Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
Showing posts with label government policy. Show all posts
Showing posts with label government policy. Show all posts
Wednesday, January 28, 2009
Tuesday, December 2, 2008
Trying to Understand the Recession
It is official now…the United States has been in recession since December 2007! Right now the current recession is the third longest recession since World War II and most economists believe that this recession will at least tie the other two recessions in terms of duration…a period of 16 months.
Among the major factors behind such a belief is that housing prices are still declining, housing sales are still falling, layoffs have just started to takeoff and financial institutions are still reluctant to lend…even if people and companies are willing to borrow. Some feel that the real recession is just starting to hit.
Growth-wise, real GDP rose, year-over-year, at a 0.7% rate in the third quarter of 2008, down from 2.8% in the third quarter of 2007 and 2.3% in the fourth quarter of that year. Real GDP declined in the third quarter of 2008 from the second quarter of 2008 and is expected to decline once again going from the third quarter to the fourth quarter.
The extent of this recession has even got some people talking about deflation!
Now that is something! It is something because the year-over-year rate of change in the Implicit Price Deflator of GPD, although it drops when there is a recession, has only become negative once since World War II and that was in the 1948-49 recession. (See chart from the Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=GNPDEF&s[1][transformation]=pc1.) Over the past seven quarters the Implicit GDP Price Deflator has averaged a 2.5% year-over-year rate of increase and increased by 2.6% in the third quarter of 2008 over the third quarter of 2007.
It is important to talk about what is happening to prices at the same time one is talking about what is happening to economic activity because that gives us a clue as to what factors are dominating economic activity. If both prices and output move in the same direction then one can say that demand factors are dominating the market. If prices and output move in opposite directions then one can say that supply factors are dominating the market. To understand what is happening in the economy, one must get some feel for which side of a market is dominating.
As the rate of growth of the economy has dropped from the rate of expansion that took place in the four quarters ending in the third quarter of 2007 (2.8%) to the four quarters ending in the third quarter of 2008 (0.7%), the rate of inflation for the same periods remained roughly constant or has declined modestly. To get such a result the drop in the demand for goods and services would have had to been roughly matched by the decline in the supply of goods and services over this time period. That is, neither side of the market strongly dominated the behavior of the economy over the past year or so.
As I have written in several posts over the past year, supply factors seem to be just as important as, or even more important than, demand factors in the current slowdown. That is, an adjustment is taking place on the supply side of the economy that must be reckoned with if we are to fully understand what is going on in the economy and respond to the situation as effectively as possible.
A possible reason for the shift in supply is that transitions are taking place in the economy or need to take place in the economy and this is impacting cost structures and organizational patterns in a way that is altering how people do business. For example, the increase in the cost of oil during the 2007-2008 period may have caused the transportation and energy industries to begin adjusting to a new world of alternative products and services that rely less on fossil-based resources. The subsequent reduction in the cost of a barrel of oil may have little impact on decisions because of the ‘price shock’ that people absorbed through the summer of 2008. The problems in the automotive industry are just one consequence of this. And, we are seeing a lot more adjustments coming in different segments of the transportation area that are not getting such a high profile. Also, new efforts to build ‘green’ industries may result from this.
Another transition is occurring in the financial industry where thousands of people are being laid off due to the downsizing that has resulted from the collapse of the financial markets. Financial institutions, I believe, are going to go through a substantial restructuring that will be based on information technology. In the past thirty years, the financial industry has shown how it can use the computer to design financial products. Now, along with the call to restructure the regulation of financial institutions, the financial industry is going to have to use the emerging information technology to control risk and enhance the openness and transparency of the industry. In moving in this direction the financial industry will become a real leader in the creation of information markets on which the rest of the economy will model itself.
Information technology continues to transform itself and in so doing will continue to create opportunities for other industries to transform themselves. The spread of information is going to accelerate with search being an integral part of this expansion along with greater and greater connectivity between users throughout the world. Computer networks will more and more become decentralized rather than centralized.
Another area where substantial transitions are taking place is in the area of State and Local governments. The model that has been used in this arena developed after World War II and is in need of a vast overhaul. In all likelihood, the current financial difficulties are going to result in these governments modernizing their function and structure while at the same time they help rebuild the infrastructure.
These are just a few of the major transitions that are taking place in the economy right now and that predominantly affect the supply side of the economy rather than the demand side. In all the efforts to “get the economy going again” we must not restrict or prevent these changes. That is, the government programs that are designed to stimulate the economy must not “lock us into” the old way of doing things. A bailout of the auto industry that keeps things “as they are” will not be helpful in the longer run.
