Mark W. Hendrickson
Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision and Values at Grove City College, Grove City, Pennsylvania. These articles are republished from V & V, a website of the Center for Vision & Values. Editor's note: Some of these articles were written before the Presidential election.
Global stock markets have been plummeting. Where the bottom is, nobody knows. There will be gut-wrenching zigs and hopeful zags along the way; they will be of larger magnitude and -- in our digital age of instant response -- will occur with greater rapidity than ever before. Perhaps we are near the bottom. Remember, "the darkest hour precedes the dawn," although it will take somebody smarter than me (and future historians) to pinpoint when the bear market ends.
What are stock markets telling us? I think they are signifying that we are broke, that, collectively speaking, the United States of America is bankrupt. How can that be, when so many businesses are profitable and so many Americans are gainfully employed and making ends meet?
I think we are financially bankrupt in at least two ways. There is way too much leverage and way too much debt in the financial system. Leverage and debt are two-edged swords. When used in moderation, they can be constructive; when used to excess, they become destructive. Both the leverage created by financial institutions and debt (and here I include the implied debts of Uncle Sam's massive unfunded liabilities) have soared -- leverage into the hundreds of trillions and debt into the tens of trillions of dollars -- and the financial system is now tottering under the burden of that dead weight. Sooner or later this unsustainable mountain of leverage and debt will utterly collapse; whether that collapse is imminent or can be postponed, I know not.
Our real bankruptcy, though, is not financial, but political. George Washington once said, "government is like fire -- a handy servant but a dangerous master." Indeed, government (like debt and leverage) is useful when under control and dangerous when out of control. By trying to be all things to all people, Uncle Sam has led our nation into bankruptcy. But let's not place all the blame for our predicament on government and politicians. We are at fault, too. "We, the people" have repeatedly voted for those who have expanded government.
Today, we are living through a gigantic crisis. As you may have read before, the Chinese character for crisis is comprised of the characters that denote danger and opportunity. That is exactly what we face here -- great danger and great opportunity.
The danger is that we will demand more and more government programs to take care of us, even though it is Big Government that has bankrupted us. Bigger government was the policy of Hoover and Roosevelt during the Great Depression. As the economic factors of production (resources, labor, and capital) were diverted from the private sector to the public sector, the depleted private sector inevitably stagnated, producing a vicious cycle: the greater the private-sector stagnation, the greater the apparent need for more government intervention, and since government planning is inherently inefficient, the more sluggish the overall economy remained.
The opportunity we now have is to renounce the errors of our ways. We can forsake our debt addiction -- the bad habit of enjoying things today while paying for them later. We can relearn the lesson that capital is an economy's lifeblood, precious and limited in supply, and therefore that it is to be invested wisely in wealth-creating enterprises rather than used to just create more financial paper to generate commissions for financial gamesters.
Most importantly, we can reject the demoralized desire to get something for nothing through the political process. We have made a false idol out of government. Government doesn't create the wealth that raises standards of living; profit-seeking individuals and businesses do. To use a biological analogy, the private economy is the host, and the government a mere leech on that host. We need to understand that it is not within the power of government to create wealth sufficient to guarantee our retirements, to pay for our health care, or to give everyone a house or an income, because in trying to do so, government slowly bleeds the productive economy -- the private sector -- to death.
So which will it be? Will Americans seize the opportunity to return to free markets, and return to the ethos of self-responsibility and voluntary charity for those in need? Will we rediscover the value of thrift and deferring present gratification? Will we insist on sound money and renounce counterfeit paper "wealth" that is being vaporized before our eyes? Will we reject the seductive ethos of "something for nothing," reaffirm the sanctity of private property, and get government out of the destructive business of redistributing wealth? Or will we live dangerously, and beg Uncle Sam to do anything -- even nationalize everything -- as long as he takes care of us?
From what I can see, the American people want more government. Most of us prefer the devil we know -- Big Government -- to the great unknown -- free markets. How ironic and tragic that we would defeat socialism in the Cold War and then voluntarily put the chains of socialism on ourselves.
