The Frame of Mind of American Economic Policymakers, Part I

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 country.

“Individual 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.

“Unfortunately 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.

“This 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 mal distribution 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?

Milton Friedman: 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.

Milton Friedman: 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’.

Mankiw: 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:

Mankiw: 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.

Silvio 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 Farm – published in 1945 – which refuted most of his arguments for a “social state”.


Dr. Marc Faber
for The Daily Reckoning