THE BEAR'S LAIR A government failure, not the market's
By Martin Hutchinson
As commentators have come to realize the depth of the economic mess in which
the United States is now mired, an increasingly loud theme of their wailings is
that the free market has failed, so that we need more government regulation and
state control.
One expects the Democratic presidential candidates to take this view (though
Barack Obama is mercifully mild on the subject) but we hear it also from John
McCain, nominally a Republican. The truth is quite the opposite: the free
market has not failed. In the US over the past few decades it was never
properly tried. Time after time, bedrock principles of a free market economy
have been
violated by the corrupt and overblown US government.
The most fundamental way in which free market principles have been violated,
central to the entire course of the US economy over the past 13 years, is
monetary policy. Economic theory is based on money, the unit of measurement,
being fixed in value so that its fluctuations do not affect purchase and sale
decisions. It is well known that in the Weimar Republic hyperinflation of 1923
or the Latin American periodic hyperinflations, the economic system did not
work properly because price signals were not properly transmitted through the
monetary mechanism and consumers were forced to modify their behavior to take
account of the quirks in money.
The average apartment-dwelling German consumer of 1923 did not intrinsically
need a wheelbarrow, but was forced to buy one anyway to carry his money if he
wanted to go shopping, since Diners Club had not yet invented the credit card.
In the United States since 1995, the Federal Reserve has increased the broad
money supply - whether measured by M3, disgracefully discontinued by the Fed in
March 2006, or by the St Louis Fed's Money of Zero Maturity (MZM)- almost 4%
per annum faster than the growth rate of nominal GDP.
The true potential increase in money-generated activity may well have been
somewhat greater than that because new and more efficient payment mechanisms,
PayPal and the like, have been introduced during that 13-year period. Thus one
would expect the velocity of money, its ability to generate economic activity,
to have increased. This money supply increase was wholly artificial, generated
by actions of government, notably former Fed chairman Alan Greenspan's bizarre
1993 decision to cease targeting the money supply in forming monetary policy.
It had nothing whatever to do with the market.
Wall Street, the Fed and the Bill Clinton and George W Bush administrations
would claim that, since inflation has been modest during the period, the
market's price mechanism has not been distorted and no harm has been done. But
that is of course unmitigated twaddle.
Because of global outsourcing through the Internet and modern telecoms,
consumer prices have not risen much (though they have gained more than is
admitted by the Bureau of Labor Statistics, more on which later) but we have
been subjected to a series of asset bubbles. First, stocks soared in the late
1990s to levels entirely unjustifiable on any reasonable valuation mechanism,
with even the Dow Jones Index of 2000 being more than double its proper level.
That had happened previously in history, in 1929 in the United States (though
1929's overvaluation was less egregious) and in 1989-90 in Japan; in both cases
it resulted in a severe economic downturn, the one unprecedented in its depth,
the other unprecedented in its duration.
In the US after 2000, the solution was to expand the money supply still
further, overriding the market's natural deflationary corrective mechanisms by
forcing real interest rates down to well below zero. That, allied to the
"creativity" of the housing finance sector produced a boom in housing that was
unprecedented in the United States. When that in turn led to disaster, the Fed
over-expanded money supply yet again, and produced a commodity bubble that has
pushed the oil price up by 50% in eight months and is now threatening the
entire fabric of the world economy as well as potentially starving millions of
the Third World's impoverished people. While the poor may starve, the rich,
either asset owners or, as on Wall Street and in corporate top management,
asset manipulators, have done very well indeed from cheap money, much better
than they should have done in a truly free market.
Policy begets excess
These three highly damaging excesses, the stock bubble, the housing bubble and
the commodities bubble, all utilized the mechanisms of the free market, but
their underlying cause was a government policy: the Fed's excessive monetary
expansion over 13 years. Since Jean-Claude Trichet took over the European
Central Bank from Wim Duisenberg in late 2003, the ECB has joined in excessive
expansionism, pushing euro M3 up by 8.3% annually compared with a 4.3% annual
rise in nominal eurozone gross domestic product, the same 4% annual excess of
monetary expansion as in the United States.
The Bank of Japan, the People's Bank of China and the Reserve Bank of India
have also pursued excessively expansionary monetary policies. International
reserves of foreign exchange increased by almost 17% per annum in the decade to
December 2007, almost treble the increase in nominal global GDP. The current
global inflation was thus inevitable; it is likely to get substantially worse.
The excesses of the housing bubble and the especially damaging nature of the
subsequent housing finance collapse were also due to government, in this case
misguided regulation.
Fannie Mae and Freddie Mac, those tottering behemoths of the housing finance
market, should not exist in a free market system. Their superfluous
quasi-government guarantees of housing finance led to the advent of
securitization, a pernicious Wall Street product that separated the origination
of home loans from their ownership.
The interest rate ceilings of the 1970s, followed by the partial cack-handed
deregulation of the sector in the 1980s, led to the collapse of the savings and
loans, destroying the local system of housing finance that has worked well in
other countries and worked perfectly adequately in the US before the 1970s.
However it was bank capital regulations, and the loophole that allowed banks to
create minimally capitalized special purpose vehicles to hold securitized home
mortgages that produced the subprime bonanza and subsequent collapse. Again,
all were actions of government, to which the free market simply reacted.
As an indication that the innovations in housing finance were not driven by a
true free market, the cost of home loans increased from an average of 108 basis
points above 20-year mortgages in 1972-78 to 122 points above that average in
2000-06. If an innovation increases the price of a product to the consumer, we
can be certain that the innovation, like the automobile fuel economy standards
of the 1980s, was directed by government, not the market.