It saddens me when I see a member of my profession go over to "the dark side," that is, to politics. Politics replaces voluntary action with compulsion, private contract with coercion. Government intervention imposes distortions, inefficiencies, and extra costs on society. In essence, politics is "anti-economics" a nullification of economics, so for an economist to argue for more government control over private economic decisions and transactions, is anomalous, pathetic, and an abandonment of economic truth.
We see frequent examples of economists mutilating economic principles during an election year. The latest example is an article, "The Great Debate," by Alan Blinder, Princeton professor, former vice chairman of the Federal Reserve System, and adviser to Democratic politicians. In his article, Blinder uses misleading terminology, meaningless statistics, and common economic fallacies to hype Barack Obama's campaign for the presidency.
Blinder wastes no time in misleading his readers. In his opening paragraph, he writes, "McCain wants more tax cuts for the rich; Obama wants tax cuts for the poor . . ." Fact: McCain wants to retain the Bush tax rate cuts, not enlarge them. Like Democratic President John Kennedy and Republican President Ronald Reagan, McCain favors non-punitive marginal tax rates because they enhance economic growth and job creation. Fact: even with the Bush reductions in marginal tax rates, the tax rate on the rich is significantly higher than on the non-rich, and the rich's share of total income tax payments has increased. Fact: Obama can't give tax cuts to the poor, because the poor already pay zero federal income tax; what Obama proposes are tax credits, i.e., a negative income tax whereby the Treasury would mail checks to low-income Americans.
Blinder proceeds to assert that "the United States economy has grown faster, on average, under Democratic presidents than under Republicans" since 1948, then cites figures -- data which I do not dispute -- to "prove" his point. In doing so, he commits a historicist fallacy that my first-year economics students can see through. Just because two facts exist concurrently doesn't mean that there is a cause/effect relation between them. For example, ever since Alaska and Hawaii joined the Union in 1959 and 1960, respectively, the federal budget has rarely been balanced and national debt has exploded, but that surely doesn't mean that the solution for our country's fiscal woes is to expel those two states from the Union.
Policies, not parties, determine differences in economic performance. Kennedy's tax cuts gave a boost to the economy. That stimulus was blunted by Johnson's unsustainable "guns and butter" policies, which spawned an inflationary period that hobbled economic performance under Nixon, Ford, and Carter. Only when Reagan cut taxes and defended the dollar was prosperity established as a long-term trend again.
Blinder concedes: "presidents have limited leverage over the nation's economy." Indeed, economic conditions under a president are often largely predetermined by events that happen before a president is even elected. Blinder also concedes that Federal Reserve policy often has more impact on economic growth than do presidents. I would add that Congress, which has the constitutional power of the purse, has more control over fiscal policy than presidents do, and during many years when Republicans were in the White House, Democrats controlled Congress, which further erodes Blinder's partisan thesis.
Blinder's other main argument is that "when Democrats were in the White House, lower-income families experienced slightly faster income growth than higher-income families -- which means that incomes were equalizing," and that the opposite happens under Republican presidents. Again, no clear explanation of economic cause-and-effect ensues. Are presidential policies the cause of these statistics?
The two primary causes of poverty in America are not finishing high school and teenage girls becoming unwed mothers. How do presidents control those variables? Another nonpolitical factor in statistical income disparity is that the last few decades have seen marvelous technological breakthroughs and unprecedented growth in new businesses. The result? Huge numbers of new millionaires and more than a few billionaires. Average incomes inevitably are skewed toward the rich in such an era, regardless of which party holds the White House. And the good news is, if we look at absolute rather than relative levels of income, all quintiles are experiencing rising incomes.
It is Professor Blinder's right to shill for Obama if he so desires, but a more candid, economically credible pro-Obama argument would be: my candidate wants to redistribute wealth from rich to poor to reduce income inequality; he wants to increase all sorts of federal spending. If Congress enacts his program, the short-term effect will likely be a boost to economic growth. In the long run, though, such booms generally wear off, and overall growth will slow as it has wherever and whenever government has absorbed a larger share of a country's economic activity.