It could be that the economy of the United States, and the world, is now going through a major restructuring, a restructuring that seems to occur every 60-80 years or so. In a sense, we are going from one age into another. One could say that the United States went through another major restructuring in the 1930s when the country was transitioning from an economy based predominantly upon agriculture to one that was based predominantly upon manufacturing. Maybe this is the time of transition from manufacturing to (you insert your term for it). Maybe the world of the ‘manufacturer’, and all that supports it, has significantly passed its peak and government props can no longer sustain it.
Two things can be drawn from this. First, government programs that just rely on stimulating demand will not prove to be very effective. The transitions must take place. They will take place relatively rapidly or they will take place at a much slower pace if the government supports the status quo. We…the government…must be careful here.
Let me state this again…the adjustments are going to take place…whether or not the government slows them down!
Second, these areas of transition are going to create major new opportunities for investment to those that are lucky enough…or wise enough…to choose the right companies. Referring to the 1930s once again, one can reference many investments that provided exceptional returns to those that sought them out and committed to them during the period in which the economy was adjusting to the brave new world that was coming. It is my belief that there will be numerous such opportunities available to us in the near future.
Among the major factors behind such a belief is that housing prices are still declining, housing sales are still falling, layoffs have just started to takeoff and financial institutions are still reluctant to lend…even if people and companies are willing to borrow. Some feel that the real recession is just starting to hit.
Growth-wise, real GDP rose, year-over-year, at a 0.7% rate in the third quarter of 2008, down from 2.8% in the third quarter of 2007 and 2.3% in the fourth quarter of that year. Real GDP declined in the third quarter of 2008 from the second quarter of 2008 and is expected to decline once again going from the third quarter to the fourth quarter.
The extent of this recession has even got some people talking about deflation!
Now that is something! It is something because the year-over-year rate of change in the Implicit Price Deflator of GPD, although it drops when there is a recession, has only become negative once since World War II and that was in the 1948-49 recession. (See chart from the Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=GNPDEF&s[1][transformation]=pc1.) Over the past seven quarters the Implicit GDP Price Deflator has averaged a 2.5% year-over-year rate of increase and increased by 2.6% in the third quarter of 2008 over the third quarter of 2007.
It is important to talk about what is happening to prices at the same time one is talking about what is happening to economic activity because that gives us a clue as to what factors are dominating economic activity. If both prices and output move in the same direction then one can say that demand factors are dominating the market. If prices and output move in opposite directions then one can say that supply factors are dominating the market. To understand what is happening in the economy, one must get some feel for which side of a market is dominating.
As the rate of growth of the economy has dropped from the rate of expansion that took place in the four quarters ending in the third quarter of 2007 (2.8%) to the four quarters ending in the third quarter of 2008 (0.7%), the rate of inflation for the same periods remained roughly constant or has declined modestly. To get such a result the drop in the demand for goods and services would have had to been roughly matched by the decline in the supply of goods and services over this time period. That is, neither side of the market strongly dominated the behavior of the economy over the past year or so.
As I have written in several posts over the past year, supply factors seem to be just as important as, or even more important than, demand factors in the current slowdown. That is, an adjustment is taking place on the supply side of the economy that must be reckoned with if we are to fully understand what is going on in the economy and respond to the situation as effectively as possible.
A possible reason for the shift in supply is that transitions are taking place in the economy or need to take place in the economy and this is impacting cost structures and organizational patterns in a way that is altering how people do business. For example, the increase in the cost of oil during the 2007-2008 period may have caused the transportation and energy industries to begin adjusting to a new world of alternative products and services that rely less on fossil-based resources. The subsequent reduction in the cost of a barrel of oil may have little impact on decisions because of the ‘price shock’ that people absorbed through the summer of 2008. The problems in the automotive industry are just one consequence of this. And, we are seeing a lot more adjustments coming in different segments of the transportation area that are not getting such a high profile. Also, new efforts to build ‘green’ industries may result from this.
Another transition is occurring in the financial industry where thousands of people are being laid off due to the downsizing that has resulted from the collapse of the financial markets. Financial institutions, I believe, are going to go through a substantial restructuring that will be based on information technology. In the past thirty years, the financial industry has shown how it can use the computer to design financial products. Now, along with the call to restructure the regulation of financial institutions, the financial industry is going to have to use the emerging information technology to control risk and enhance the openness and transparency of the industry. In moving in this direction the financial industry will become a real leader in the creation of information markets on which the rest of the economy will model itself.
