Abolish the Fed? And then what?

Title: The Dumbest Idea in the World

Abolish the Fed? Really?

In the land of dumb ideas, some stand head and shoulders above the rest. Like abolishing the Federal Reserve.

The idea is gaining credence because it is part of Rand Paul’s campaign for US Senate in Kentucky. Rand Paul is now talking about strict oversight of the Federal Reserve, but in the past he has discussed complete abolition of the Fed. This proposal is essentially the same as his father’s proposal to abolish the Fed and return the U.S. currency to the gold standard.

The idea is born of frustration with current conditions, but the cure would be far worse than the disease.

There are two basic problems with abolishing the Fed: history and reality. The Fed was established to prevent the wild swings in the value and supply of money in the 18th century. Without it there is no telling what would happen to the money supply. The other problem is that without the Fed the “market” would establish the value of money. But the market it no longer some pastoral vision from Adam Smith, with the exchange rate established by the farmer, the butcher and the greengrocer. Today the “market” is the international financial market, which is dominated by the central banks of major economic players and sovereign wealth funds of major economies. Abolishing the Federal Reserve would mean that the value of the American currency would be set by entities like the European Central Bank, the People’s Bank of China (which has more financial assets than any other public institution on earth)and Saudi Arabia’s sovereign wealth fund.  

Those who advocate abolishing the Federal Reserve say that the value of money would be more stable because it would be based on the gold standard. But the value of gold is not fixed; it is based on the value set by the commodities markets. People flee to gold for a sense of stability, but its value is set by supply and demand. If one nation or large fiscal entity wants to drive up the price, it could. Just look at what the Hunt brothers did to the price of silver in the 1980’s. While the United States has the world’s largest gold reserves, the Chinese and the Russians also have large gold holdings. If either decided to liquidate their gold reserves it could drive down the price of gold and essentially devalue the U.S. Dollar. And China has enough other assets (including U.S. Treasuries) that it could easily start buying gold, driving up its value and the price of the U.S. Dollar.      

I recognize the problems with the Federal Reserve, and the frustration over its opacity, but abolishing it is one of the dumbest ideas I have ever heard.

Some background data:

History of the founding of the Fed:

http://www.newyorkfed.org/aboutthefed/history_article.html

See also:

http://meganmcardle.theatlantic.com/archives/2007/12/the_good_old_days_werent_alway.php

http://meganmcardle.theatlantic.com/archives/2007/09/theres_gold_in_them_thar_stand.php

How about some history with your Tea?

In discussing the Tea Party movement, David Adams, campaign manager for Rand Paul, said that the guiding principles of the Tea Party movement are “distinctly Kentuckian: balanced budgets and getting government out of the business of picking economic winners and losers.”

If Adams and the Tea Party want to suggest as a matter of economics or of political philosophy that government should not be in the business of picking economic winners and losers they are free to do so. But it is simply wrong to suggest that this is the historical norm or historical reality. The government has been in the business of picking economic winners and losers since George Washington sided with Alexander Hamilton and chartered the First Bank of the United States.  The government picked economic winners and losers in when it granted the charter to provide steam ship service on the Hudson River to Robert Fulton rather than John Fitch, James Rumsey, or John Stevens. 

The Government picked economic winners and losers when it funded canals to open up the interior. The government program to fund canals, by the way, was one of the main programs of Henry Clay, the powerful Whig Speaker of the House from Lexington, Kentucky.

The government picked economic winners and losers when it built the Transcontinental Railroad. It picked winners and losers when it granted Edison the first contract to build electric service in New Jersey. It picked winners and losers when it bought planes for the Army and the Postal Service at the dawn of aviation. It picked winners and losers when it let the contracts to build ENIAC, the first digital computer. It picked economic winners and losers when it decided where to build the interstate highway system. It picked winners and losers when it selected IBM to build computers for the space program. These are just a sampling, but the point is that government involvement in picking economic winners and losers is pervasive through our economy and our history.

Whether this is right or wrong as a matter of political philosophy is an interesting question. Perhaps it is wrong for government to become as involved as it is. This is an issue that certainly should be discussed.

But whether it is right or wrong as a matter of economics is another matter. Perhaps government should have no role in the economy, but is has since the dawn of government. (Recall Joseph’s involvement in Egyptian agriculture, see Genesis 41:37 – 57.) Government and the economy are so intertwined that it is difficult to know where one starts and the other ends.

To suggest, as Mr. Adams does, that government should have no role in “picking economic winners and losers” is an interesting philosophical theory. But it is little more than a theory.