It is sad to see economic principles abused in such a tortured subservience to political expediency. In this election season, when an economist speaks, caveat lector -- let the reader beware.
Blaming the Free Market
It's finger-pointing time, folks. Whose fault is the ongoing financial crack-up that has hurt, angered, and frightened so many people? There is plenty of blame to go around, and the American people deserve to know the culprits. Simple justice, though, demands that the innocent not be condemned with the guilty. Already there is one innocent that has been unfairly maligned as a cause of the debacle -- the free market.
The current crisis began with a real-estate bubble that morphed into a financial house of cards. The real-estate bubble was generated by the expansionary credit policy of the Federal Reserve System. The Fed, having been created by Congress to act as Uncle Sam's banking agent, and the Fed's policies, are emphatically not free-market phenomena.
Neither are Fannie Mae and Freddie Mac. Congress gave Fannie and Freddie a privileged status that had these effects: first, enriching their top executives along with key congressional allies (time for some ethics hearings on Capitol Hill!); second, becoming the dominant player in what historically had been a private market for home mortgages; and third, sticking the American taxpayers with hundreds of billions of dollars of bad mortgage debt. Thanks, Uncle Sam.
That having been said, the Wall Street titans that have headlined the financial crisis this year (Bear Stearns, Lehman Brothers, AIG, etc.) were not created by government. However, the problems in the financial industry have resulted from a political failure, namely, improper regulation.
Liberals repeatedly accuse conservatives of being ideologically opposed to regulation. What nonsense! Neither "free markets" nor "deregulation" mean "no rules." On the contrary, they assume the rule of law. What they oppose is excessive, stifling, and costly overregulation. The Latin root of "regulation"-- regula -- means "rule" and also connotes regularity, that is, predictability and constancy as opposed to arbitrariness and privilege. No market can function without clear rules of the game, and no true defender of free markets is dogmatically "anti-regulation." That would be absurd.
The crisis today isn't due to an absence of regulation, but the presence of mistaken regulation. For example, the Clinton administration, invoking the Community Reinvestment Act, imposed new regulations that penalized lending institutions if they didn't lend "enough" money in low-income neighborhoods, regardless of the credit-worthiness of the borrowers. This regulatory regime undermined the traditional, market-based practice of risk-assessment that is the primary fiduciary duty of lending institutions. Regulators forced lenders to abandon financial prudence in subservience to a political goal, and then compounded the risk by allowing the proliferation of zero-down and no- or low-documentation mortgages. These regulatory blunders have come back to haunt us. They are responsible for the current wave of mortgage defaults and foreclosures, which in turn have torpedoed mortgage-backed securities and the many layers of financial derivatives based on them.
Another instance of regulatory failure occurred in 2005, when Republicans sought to diminish the risk of an eventual collapse of Fannie and Freddie by imposing stricter capital standards on them. That attempt was blocked on a party-line vote by Democrats.
What kind of rules does a market economy need to function well? In a society of free people, the primary rule is that one person's freedom ends when it intrudes on another person's rights. Thus, the right of free speech doesn't include the right to yell "Fire!" in a crowded theater. Similarly, we have a right to seek profit, but not if our actions would wreck the entire financial system and ruin others.
We need rules against dangerous excesses -- things like giant investment banks leveraging shaky debt instruments by a factor of over 30-to-1 or creating hundreds of trillions of dollars worth of financial derivatives. In 1998, the firm Long Term Capital Management (LTCM) shook the foundations of our financial system when its $1 trillion portfolio of derivatives started to implode. That was our warning that we needed rules to protect innocent people from the fallout of a financial nuclear explosion. Sadly, we didn't heed that warning. Firms far larger than LTCM have created over $100 trillion in derivatives, threatening the viability of our country's financial structure. Why was this permitted?
