Discipline is Needed for Real Economic Performance

There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”

During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.

Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)

The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.

Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.

Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.

Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)

Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.

The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.

Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.

Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!

Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.

In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.

But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.

In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.

Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!