To operate properly, the modern free market needs accurate economic statistics.
Before 1900, the economy operated satisfactorily without such statistics,
though swings in the business cycle were more extreme since planning for
inventory and capital expenditure was more difficult. Lack of statistics thus
has a cost, but only a moderate one.
Bad statistics carry a cost
Much larger than the cost of no statistics, however, is the cost of inaccurate
statistics that are nevertheless regarded by the market as credible. Those can
produce distortions lasting many years, including excessive consumption and
excessive asset price inflation. The short-term effect of dishonest statistics
may be positive, like that of embezzlement (which increases GDP through the
multiplier effect until the victim discovers his loss). However the long-term
effect in destruction of both value and confidence is far greater and more
prolonged; indeed in some respects it may be permanent.
We can thus blame the government for significant economic distortion over the
past decade, through its falsification of inflation figures. The Boskin
Commission of 1996 allowed the government to "adjust" inflation figures by
taking account of "hedonic" effects, by which, supposedly, products improved in
quality in ways not captured by inflation calculations. The example always
given was the tech sector, in which processing power doubled every 18 months.
Thus following Boskin, US price indices were adjusted to take account of that
doubling, being rebased every year in order to take account of each subsequent
year's progress in processor power.
There are three problems with this. First, doubling processor power does not
anything like double the benefit one gets from a computer; the computers of
today are at most twice as "hedonic" as those of 1998, not 64 times as hedonic
as predicted by their increase in processing power. Second, the annual
rebalancing allows the price benefits in the tech sector to be repeated every
year, as though computers were now available for $5. Third, the Boskin
methodology took no account of the costs imposed on consumers through
technology, for example the negative hedonic effect of automated telephone help
lines, which appear deliberately designed to maximize the time wasted and
minimize the probability of getting the consumer's problem solved.
(As
an aside, US taxpayers and the economy generally
dodged a bullet when the presidential candidacy of
former New York mayor Rudy Giuliani collapsed. Not
only was his chief foreign policy advisor, Norman
Podhoretz, author of World War IV – the long
global struggle against Islamofascism - think for a
moment of the budgetary effect of that approach to security policy - but his
chief economic advisor was Michael Boskin. Phew!)
The Boskinized price indices are thus downward biased, probably by about
0.8%-1% per annum, thus saving the government trillions of dollars on social
security payments for the unfortunate elderly. As well as ripping off old folk,
this has caused a number of distortions.
Since nominal GDP is known, real GDP growth rates are distorted upwards by the
same amount as price indices are distorted downwards. Likewise, productivity
growth figures are also distorted upwards; the "productivity miracle" relied
upon by Fed chairman Alan Greenspan for his misguided monetary policy was a
mere statistical fiction. With such distortion, it is little wonder that the
voting public has come to suspect published economic growth figures or to
assume that even more of such growth has gone to "the rich" than is actually
the case.
The price index distortion has since January 2008 grown even worse, through the
use (or more probably misuse) of seasonal adjustments, by which "unadjusted"
price indices are smoothed for seasonal effects, providing a supposedly more
accurate picture of consumer price inflation. Such seasonal adjustments are
ignored in setting social security and bond indexation. There is thus no
further cash fraud against the public. However adjustments have been used to
produce spuriously low consumer price inflation figures, certainly in March and
April 2008, thus propping up the stock market and appearing to justify the Fed
in its manic loosening of monetary policy.
March's consumer price index was adjusted down by 0.6%, from 0.9% to 0.3%,
while April’s was adjusted down by 0.4%, from 0.6% to 0.2% - both "adjusted"
figures were greeted by the stock market with a sharp upward move. In the 10
years to 2007, no seasonal adjustment has ever exceeded 0.3%, plus or minus;
the probabilities that the March and April seasonal adjustments were randomly
arrived at by the same method as those of the last decade were thus 0.18% and
2.3% respectively (so the probability of two such anomalies in successive
months was 0.0041%, about 1 in 25,000.)
If the raw March and April figures are adjusted by the average March and April
seasonal adjustments of the last decade, consumer price inflation in those two
months averaged 7.4% per annum. Needless to say, neither the bond market, where
10-year Treasuries yield 3.9%, nor the stock market, within 10% of its
overblown all-time high, comes close to reflecting this. Again, the losses and
poor investment decisions caused by this massively false market are due to the
government, not market failure.
The list goes on
There are many other "market failures" which are in reality due to government
manipulation. Real wage rates for low-skill US employees have dropped sharply
in the last 30 years, primarily due not to globalization and free trade but to
government's failure to enforce immigration laws, which has led to excessive
low-cost illegal immigrant wage competition.
The shortage of graduate engineers is due to the H1B visa program, which lets
in floods of engineers but not lawyers, so the average earnings of a young
graduate lawyer are more than twice those of an equivalently qualified young
graduate engineer. Distortions in agriculture policy are notoriously the result
of government meddling, reportedly about to get worse with the new $300 billion
farm bill. (It is however not true that all of the world’s high food prices are
caused by US ethanol subsidies. An even more important cause is excessively lax
US and global monetary policy.
The number of lobbyists in Washington has more than doubled since 2000, so
consequently has the level of wasteful earmarks and destructive special
interest legislation. McCain's "cap and trade" environment proposal would open
up a huge new arena for government favor-shopping and do almost nothing to
reduce carbon emissions, even were such a reduction desirable (Obama's proposal
is somewhat more market-oriented.)
Don't let anybody tell you in this election season that the "market has
failed". In the United States since about 1995, it has never been allowed to
operate properly.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