We face a financial cataclysm, not because of market failure, but due to political failure. Government interference with free markets, combined with government's failure to perform its primary function of protecting the people, has brought us to the brink. In the desperate attempt to postpone the day of reckoning, the only solutions being proposed are additional government interventions, even partial nationalizations, and less reliance on markets. When things continue to worsen, please, just don't blame "free markets." They no longer exist.
Thoughts on "the Big Bailout" [Written September 30]
The biggest bailout plan (so far?) will continue to be revised in an attempt to win approval of a congressional majority. The goal of the Emergency Economic Stabilization Act of 2008 is to put the brakes on the unwinding of the largest debt and leverage bubble in history in the hope of preventing a crash.
Nobody feels good about this extraordinary proposal. It is terribly expensive, it expands government power tremendously, it strikes many as being terribly unfair for rescuing fat cats, it is supported even by some who acknowledge that it may not work, and it is (at best) the lesser of two evils.
The partisan politics of the bailout negotiations have been fascinating. A majority of congressional Democrats favor the bailout, even though polls show most Americans dislike it. A majority of Republicans have resisted the bailout. This is a very high-risk strategy, because if the financial system collapses before Election Day, the public probably would take it out on the party currently in the White House, thereby guaranteeing a Democratic triumph in the November elections.
One particularly cynical aspect of the bailout negotiations was the Democrats' request for 20 percent of any profits that the Treasury might make on the eventual sale of assets that they would purchase under the plan; those profits would go to groups that serve as slush funds and lobbyists for Democratic special interests. The profits would go there instead of back to the Treasury. Republicans naturally balked at agreeing to fund the Democratic political machine as a condition of trying to rescue the country.
The heart of the plan is to allow the Treasury to purchase bad mortgages from various financial institutions -- financial instruments that nobody knows how to value, for which there are no market prices, and indeed, for which there is no market at all. Few financial experts, however, believe that the Treasury can save all the banks and other financial companies that are choking on these depreciated, possibly worthless, assets. Officially, there are 117 banks on the FDIC's "in trouble" list, but private estimates say it's more like 1400 banks. How will Treasury decide which firms to save? Will there be a merit system, or will it all boil down to who has the best personal connections and most influential lobbyists?
Economics teaches us that policies have costs as well as benefits. While preventing the financial system from collapsing is something that most of us would prefer, the bailout plan will interfere with markets from correctly pricing assets that are currently mispriced. That is, in an effort to prop up floundering financial institutions, the Treasury interventions are designed to keep housing prices from falling. But housing prices got way out of balance in recent years, stretching beyond the affordability of many Americans. The negative side of falling housing prices is a lot of pain to homeowners, particularly those who would end up with negative equity, as well as the financial institutions holding mortgages and mortgage-backed securities (MBSs). That is a huge negative, because the MBSs are spread throughout the global financial system, which is tottering as falling housing prices erode the foundation of the huge financial house of cards resting on them. But if the market prevails, with all its merciless short-term pain, the outcome will be more affordable housing prices -- a boon to younger Americans just entering the workforce.
The original wording of Treasury Secretary Paulson's proposal included a provision that would make his office's decisions unreviewable and irreversible. At this moment, I don't know if that language remains intact. It probably doesn't, but just the fact that someone would dare to propose that an unelected official and his team would have sole discretion over the use of $700 billion of taxpayer monies is incredible. It would utterly banish the "checks and balances" principle of our representative system of government. I rarely agree with Speaker of the House Nancy Pelosi, but when she told, "60 Minutes" that the proposal asked for "czar-like powers," she was spot on.
What, exactly, should Uncle Sam do? I am asked that question frequently these days. The short answer is "I don't know." Neither does anyone else. I'm not sure that King Solomon, with all his legendary wisdom, could solve this problem. The policy-makers certainly will try to preserve the existing system, even though the system is full of financial rot, such as excessive debt and leverage. On the other hand, the market -- that is, all of us as buyers and sellers -- will ultimately assert itself, correct the excesses, the price assets rationally, as surely as water finds its way to the sea. All this economist can do is sit back and watch this extraordinary drama unfold.