Information technology continues to transform itself and in so doing will continue to create opportunities for other industries to transform themselves. The spread of information is going to accelerate with search being an integral part of this expansion along with greater and greater connectivity between users throughout the world. Computer networks will more and more become decentralized rather than centralized.
Another area where substantial transitions are taking place is in the area of State and Local governments. The model that has been used in this arena developed after World War II and is in need of a vast overhaul. In all likelihood, the current financial difficulties are going to result in these governments modernizing their function and structure while at the same time they help rebuild the infrastructure.
These are just a few of the major transitions that are taking place in the economy right now and that predominantly affect the supply side of the economy rather than the demand side. In all the efforts to “get the economy going again” we must not restrict or prevent these changes. That is, the government programs that are designed to stimulate the economy must not “lock us into” the old way of doing things. A bailout of the auto industry that keeps things “as they are” will not be helpful in the longer run.
It could be that the economy of the United States, and the world, is now going through a major restructuring, a restructuring that seems to occur every 60-80 years or so. In a sense, we are going from one age into another. One could say that the United States went through another major restructuring in the 1930s when the country was transitioning from an economy based predominantly upon agriculture to one that was based predominantly upon manufacturing. Maybe this is the time of transition from manufacturing to (you insert your term for it). Maybe the world of the ‘manufacturer’, and all that supports it, has significantly passed its peak and government props can no longer sustain it.
Two things can be drawn from this. First, government programs that just rely on stimulating demand will not prove to be very effective. The transitions must take place. They will take place relatively rapidly or they will take place at a much slower pace if the government supports the status quo. We…the government…must be careful here.
Let me state this again…the adjustments are going to take place…whether or not the government slows them down!
Second, these areas of transition are going to create major new opportunities for investment to those that are lucky enough…or wise enough…to choose the right companies. Referring to the 1930s once again, one can reference many investments that provided exceptional returns to those that sought them out and committed to them during the period in which the economy was adjusting to the brave new world that was coming. It is my belief that there will be numerous such opportunities available to us in the near future.
Monday, June 16, 2008
"Rubinomics"--Two
The concept of “Rubinomics” seems to generate some rather emotional responses…for and against the basic ideas…for and against Robert Rubin. Therefore, I felt the need to follow up my earlier post (June 13, 2008) on “Rubinomics” with this post, ““Rubinomics”—two’.
First, it is perhaps destructive of a idea to tie it so closely to an individual. “Rubinomics” and Robert Rubin seem to draw a visceral response much as did “Keynesian” and John Maynard Keynes. Milton Friedman was lucky enough not to get his name tied to the prominent idea which he promoted, “Monetarism”…which did allow for the creation of an opposition title…proponents were not called “Keynesians” but “Fiscalists”.
Calling something by a person’s name can be used to draw together those opposed to the person and his/her ideas and as a term of derision. It can also be used to rally those that pursue similar ends. Oftentimes the use of such titles direct attention away from the real issues at hand and the policies being proposed. Name-calling can be helpful…and it can be destructive. In order for any productive discussion to take place, however, focus must be returned to the real issues at hand.
Second, ideas must be placed within their historical context. In the case of “Rubinomics”, we have to go back to the Paris Peace Talks following World War I. To create the economic situation at that time is very simple terms I will argue that there were two major conditions at hand. The allies were very divided in terms of what they wanted to achieve…there were as many programs for the “new world order” as there were major nations involved in the discussions. In addition, the Russian Revolution had just taken place and there was great fear among the discussant nations that the threat to the future was labor unrest and the Bolsheviks, the proposed new order for the revolutionary world.
This was the world that John Maynard Keynes was involved in and his goal was to create a model of the world in which labor unrest could be avoided as much as possible so that the wave of revolution did not overcome the Western world as he knew it. The fundamentals of his model were fixed exchange rates between countries so that each nation could pursue its own independent economic policy and a government program to stimulate a national economy so as to avoid severe economic collapse and maintain high rates of employment.
As is well known, Keynes worked over the next twenty years or so to develop a theoretical model to support his perception of the world and to bring politicians and institutions to incorporate his ideas for low employment and peace. He then continued to work throughout World War II to create the international financial system that would actually implement his ideas.