There is a term in political philosophy for people who suggest that government should be run based on untested theories, and it is not “conservative.” The soul of conservativism is the idea that human affairs should be governed by time tested and practical methods. Conservatives have long opposed “liberals” whom they castigate for trying to reform society based on untested social theories. But now some want to restructure society based on untested economic theories. The term for someone who wants to try to reshape society based on untested theories is not liberal or conservative, but radical. The reality is that the theory of the totally unconstrained free market is neither liberal or conservative but radical.

Changing Economics and Changing Politics

In an article in National Affairs, Jim Manzi, a senior fellow at the conservative Manhattan Institute says that the world’s economy has changed dramatically in the last twenty years or so, and neither American political party knows how to deal with the new economic reality. He says that basically Republicans have become free market fundamentalists, but fail to appreciate that the free market can create a variety of unfavorable conditions that have a negative impact on society. He says that Democrats, in contrast, are far too focused on maintaining social cohesion, often at the expense of a vibrant economy. It is a fascinating article that I recommend to anyone interested in understanding the changes and problems of the modern world. It is currently available on-line at: http://nationalaffairs.com/publications/detail/keeping-americas-edge

I want to address one of the issues that Manzi discusses. He notes that modern businesses need to be flexible to compete in the world economy. If a business is not flexible it will lose out to more flexible competition from other countries. Flexibility means that a company must be able to quickly shift production, merge with other companies or spin off certain production lines, close unprofitable lines of business and nimbly open others. It also needs to be able to find and hire the best people, and on the flip side, let unproductive people go. This flexibility is fundamental to competition and vital to success.

But this flexibility for business equates to lack of stability of workers. The papers are full of stories of companies cutting workers, many due to the recession, but others in order to compete with foreign competition. Downsizing and outsourcing were common throughout the last decade. Some studies indicate that the average worker today will change jobs ten times in his or her career. Companies must be flexible, and so too must be workers. But this flexibility equates to a lack of stability. Polls indicate widespread anxiety among workers as they contemplate company bankruptcies, mergers, layoffs, and outsourcing.

Workers are citizens and voters. And polls indicate widespread concern among the voting public. One recent poll I saw indicated that 60% of the respondents felt that their children would not enjoy the same quality of life and lifestyle that they did. This economic uncertainly leads to political uncertainty. I personally believe that the recent interest in new and untested politicians (including both Barack Obama and Sarah Palin) is due in no small measure to the believe that the old politicians did not do well by the economy and the public.

That is one issue, but the more fundamental issue is that what is good for business is, in this case at least, not good for politics. A modern economy needs – truly and fundamentally needs – flexibility. But that flexibility leads to social and political anxiety.

People entering the workforce in America today know and understand that they will not work for a single company their entire career. They will not work forty years of GM, or Sears, or IBM, or AT & T, and retire with a gold watch and a nice pension. They will change jobs frequently, and as a result they are largely responsible for planning and saving for their retirement. They have no sense that loyalty to a company will result in the company protecting them, not because the company is venal, but because the company is fighting for its own survival in the uncertain seas of the world economy. That is the new economic reality. It is unsettling for workers, and since workers are voters, it is creating political uncertainty as well. And that is the new political reality.     

China as the New Clean Energy Superpower

It’s common knowledge that China is building more coal fired power plants than the rest of the world combined. But what is less reported is that China is now the leading producer of both solar panels and wind turbines. China needs energy to feed growing demand, but it also understands that renewable energy will be a vital part of the energy supply of the future. While it is certainly good for the world that China has embraced clean technology, it could potentially be a problem for the United States. It is quite possible that if the United States does not aggressively pursue renewable technology now, which will result in developing new and improved solar panels and new and improved wind turbines, we will end up buying those products from China.

Currently renewable supply only a small percent of China’s needs, but China intends to produce 8 percent of its energy needs from renewable, including wind, solar and biomass, by 2020. Renewable also produce jobs. According to a recent New York Times article, China employs over 1 million people in its renewable energy sector, and is adding over 100,000 jobs a year.

See, http://www.nytimes.com/2010/01/31/business/energy-environment/31renew.html?ref=science

This growth in renewable energy in China is the direct result of government intervention in the economy, and China recently created a National Energy Commission to oversee all energy needs and to push for increased use of renewable.

The New York Times article notes that China has an advantage in developing renewable energy: it is starting from scratch. It has an increased need, and it is just as easy (actually easier) to build a renewable facility as a coal fired power plant. And since everything is starting from scratch, the cost of installing clean versus coal is roughly competitive. In the United States, and other developed markets, the issue is replacement of existing power generation, and so renewables are competing with an existing market.

