Depression Mitigation

by Michael S. Rozeff
by Michael S. Rozeff

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The global economy is headed downwards. Falling stock markets, failing banks, and rising unemployment all attest to that fact. So far, some very large failures have occurred in the United States and in Europe. Can other regions be far behind? The signs of Great Depression II are not favorable. Already people are growing fearful and joking about primitive means of survival in the expectation that the vast industrial and trade system upon which we all depend will break down.

What can be done to prevent the worst outcomes and live through this adjustment with the least possible damage to our lives? This is the question that the best minds should be turning to. The answers require close examination, both in terms of a correct understanding of what is occurring and an historical understanding of similar past occurrences.

In the last Great Depression of the 1930s we saw a variety of reactions and State-led policies that failed to alleviate the economic declines, such as currency devaluations, international trade barriers, price controls, tax increases, money supply increases, and more. Are we destined to repeat the errors of the past, or will we (States) do better this time?

The general policy of increasing taxes to stem depression does not work. The center of economic activity in any economy is entrepreneurial activity in the private business sector. Taxes shift capital from that dynamic focal point to government where it mainly goes either to consumption or waste or below-par projects for which there is little or no demand. This has no permanent effect in creating employment. The Congress already passed a lump-sum rebate plan in the amount of approximately $160 billion that had, if anything at all, only the most minor and temporary effect on stemming the downturn. Since government spending remains high, that money is being made up in the form of other taxes and borrowing, thereby neutralizing any tax cut.

Furthermore, tax rates remain the same. Speaking of tax rates, the next President promises to be Obama, and his agenda includes very substantial tax increases. Implementing that agenda will surely drive the economy further downwards. We can expect stock markets to anticipate and reflect any tax increases proposed by Obama by going down further.

Any increased tax in any form makes matters worse. That is one general principle. The bailout bill now before Congress (whose title is EMERGENCY ECONOMIC STABILIZATION ACT OF 2008) is a giant tax increase. The American people are better judges of this than their Congress is. The bill is not only a wealth transfer, but a counterproductive wealth transfer. The private economy loses the ability and the right to place funds at the disposal of productive entrepreneurs. The Secretary of the Treasury, through his paid contractors and employees, disposes of $700 billion as he sees fit. Mainly he is authorized to buy up mortgage-related securities whose value is highly questionable. The funds pass into the hands of bankers who are not subject to capital market discipline and have little or no incentive to use these funds any more productively than they have in the past. They will still be under the restrictions and inducements of the Congress who wishes them to subsidize housing and construction. For the Congress has saved Fannie Mae and Freddie Mac and even raised the amounts that they can spend on mortgages in 2009.

Ordinarily, Americans would spend and invest the $700 billion on those items that bring them value and on investments with promising returns. Entrepreneurs would compete for a portion of this capital. But this huge tax increase cuts off this possibility. If entrepreneurs do not fund their projects, employment growth will stagnate and turn negative.

Over the past year or so, we have seen both the Federal Reserve and Congress hastily improvise measures that they thought would mitigate the oncoming depression. The Congress (using the Treasury) has taken over Fannie Mae and Freddie Mac (F & F). The Fed has loaned heavily to the insurer AIG and to many other banks, including foreign central banks. In essence, all of these measures are tax increases in one form or another.

The Congress intends to make good on the loan obligations and guarantees of F & F. If it borrows to do this, the borrowing will entail future taxes. F & F are not profitable enterprises. Their cash flows will not suffice to service their obligations to pay out money to creditors. U.S. tax payers will foot the bill. That is why these takeovers are hidden tax increases, and that policy, as explained above, will not mitigate depression. It makes it worse.

The Fed’s operations will end up creating another form of tax, namely, an inflation tax. The Fed has no significant policy tool other than money creation, and it is now vigorously employing that tool. That is a policy of money inflation which causes price inflation. This reduces the purchasing power of the dollar in the hands of the public, acting as a tax, while shifting new money once again to the banks. As with the bailout bill, this replaces the discipline of the capital market by the discretion of the Fed, which is really no discretion and control at all over the use of those funds.

This Fed policy, it should be emphasized, supports banks as lenders and financial intermediaries as opposed to companies obtaining finance directly from investors through their issues of commercial paper and bonds as well as venture capital and issues of stock. There is no reason at all to favor banks in allocating capital to business over the direct route of investors providing capital to industry and trade via capital markets. There is a role for both the capital markets directly to provide capital to business and banks to intermediate and provide capital to business. There is no reason to tilt the system strongly in favor of banks, which is what the Fed is doing when it bails out bank after bank. This can only harm recovery by draining funds away from capital markets.