So, for roughly fifty-five years efforts were made to try and create a world of fixed foreign exchange rates and the institutions and rules that could maintain such a system so that countries could operate their fiscal and monetary policies in a relatively independent manner. As history has shown, this system proved to be unworkable in the long run…because even in such a regime, nations cannot operate fully independently of one another. The post-World War II period was dotted with inflations and devaluations that periodically disrupted the system. In the early 1970s the system broke down. (I am in the process of writing a book on this period and the theoretical and practical issues that were a part of this history.)
The next twenty years or so the nations learned to operate in a world that was becoming more global and integrated in nature. Nation after nation learned that in such a world that they could not operate independently of one another and that a firm discipline needed to be maintained in order to exert some control over their destiny. A lack of governmental discipline and the slight smell of inflation could set into play forces in international financial markets that would completely disrupt the internal policies that these nations were attempting to follow. Nation after nation had to bring their budgets under control and follow a strictly disciplined approach to their debt creation. Also, these nations made their central banks independent of the national government and charged them with keeping inflation under control. This has become the foundation of the model for international cooperation on international trade and globalization.
The next fifteen years or so the world had to deal with a United States that was at first receptive to this new world financial order and then at odds with the system and even rebellious. It was within this context that “Rubinomics” was born. Again, putting things in relatively simple terms, the fundamentals of “Rubinomics”, to me, is the essence of the “new world order”. First, a country needs to get its fiscal affairs in order and minimize its creation of new debt. Second, the nation needs an independent central bank whose primary focus is on controlling inflation…and little else. Third, this country needs to operate as a partner within the world…even though it may be the world’s only super power…and help to facilitate the growth and interaction of nations into as fully an integrated world as possible.
It seems to me that this approach was attempted in the 1990s and was relatively successful. It seems to me that this approach was snubbed in the first decade of the twenty-first century and, as a consequence, we have substantial financial dislocation in the world and a fractured world community. It seems to me that “Humpty-Dumpty” needs to be put back together again.
Where do we start?
Paul Volcker (whoops another name), I believe, was right in writing “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.) This is where the United States must start!
United States fiscal and monetary policy must be responsive to what the rest of the world is trying to tell us. If the value of the U. S. dollar has been falling for seven years or so, maybe the market is trying to tell it something. This is what happened in the 1972-1992 period to many other countries. (Last post I mentioned a book by Steven Solomon that reviews this period: “The Confidence Game: How Unelected Central Bankers are Governing the Changed World Economy”, 1995.) In the Clinton years, policymakers seemed to understand this message. In the years that followed, the policymakers seemed to go out-of-their-way to avoid hearing this message.
The United States needs to start listening again. The Federal budget must be brought under control and the nation must move ahead in a disciplined manner with respect to debt creation. The Federal Reserve System must not be charged with multiple responsibilities that distract it from what should be its main focus…inflation. Note that this is more complex than just concentrating on the “flow” prices that are captured in the major price indices. There will be more on this in future posts.
There is no question that the United States government needs to review its fiscal programs and policies, its needed public investment. A lively debate must take place with respect to things like the war in Iraq and elsewhere, universal health care, the infrastructure, education, and so on. But, this discussion must take place within the constraint of what it takes to be a partner within the world community and operate according to the rules of membership. We may not like this…we Americans do not take well to the discipline of others. But, we are a member of the world community and we must be a GOOD member. Citizens of the United States must remember this.
We must also get away from the “Fundamentalism” that permeates both ends of the political spectrum. We cannot promote a left wing “Tax and Spend” fundamentalism any more than we can promote a right wind “Tax Cut and Spend” fundamentalism. We cannot be locked into past doctrine…we must be more pragmatic in practice. We cannot hold up politically correct tests of membership…from the right or from the left. We must shake off these remnants of the past!
First, it is perhaps destructive of a idea to tie it so closely to an individual. “Rubinomics” and Robert Rubin seem to draw a visceral response much as did “Keynesian” and John Maynard Keynes. Milton Friedman was lucky enough not to get his name tied to the prominent idea which he promoted, “Monetarism”…which did allow for the creation of an opposition title…proponents were not called “Keynesians” but “Fiscalists”.
Calling something by a person’s name can be used to draw together those opposed to the person and his/her ideas and as a term of derision. It can also be used to rally those that pursue similar ends. Oftentimes the use of such titles direct attention away from the real issues at hand and the policies being proposed. Name-calling can be helpful…and it can be destructive. In order for any productive discussion to take place, however, focus must be returned to the real issues at hand.
