to whom,
“It May be Time for the Fed to Go Negative” (see Wall
Street Journal of April 19, 2009). For the ease of the reader
I have added some comments, which will be noted in italics and with
a “MF.”

With unemployment rising and the financial system in shambles,
it’s hard not to feel negative about the economy right now.
The answer to our problems, however, could well be more negativity.
But I’m not talking about attitude. I’m talking about
numbers [MF: He means negative interest rates]… What
is the best way for an economy to escape a recession? Until recently,
most economists relied on monetary policy. Recessions result from
an insufficient demand for goods and services – and so, the
thinking goes, our central bank can remedy this deficiency by
cutting interest rates. Lower interest rates encourage households
and businesses to borrow and spend. More spending means more demand
for goods and services, which leads to greater employment for
workers to meet that demand.

There is no
clear evidence that interest rate cuts stimulate lasting employment
gains, because “lower interest rates encourage households and
businesses to borrow and spend.” If an industry is plagued
by overcapacities (the oil and mining industry in the 1980s and
1990s), lower interest rates (interest rates fell throughout the
1980s and 1990s) are irrelevant. (The same applies for autos now.)
In addition, interest rate cuts that encourage households to borrow
and spend may not help employment in the country that implements
such policies (the US after 2001) but instead in another country
(China), where production costs are lower and where a large pool
of savings is available for capital spending. (Also, it is not consumption
that creates prosperity but capital formation.) To his credit, Mankiw
recognizes this problem. He writes:

The problem today, it seems, is that the Federal Reserve has done
just about as much interest rate cutting as it can. Its target
for the federal funds rate is about zero, so it has turned to
other tools, such as buying longer-term debt securities, to get
the economy going again. But the efficacy of those tools is uncertain,
and there are risks associated with them…

So why shouldn’t
the Fed just keep cutting interest rates? Why not lower the target
interest rate to, say, negative 3%? At that interest rate, you
could borrow and spend $100 and repay $97 next year. This opportunity
would surely generate more borrowing and aggregate demand.

The problem
with negative interest rates, however, is quickly apparent: nobody
would lend on those terms. Rather than giving your money to a
borrower who promises a negative return, it would be better to
stick the cash in your mattress. Because holding money promises
a return of exactly zero, lenders cannot offer less. Unless, that
is, we figure out a way to make holding money less attractive.

At one of
my recent Harvard seminars, a graduate student proposed a clever
scheme to do exactly that. Imagine that the Fed were to announce
that, a year from today, it would pick a digit from zero to 9
out of a hat. All currency with a serial number ending in that
digit would no longer be legal tender. Suddenly, the expected
return to holding currency would become negative 10%. That move
would free the Fed to cut interest rates below zero.

People would
be delighted to lend money at negative 3%, since losing 3% is
better than losing 10%. Of course, some people might decide that
at those rates, they would rather spend the money – for example,
by buying a new car. But because expanding aggregate demand is
precisely the goal of the interest rate cut, such an incentive
isn’t a flaw – it’s a benefit. [MF: I think
that most people would choose to invest in another country where
savings wouldn’t lose 3% per year.]

The idea
of making money earn a negative return is not entirely new. In
the late 19th century, the German economist Silvio Gesell argued
for a tax on holding money. He was concerned that during times
of financial stress, people hoard money rather than lend it. John
Maynard Keynes approvingly cited the idea of a carrying tax on
money. With banks now holding substantial excess reserves, Gesell’s
concern about cash hoarding suddenly seems very modern.

Gesell (1862–1930) was a rather obscure economist, but a cult
formed around his more outlandish socialist and land nationalization
ideas. He was the author of Die Reformation des Münzwesens
als Brücke zum Sozialen Staat (The Reformation of the
Monetary System as a Bridge to a Social State – read “socialism”).

In fact, I
had forgotten about him until Mankiw brought him up, but I remember
well how my history teacher in high school – who also had a
socialist tick, but was an outstanding historian – discussed
him at length in the context of socialism and land reforms through
expropriation. (Right throughout the course of history, this has
never worked. Also, Gesell’s tax on cash had more to do with
soaking the rich than stimulating consumption.)

In 1919, Gesell
was called to take part in the Bavarian Soviet Republic by Ernest
Niekisch. The Republic offered him a seat on the Socialisation Commission
and later appointed him as the People’s Representative for
Finances. Fortunately (for the world), his term of office lasted
only seven days. After the bloody end of the Soviet Republic, Gesell
was held in detention for several months and was later acquitted
of treason. Unfortunately, he never had the opportunity to read
George Orwell’s Animal
– published in 1945 – which refuted most
of his arguments for a “social state.”

Watch for
Part II tomorrow.

12, 2009

Marc Faber [send him
] lives in Chiangmai, Thailand and is the author of Tomorrow’s

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