The Congress and the Fed advertise that their actions will create liquidity and unlock markets in gridlock. This is completely false. The Fed cannot create liquidity by printing Federal Reserve notes, as this is not real capital. Neither can Congress create liquidity by taxing the public.

In addition, Bernanke spoke recently of the Fed or the government or the tax payers creating liquidity in markets for assets that have closed down or locked up as prices have tumbled drastically. Another case is the interbank loan market that is drying up.

Bernanke is not talking about simply hyping the money supply. That is not the liquidity being referred to. He's talking about the volume and depth of trading in an asset market.

Unfortunately, the Chairman's knowledge of finance is abysmal. There is no way that the government or the Fed can create liquidity or jump start liquidity in a market by injecting liquidity. This is a false medical analogy. The Fed would have to enter the market and become an active participant in it, a dealer with a bid-asked spread. And once it did that, it could not make a price higher than the market price or else the rest of the traders would dump enormous amounts of securities in the Fed's hands. The market would no longer even resemble a free market.

The financial concept that the Chairman is missing is that liquidity is endogenous to a market. It is not exogenous. Markets develop liquidity from within their own trading. It's not something that is imported from outside of the actual trading.

We should not accept the idea of an outside agent being able to "save" a market by injecting liquidity.

Congress and the Fed caused the problems that the economy faces and that have a focal point in the bad loans that many banks and other financial institutions now hold. They should not be taking any new measures as they have been doing and are now contemplating that add on new taxes designed to rescue and otherwise keep afloat these institutions. Tax increases harm economic activity without solving the problems. They only make matters worse.

There are ways to resolve the bad loan issue. One is to resolve the issues via the market for corporate control. This is already happening. As investors learn about the bad loans, they mark down the prices of the bank stocks and other stocks that have exposure to these loans. This entices outside capital to gain control over these institutions, partly or fully. What government (regulators) can do to hasten this process is encourage these institutions to open their books to public view and reveal their holdings of the toxic and tainted securities so that outside investors can know their worth better. The states and the regulators can repeal the existing rules relating to takeover, tender offers, proxy contests, foreign control, and ownership reporting, etc. under the Williams Act of 1968 and other similar statutes. The idea is to free up the market for corporate control so that it functions more effectively than now. Similarly, Sarbanes-Oxley should be repealed. There should not be statutory limits on executive pay. There are no doubt dozens of other regulations that can be lifted that will help the troubled banks be reorganized, for that is one of the major issues that needs to be addressed.

A second major way to resolve the problems is to attack them at their source. The nation should have monetary freedom. Much of what we are seeing stems from the structure of the banking industry with the central bank at its apex. Congress is moving in precisely the wrong direction to give the Fed even more power and influence. The Fed is the nation’s money monopolist. There is no economic justification whatsoever (much less a moral justification) for the Fed to have this power. It really means that the Congress and government have this power. It is a power they have seized, with Supreme Court approval. With this power and the law that makes their notes into legal tender, individuals and individual banks no longer can issue their own notes or other such money instruments that can compete to pass as currency in the hands of the public. Competition in the issuing of money instruments has not been entirely stifled, for we have seen the rise of credit cards and electronic transfers. But while there is some competition in the medium of exchange, there is no competition in the medium of account. It remains the dollar. Monetary freedom entails freedom for innovation and competition in the medium of account.

Entrepreneurs and existing companies of all kinds should be completely free to experiment with and innovate in new kinds of money instruments, based on a variety of media of account. This can occur, but only if Congress and the states lift the restrictions present on entry into the money and banking industries and remove their many and varied unnecessary regulatory encumbrances so that a parallel system or systems can arise. The existing banking system with its deposit insurance can go on for a while, as the FDIC works out some bank bankruptcies. But the investment activities of insured banks need to be regulated so as to prevent the moral hazard problems caused by deposit insurance. New forms of banking are likely to be so far superior to the old that they will survive and prosper even without deposit insurance, just as the money market funds have gained so greatly in popularity.

Congress should not increase insured bank deposit limits and should not insure money market funds. Raising the deposit limits is a straight subsidy to bank stockholders. Bank stocks in Ireland rose sharply when the government insured all deposits. Money market funds have been a notable private sector innovation. Bringing them under government insurance is a step in exactly the wrong direction. It makes future regulatory steps far more likely. The industry and investors will suffer.

There will be no Great Depression II if the people gain monetary freedom, for entrepreneurs can rapidly construct alternatives to the existing and failed money and banking system.

October 4, 2008

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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