Second, ideas must be placed within their historical context. In the case of “Rubinomics”, we have to go back to the Paris Peace Talks following World War I. To create the economic situation at that time is very simple terms I will argue that there were two major conditions at hand. The allies were very divided in terms of what they wanted to achieve…there were as many programs for the “new world order” as there were major nations involved in the discussions. In addition, the Russian Revolution had just taken place and there was great fear among the discussant nations that the threat to the future was labor unrest and the Bolsheviks, the proposed new order for the revolutionary world.
This was the world that John Maynard Keynes was involved in and his goal was to create a model of the world in which labor unrest could be avoided as much as possible so that the wave of revolution did not overcome the Western world as he knew it. The fundamentals of his model were fixed exchange rates between countries so that each nation could pursue its own independent economic policy and a government program to stimulate a national economy so as to avoid severe economic collapse and maintain high rates of employment.
As is well known, Keynes worked over the next twenty years or so to develop a theoretical model to support his perception of the world and to bring politicians and institutions to incorporate his ideas for low employment and peace. He then continued to work throughout World War II to create the international financial system that would actually implement his ideas.
So, for roughly fifty-five years efforts were made to try and create a world of fixed foreign exchange rates and the institutions and rules that could maintain such a system so that countries could operate their fiscal and monetary policies in a relatively independent manner. As history has shown, this system proved to be unworkable in the long run…because even in such a regime, nations cannot operate fully independently of one another. The post-World War II period was dotted with inflations and devaluations that periodically disrupted the system. In the early 1970s the system broke down. (I am in the process of writing a book on this period and the theoretical and practical issues that were a part of this history.)
The next twenty years or so the nations learned to operate in a world that was becoming more global and integrated in nature. Nation after nation learned that in such a world that they could not operate independently of one another and that a firm discipline needed to be maintained in order to exert some control over their destiny. A lack of governmental discipline and the slight smell of inflation could set into play forces in international financial markets that would completely disrupt the internal policies that these nations were attempting to follow. Nation after nation had to bring their budgets under control and follow a strictly disciplined approach to their debt creation. Also, these nations made their central banks independent of the national government and charged them with keeping inflation under control. This has become the foundation of the model for international cooperation on international trade and globalization.
The next fifteen years or so the world had to deal with a United States that was at first receptive to this new world financial order and then at odds with the system and even rebellious. It was within this context that “Rubinomics” was born. Again, putting things in relatively simple terms, the fundamentals of “Rubinomics”, to me, is the essence of the “new world order”. First, a country needs to get its fiscal affairs in order and minimize its creation of new debt. Second, the nation needs an independent central bank whose primary focus is on controlling inflation…and little else. Third, this country needs to operate as a partner within the world…even though it may be the world’s only super power…and help to facilitate the growth and interaction of nations into as fully an integrated world as possible.
It seems to me that this approach was attempted in the 1990s and was relatively successful. It seems to me that this approach was snubbed in the first decade of the twenty-first century and, as a consequence, we have substantial financial dislocation in the world and a fractured world community. It seems to me that “Humpty-Dumpty” needs to be put back together again.
Where do we start?
Paul Volcker (whoops another name), I believe, was right in writing “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.) This is where the United States must start!
United States fiscal and monetary policy must be responsive to what the rest of the world is trying to tell us. If the value of the U. S. dollar has been falling for seven years or so, maybe the market is trying to tell it something. This is what happened in the 1972-1992 period to many other countries. (Last post I mentioned a book by Steven Solomon that reviews this period: “The Confidence Game: How Unelected Central Bankers are Governing the Changed World Economy”, 1995.) In the Clinton years, policymakers seemed to understand this message. In the years that followed, the policymakers seemed to go out-of-their-way to avoid hearing this message.
The United States needs to start listening again. The Federal budget must be brought under control and the nation must move ahead in a disciplined manner with respect to debt creation. The Federal Reserve System must not be charged with multiple responsibilities that distract it from what should be its main focus…inflation. Note that this is more complex than just concentrating on the “flow” prices that are captured in the major price indices. There will be more on this in future posts.