Renewable energy does cost more than coal energy in China. Wind is as much as 40 percent more expensive than coal, and solar is about twice as expensive. But increased production drives down costs, and eventually the cost for energy from renewables will come down. And, as coal use goes up worldwide the price will go up as well, and perhaps the two cost models will meet and the cost per kilowatt will be the same.

But Chinese renewable energy companies are also interested in dominating the world market for solar panels and wind turbines. This will allow them to recoup some of their development costs by selling equipment overseas. It will also result in their domination of the supply of these products. So, there is the distinct possibility that we will trade reliance on Middle Eastern oil for our energy needs for reliance on Chinese technology for our energy needs.

So we have a couple of choice. One is to ignore renewable energy, and then when we do need alternate sources of energy we will be forced to go to China to buy the equipment. The other option is to begin developing sources of renewable here at home. I like the second choice.

Simple Solutions and Complex Problems

[Orignally Posted on Campaign Blog on April 25]

The financial problems of the Commonwealth, and of the nation, are serious and significant. They arise from a complex set of issues, from tax policy and the changing nature of manufacturing, to competition from China and globalization. Yet some people see the solution is simplistic terms.          

Representative Stan Lee said “You can’t spend your way out of a recession. You can’t tax yourself to prosperity. You can’t borrow your way out of debt.”

With one simple sentence, Lee rejects one hundred years of evidence that Keynesian economics works. This nation only recovered from the Great Depression because of World War Two. The Great Depression ended because of government spending. Since the Second World War there have been recessions around the world, and nations have tried many possible solutions. Japan and Argentina tried cuts to government to end their major recessions, and those nations are still weekend. In Japan the 1990’s are known as the lost decade. Sweden spent its way out of a financial collapse in the late 1990’s, and the recession lasted less than a year. History teaches that done right, a nation can spend its way out of a recession.

With another simple sentence, Lee shows that he has never even contemplated the world beyond this nation’s borders. Why, for example, do Scandinavian countries have high standards of living (read a rich population) when they have high taxes, while South American countries have low standards of living when they have low tax rates? Until the 1960’s, the standard of living in Argentina, Venezuela, Chile, and Brazil was comparable to the standard of living of most of Europe.     

I know that many conservatives will say that they don’t want to be like Europe. That’s fine. But I don’t want to be like Brazil. And when I hear them talk about their ideal tax and regulatory schemes I think of Brazil: vastly rich and lightly taxed small upper class and teaming slums of the poor.

Finally, Mr. Lee says you can’t borrow your way out of debt. That is probably news to many businesses that routinely borrow money to invest in new technology or facilities all in an attempt to increase their revenue. I often hear conservatives say we should operate government more like a business, but then I hear things like Mr. Lee’s statement, and I wonder if they have any concept of what business really does.

We are faced with many complex problems. We will have a hard time solving these problems if we are so constrained by clichés and sound bites that we can’t think.      

So This is How Capitalism Works

According to standard theory, capitalism, or at least “free market” capitalism, works by individuals and businesses trying to maximize their own self interest. In essence they act selfishly and the net result is that they create a benefit for the overall society. While selfishness might seem dangerous, this selfish behavior is actually constrained by the market. If, for example, a company acts selfishly by selling shoddy goods, they will eventually loose sales when the public finds out that they are buying junk. This acts as negative reinforcement which essentially constrains the company’s ability to sell junk. A rational company will, therefore, not sell junk.  There are two important aspects of the free market that help to provide this governor of selfish behavior: the first is that people as economic actors are assumed to act rationally, and the second is the idea that the market works best when everyone has complete and accurate information. So to continue with my example, we should assume that people will act rationally and not purchase shoddy goods, and second we should assume that people will have an easy ability to know what is a shoddy good. The problem with the free market, however, is that (1) people are not rational, and (2) people do not have complete and accurate information. Examples of both abound. Advertising is based on the proven fact that people can be swayed to buy things that they do not need. And, even with the internet, we do not have complete and accurate information about products and services in the marketplace. So these regulators of selfish behavior do not work properly. Despite that, many economic purists believe that it is not just OK, but actually preferable, for people to act selfishly.  