A Bailout for Detroit
It was bound to happen. In this "Year of the bailout," why shouldn't Detroit get into the act? The financial community has maintained a death-watch over GM and Ford for months as they hemorrhage floods of red ink. Bankruptcy is viewed more as a matter of "when," not "if."
On August 5, John Dingell, the powerful Michigan congressman whose district lies in the heart of "Big Three" country, acted. Dingell has proposed a government "loan" of $25 billion to the Big Three, ostensibly to speed up the transition to manufacturing alternative-fuel cars.
Question: If it's just a lack of capital that is preventing the Big Three from making the transition to a profitable future, then why aren't private, profit-seeking lenders issuing loans to them? For that matter, since the stock prices of GM and Ford are so depressed that the two companies combined are priced at less than $17 billion, then why doesn't some deep-pocket value investor like Warren Buffett just buy them?
The reason nobody in the private sector wants to invest in GM or Ford, or to buy privately owned Chrysler, is that their business models aren't viable. Their cost structure -- particularly their cost of labor -- is prohibitively expensive. The consensus is that, regardless of what kind of fuel their cars use, the Big Three simply can't compete with lower-cost producers. Cars can be profitably made in the United States with labor compensation packages in the $40-$50/hour range (Honda, Toyota, and Nissan have demonstrated that) but not when labor legacy costs and compensation packages total over $70 per hour, as they do at GM.
The Big Three have been surviving by selling off assets and shrinking their operations. What they clearly must do to avoid shrinking to nothing is to reduce their labor costs. And if GM and Ford continue to operate at a loss, how would they ever repay the government's "loan?" Answer: They wouldn't; thus, what Dingell calls a "loan" is a euphemism for a bailout.
This bailout is economically destructive. Without the companies correcting their fundamental problem of too-high labor costs, giving them more money would amount to throwing good money after bad. It also ignores the basic economic truth that the bigger a money-losing company is, the better it is for society if it shuts down. That may seem counterintuitive, so let's think it through:
When a corporation suffers chronic losses, it means that society's limited supply of factors of production are being used uneconomically -- that, on a net basis, the company is extinguishing wealth. The larger the company, the more assets are being employed uneconomically. The sooner the unprofitable company folds, the sooner its assets can be reallocated to economic production that earns a positive return -- that is, that generates rather than destroys wealth for society. In the case of a potential GM liquidation, its erstwhile employees and manufacturing plants might even be used for making cars, but at lower salaries and wages.
There are ethical problems with a Detroit bailout, too. To subsidize the Big Three under any circumstances is bad enough. Why should Congress rescue these particular businesses when Congress allows thousands of other businesses to fold all the time? It is manifestly unfair to transfer wealth from millions of Americans who earn far less than their blue-collar and white-collar counterparts to those higher-paid workers.
Despite the economic and ethical problems with a Big Three bailout, politically there is an excellent chance that it will happen. Given the immense financial clout of the unions, any political leader who opposed such a bailout would be pilloried as an enemy of America's workers. That, of course, would be a misrepresentation. A bailout of the Big Three would do nothing for most American workers, but would help only a minority of workers -- the elite, the aristocrats, of the American blue-collar workers, who make far more than most of their fellow workers.
If the Big Three receive a bailout, it will be due to the immense power of unions. For decades, the unions have extracted premium wage packages from their fellow Americans through unnecessarily high-priced autos. Now that it appears they have finally killed the goose that laid their golden egg (i.e., the domestic car companies), unions like the UAW will continue to siphon money from fellow Americans and fellow workers into their own bank accounts. The only difference is that the government, rather than Ford and GM, will collect the money for them.
A Big Three bailout would be a travesty. It would be another sad instance of special-interest politics trumping economic rationality in America. And guess who is going to pay the bill? *
"The ultimate result of shielding men from the effects of folly is to fill the world with fools." --Herbert Spencer