There is no question that the United States government needs to review its fiscal programs and policies, its needed public investment. A lively debate must take place with respect to things like the war in Iraq and elsewhere, universal health care, the infrastructure, education, and so on. But, this discussion must take place within the constraint of what it takes to be a partner within the world community and operate according to the rules of membership. We may not like this…we Americans do not take well to the discipline of others. But, we are a member of the world community and we must be a GOOD member. Citizens of the United States must remember this.
We must also get away from the “Fundamentalism” that permeates both ends of the political spectrum. We cannot promote a left wing “Tax and Spend” fundamentalism any more than we can promote a right wind “Tax Cut and Spend” fundamentalism. We cannot be locked into past doctrine…we must be more pragmatic in practice. We cannot hold up politically correct tests of membership…from the right or from the left. We must shake off these remnants of the past!
Monday, April 14, 2008
Is it Time to Focus on the Value of the Dollar?
Critics of John Maynard Keynes have charged the great man with changing his mind too often. They said that he could not maintain a position for an extended period of time. Keynes countered this criticism with the remark: “When the situation changes, I change my mind. What do you do?”
It seems to me that it is time for Keynesians, and others, to change their minds with respect to policy prescriptions pertaining to employment and the value of the dollar. In this highly integrated world, countries cannot conduct their monetary and fiscal policies independently of one another as the United States has been attempting to do in recent years and did for most of the latter part of the 20th century. The basic philosophy behind this effort is the desire for a county to achieve low rates of unemployment independently of what monetary and fiscal policies are being followed in any other country.
I am not arguing that we should not be in favor of low unemployment. It is just that the philosophy supporting current thinking in the United States emphasizes this one goal over any other and is captured in both The Employment Act of 1946 and the so-called Humphrey-Hawkins Full Employment Act of 1978. There is a long history preceding these “acts” and this history needs to be reviewed to put the current situation into a proper perspective. A good reference is the book by Donald Markwell, “John Maynard Keynes and International Relations: Economic Paths to War and Peace.” (Oxford University Press, 2006)
We pick up the story around 1919 at the Paris Peace Conference. Historically, Keynes had taught and written about the Purchasing Power Parity theory of relative foreign exchange values and had been in favor of flexible foreign exchange rates. However, given the events taking place in the second decade of the 20th century, he changed his mind about how the world economy should be set up in order to save capitalism. At the peace conference, Keynes became a very vocal advocate for fixed exchange rates which would allow countries to seek high rates of employment within their own borders and do this independently of other countries. He worked very hard, both theoretically and practically, to devise a system of exchange rates in which this national independence could be achieved.
The reason for this change of mind was the unrest the Western nations were feeling concerning recent events in Russia and the growing support for the ideas of Marx and Engels. In particular, the Communist movement was gaining ground in most of Europe and the Russian Revolution cemented the idea that a Bolshevik uprising could actually take place. There were legitimate fears that the working classes, if unhappy enough, could rise up and gain control of a nation’s government. This concern supplied the rationale for attempting to develop governmental policies that would help to ensure that a country achieved and then maintained low rates of unemployment. The old ideas had to be revised in the light of new events and new information. The situation had changed so Keynes changed his mind.
Keynes worked for the next twenty-five years or so to create such a system. His efforts were directed along three different paths. First, he attempted to develop the philosophical and scientific foundation for this new way to look at economic policy making. Second, he conducted an almost continuous campaign in the popular press, newspapers and magazines, in an attempt to educate the public along the lines he was thinking as well as to advocate policies. Third, when asked, he devoted time and energy toward the actual creation of such a system; a system that would achieve the integrated world for which he hoped.
The philosophical and scientific work that he did resulted in the publication of his masterpiece, “The General Theory of Employment, Interest, and Money.” This book became the basis for what became known as Keynesian Economics and provided the intellectual rationale in the United States for the passage of The Employment Act of 1946. The Bretton Woods Conference, which began in 1944, produced the world financial system that incorporated much of what Keynes wanted. He was very active in this conference and, in fact, dominated the result. The system included fixed foreign exchange rates that would or could be changed over time as was required. This basis became the operational standard for the world during the next 30-40 years. It was thought that this system “freed-up” national governments so that they could pursue economic policies aimed at full employment in a relatively independent fashion.
Actually, the next 30-40 years saw the system set up at Bretton Woods slowly unravel. The reason…no country could really isolate their economic policies from the economic policies of other countries. The calm of the fixed foreign exchange rate regime was continually punctuated by periodic re-adjustments that had to be made when the currency of a country had to be devalued. The devaluation usually took place after pressure built up on the currency while, at the same time, the government denied that they were going to devalue and the central bank and treasury of the country valiantly made efforts to shore up the value of the currency. Finally, the pressures became so great that the currency had to be devalued.
