Wednesday, March 10, 2010

A Time for Crybabies

The headlines of the day: “European Leaders Call for Crackdown on Derivatives” ( and “Call for Action on Speculation Rules” (

Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”

This is the time for cry-babies and the leaders of many nations in the world are not letting us down.

Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”

This, however, is getting “cause and effect” turned around!

My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”

The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”

The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.

And, what resulted from this policy bias?

Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.

In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.

In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.

The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.

In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.

All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!

And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.

Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.

Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…

One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.

A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.

We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.

Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”:

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