But that type of behavior has negative consequences. Here are two recent examples. First, a drunk commodities trader in England singlehandedly pushed up the price of oil, and cost his firm millions of dollars. Drink. Trade. Refill. Lose $10 Million. The New York Times, July 1, 2010.  http://www.nytimes.com/2010/07/01/business/global/01oil.html   The second story involves Goldman Sachs and the kinds of derivative that nearly brought down the world’s financial markets in 2008. Time Magazine: How Goldman Trashed a Town, Time, July 5, 2010. Pg 32-33. http://www.time.com/time/magazine/article/0,9171,1999417,00.html Apparently Goldman created a derivative based on adjustable rate mortgages for a trader named John Paulson, who was pretty sure they were crap and would fail, and who therefore shorted them, or bet against them. Goldman, apparently knowing they were junk, engaged in some slick trading to unload the derivatives. It involved multiple sales to various different people, and at each point the new purchaser became less aware of the true nature of the derivative. Finally a number of municipalities bought the derivatives from companies that they had dealt with before, and therefore considered reliable. But what they bought was junk, and they lost millions when the derivative market crashed.  So how does that comport with economic theory? Plenty of people acted selfishly, but what about rationally? And how could people have full and accurate information when they were being lied to? And finally, how does laissez-faire economic theory explain drunk commodities brokers?

The New Imperialists: China in Africa

I just read three articles about growing Chinese economic and political influence in Africa. The articles are:

 

The Next Empire, The Atlantic Monthly, May 2010

http://www.theatlantic.com/magazine/archive/2010/05/the-next-empire/8018

 

China’s New Continent, Time Magazine, July 5, 2010

http://www.time.com/time/specials/packages/article/0,28804,2000110_2000287_2000276,00.html

 

Look Who’s Leading, Time Magazine, July 12, 2010

http://www.time.com/time/specials/packages/article/0,28804,2000110_2000287_2001036,00.html

 

The Chinese economy is growing dramatically. They have an almost insatiable need for natural resources to supply their factories, and they are turning to Africa to obtain these resources. There are a couple of different scenarios that these articles discuss. One possibility is that the Africans will see China as new colonists, trying to exploit Africa just like the Europeans did just over a century ago. Another possibility is that the systemic problems in Africa (largely widespread corruption and ineffective governments) will prevent China from doing more than merely purchasing raw resources from Africa.

But the third possibility is that with Chinese money, and the growing professionalism described in the second Time article, African could be transformed. That would certainly be great for the Africans. But it might not be so great for the United States. The first Time article notes that China has now surpassed the United States as the leading investor in Africa. If Africa modernizes with Chinese help, African countries will most likely model their economy on China’s, and will most likely turn to China for a variety of other economic, political, and military advice.

The Chinese, apparently, see Africa as an opportunity. For the most part the United States sees Africa (or at least a majority of the nations on the Continent) as a problem needing to be fixed. The Chinese are building mines to obtain raw material, factories to process the raw material into bulk commodities, and transportation systems to move those commodities to ports for shipment to the factories of China. The United States builds schools, clinics, and water treatment facilities. For all of the admirable high-mindedness of the American projects, it is the Chinese who are raising the standard of living of the people of Africa. In twenty years, if the African economy takes off, I hope the people think kindly of the United States. Because unless things change, their main trading partner will be China.  

Kick ’em While They’re Down

Among the reasons that some Republicans give for opposing the extension of unemployment benefits is that it actually encourages people not to look for work. In other words if people are getting unemployment benefits they will not look for work, and so if their benefits end they will be forced to get a job.

There are two problems with that outlook. First it implies that most people are lazy. I think that is an ugly view of humanity, but I will save that topic for another day.

The other problem is that it ignores economic reality. The unfortunate reality in the current recession is that there are simply not as many jobs as there are people looking for and needing jobs. According to a recent article in the New York Times:

 

For young adults, the prospects in the workplace, even for the college-educated, have rarely been so bleak. Apart from the 14 percent who are unemployed and seeking work … 23 percent are not even seeking a job, according to data from the Bureau of Labor Statistics. The total, 37 percent, is the highest in more than three decades and a rate reminiscent of the 1930s. [According to the story a large chunk of that 23 percent are in the “too discouraged to look” category.] 

The college-educated among these young adults are better off. But nearly 17 percent are either unemployed or not seeking work, a record level (although some are in graduate school). The unemployment rate for college-educated young adults, 5.5 percent, is nearly double what it was on the eve of the Great Recession, in 2007, and the highest level — by almost two percentage points — since the bureau started to keep records in 1994 for those with at least four years of college.

The full story can be found at: http://www.nytimes.com/2010/07/07/business/economy/07generation.html?pagewanted=1&ref=homepage&src=me

This is a serious problem for this nation. Regardless of where you may stand on the issue of extending unemployment benefits, it is imperative that we begin to look at the major problems facing our economy, and start to come up with ways to fix them. The constant political fight in Washington, which is supposedly about “ideology”, is not even remotely addressing the real issues. And rather than address the real problems facing the economy, some Republicans are willing to kick the unemployed while they are down. Kind of sad.