In the 1960s in the United States, inflation became an issue as the Johnson administration mismanaged the government’s fiscal affairs attempting to pay for both ‘guns and butter’. This era ended as the Nixon administration ‘froze’ wages and prices in 1971 in an effort to gain control over inflation. This government also set free the dollar price of gold (which had been set at $35 per ounce) and let the dollar float in foreign exchange markets. And, as they say, the rest is history.
After this, country after country came up against the inflation dragon as the world continued to give preference in their economic policies to the goal of full employment. Yet, country after country found that they could not independently follow this kind of policy and maintain a strong currency. Country after country came to realize that they must get their fiscal budget under control and make their central bank independent of the central government so that it could follow a policy based upon controlling inflation. More and more central banks adopted ‘inflation targeting’ as their operating goal so as to achieve creditability and trust in world financial markets.
The United States has resisted this trend. As a dying gasp, the Congress enacted the Humphrey-Hawkins Full Employment Act in 1978, but this soon had to be put aside as the Carter administration was forced to confront renewed inflationary pressures and bring in Paul Volcker to lead the Federal Reserve and bring inflation under control. Once inflation was brought under control and some discipline was re-established over the conduct of monetary policy, economic growth was renewed and high levels of employment were attained. With inflation not an issue, businesses tended to concentrate on productivity and not on how to protect themselves from inflation. The unemployment rate dropped to period lows.
However, high employment has continued to be a goal of many politician and intellectuals within the United States. There has been reluctance to establish ‘inflation targeting in the U. S. Every wiggle in the unemployment rate brings cries for new and more effective government stimulus to ensure a low unemployment rate. Yet, reality continues to put holes in the arguments given to support governmental efforts to achieve such a goal. The times are not what they once were. As the times have changed, the politicians and intellectuals that continue to supports such goals need to change their minds.
The United States cannot ‘go-it-alone’. The United States must join the rest of the world and give more attention to the value of the dollar and less to immediate unemployment goals. The ‘revolt of the masses’ is not the threat it was in the 1920s and 1930s (although food issues, particularly in Asia, Africa and Latin America, may have taken over). And, as we saw in the 1990s, fiscal discipline and a non-inflationary monetary policy focused on a strong U. S. dollar, coupled with policies that support private innovation and change, can produce not only low inflation but high employment. It is my belief that Keynes, in the present world environment, would be more supportive of this kind of policy than a ‘Keynesian’ policy based upon achieving full employment, whatever that is. It is time for others to change their minds as well.
It seems to me that it is time for Keynesians, and others, to change their minds with respect to policy prescriptions pertaining to employment and the value of the dollar. In this highly integrated world, countries cannot conduct their monetary and fiscal policies independently of one another as the United States has been attempting to do in recent years and did for most of the latter part of the 20th century. The basic philosophy behind this effort is the desire for a county to achieve low rates of unemployment independently of what monetary and fiscal policies are being followed in any other country.
I am not arguing that we should not be in favor of low unemployment. It is just that the philosophy supporting current thinking in the United States emphasizes this one goal over any other and is captured in both The Employment Act of 1946 and the so-called Humphrey-Hawkins Full Employment Act of 1978. There is a long history preceding these “acts” and this history needs to be reviewed to put the current situation into a proper perspective. A good reference is the book by Donald Markwell, “John Maynard Keynes and International Relations: Economic Paths to War and Peace.” (Oxford University Press, 2006)
We pick up the story around 1919 at the Paris Peace Conference. Historically, Keynes had taught and written about the Purchasing Power Parity theory of relative foreign exchange values and had been in favor of flexible foreign exchange rates. However, given the events taking place in the second decade of the 20th century, he changed his mind about how the world economy should be set up in order to save capitalism. At the peace conference, Keynes became a very vocal advocate for fixed exchange rates which would allow countries to seek high rates of employment within their own borders and do this independently of other countries. He worked very hard, both theoretically and practically, to devise a system of exchange rates in which this national independence could be achieved.
The reason for this change of mind was the unrest the Western nations were feeling concerning recent events in Russia and the growing support for the ideas of Marx and Engels. In particular, the Communist movement was gaining ground in most of Europe and the Russian Revolution cemented the idea that a Bolshevik uprising could actually take place. There were legitimate fears that the working classes, if unhappy enough, could rise up and gain control of a nation’s government. This concern supplied the rationale for attempting to develop governmental policies that would help to ensure that a country achieved and then maintained low rates of unemployment. The old ideas had to be revised in the light of new events and new information. The situation had changed so Keynes changed his mind.
Keynes worked for the next twenty-five years or so to create such a system. His efforts were directed along three different paths. First, he attempted to develop the philosophical and scientific foundation for this new way to look at economic policy making. Second, he conducted an almost continuous campaign in the popular press, newspapers and magazines, in an attempt to educate the public along the lines he was thinking as well as to advocate policies. Third, when asked, he devoted time and energy toward the actual creation of such a system; a system that would achieve the integrated world for which he hoped.
The philosophical and scientific work that he did resulted in the publication of his masterpiece, “The General Theory of Employment, Interest, and Money.” This book became the basis for what became known as Keynesian Economics and provided the intellectual rationale in the United States for the passage of The Employment Act of 1946. The Bretton Woods Conference, which began in 1944, produced the world financial system that incorporated much of what Keynes wanted. He was very active in this conference and, in fact, dominated the result. The system included fixed foreign exchange rates that would or could be changed over time as was required. This basis became the operational standard for the world during the next 30-40 years. It was thought that this system “freed-up” national governments so that they could pursue economic policies aimed at full employment in a relatively independent fashion.
Actually, the next 30-40 years saw the system set up at Bretton Woods slowly unravel. The reason…no country could really isolate their economic policies from the economic policies of other countries. The calm of the fixed foreign exchange rate regime was continually punctuated by periodic re-adjustments that had to be made when the currency of a country had to be devalued. The devaluation usually took place after pressure built up on the currency while, at the same time, the government denied that they were going to devalue and the central bank and treasury of the country valiantly made efforts to shore up the value of the currency. Finally, the pressures became so great that the currency had to be devalued.
In the 1960s in the United States, inflation became an issue as the Johnson administration mismanaged the government’s fiscal affairs attempting to pay for both ‘guns and butter’. This era ended as the Nixon administration ‘froze’ wages and prices in 1971 in an effort to gain control over inflation. This government also set free the dollar price of gold (which had been set at $35 per ounce) and let the dollar float in foreign exchange markets. And, as they say, the rest is history.
After this, country after country came up against the inflation dragon as the world continued to give preference in their economic policies to the goal of full employment. Yet, country after country found that they could not independently follow this kind of policy and maintain a strong currency. Country after country came to realize that they must get their fiscal budget under control and make their central bank independent of the central government so that it could follow a policy based upon controlling inflation. More and more central banks adopted ‘inflation targeting’ as their operating goal so as to achieve creditability and trust in world financial markets.
The United States has resisted this trend. As a dying gasp, the Congress enacted the Humphrey-Hawkins Full Employment Act in 1978, but this soon had to be put aside as the Carter administration was forced to confront renewed inflationary pressures and bring in Paul Volcker to lead the Federal Reserve and bring inflation under control. Once inflation was brought under control and some discipline was re-established over the conduct of monetary policy, economic growth was renewed and high levels of employment were attained. With inflation not an issue, businesses tended to concentrate on productivity and not on how to protect themselves from inflation. The unemployment rate dropped to period lows.
However, high employment has continued to be a goal of many politician and intellectuals within the United States. There has been reluctance to establish ‘inflation targeting in the U. S. Every wiggle in the unemployment rate brings cries for new and more effective government stimulus to ensure a low unemployment rate. Yet, reality continues to put holes in the arguments given to support governmental efforts to achieve such a goal. The times are not what they once were. As the times have changed, the politicians and intellectuals that continue to supports such goals need to change their minds.
The United States cannot ‘go-it-alone’. The United States must join the rest of the world and give more attention to the value of the dollar and less to immediate unemployment goals. The ‘revolt of the masses’ is not the threat it was in the 1920s and 1930s (although food issues, particularly in Asia, Africa and Latin America, may have taken over). And, as we saw in the 1990s, fiscal discipline and a non-inflationary monetary policy focused on a strong U. S. dollar, coupled with policies that support private innovation and change, can produce not only low inflation but high employment. It is my belief that Keynes, in the present world environment, would be more supportive of this kind of policy than a ‘Keynesian’ policy based upon achieving full employment, whatever that is. It is time for others to change their minds as well.
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