Of Stagflation and Economic Recovery

 

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Governments create inflation.  Since governments maintain a monopoly on money creation and exercise it constantly, the results of their policies are their own, whether they wish to own them or not.  Having said that, though government got us into this inflationary mess, more government is not going to get us out.  Yet, less government might.

The current administration—including the Federal Reserve—is in a tight spot.  Many repeatedly predicted that the unwholesome monetary and fiscal policies to respond to the equally unwholesome policies of dramatic economic shutdown of the 2020 Great Cessation would eventually lead to inflation.  So they have, even worse than what we saw in the 1970s.  The incoming Biden Administration persisted in blowing air into the inflationary balloon distended the year before.

This is not a partisan statement.  We have seen two Republican administrations doom themselves at the polls by engaging in ruinous economic policies because it was an election year.  Within memory of 2020 policymakers, the outgoing Bush Administration in 2008 mishandled the sure-to-be recession coming from the bursting of the housing bubble by panicking Congress into passing the TARP legislation, which fright drove investors to the sidelines.

True, the price rise from the 2020 massive fiscal and monetary stimulus did not appear as quickly as worriers, like me, expected.  Recipients of government largesse were not spurred to spend it as spontaneously as predicted.  Neither did negative real interest rates prod much borrowing, but it did punish savers.  While economic activity remained suppressed, people for a time sat on their money with little to do.  Eventually, puzzles all finished, people started coming out as 2021 wore on.  Congressional leadership called for more stimulus whilst the flood of funds from earlier stimulus at last began to flow.

The tight spot for the current administration is how to bring down inflation without bringing down the economy.  Of course, the economy will come down if they do not, because inflation eats away at the insides of economic activity.  Current White House leaders are sensitive about comparisons with the Carter Administration, yet there is talk of following the failed Carter example of trying to drive the economic car with one foot on the brake and the other on the accelerator.  That is the program for Carteresque stagflation, a stalled economy wrapped in continued high prices.

What we should have learned—and many have—is that the way to end inflation without getting into stagflation is not more government stimulus.  It is to end disincentives to business activity.  Reduce regulatory burdens and people will find ways to solve problems and get things done.  Inflation is caused by too much money chasing too few goods and services, stagflation impeding production of goods and services.  Reducing regulatory burdens and barriers to business activity addresses both problems by promoting productivity, innovation, and expansion, which increase supply at lower costs, reward creativity, and encourage new ideas in a virtuous economic circle.  It worked in the 1980s.  It can work 40 years later.

Of the Federal Reserve and Dreams of Success

 

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It may be easy, but I think unfair, to fault the Governors of the Federal Reserve System.  Their task is more than they can handle, and yet they are required to do it.  More accurately, I should say that their tasks are more than they can handle, and yet they are required to do them.

When the Fed was created, more than a century ago, a big concern was that it would be dominated by the financiers of New York and the politicians of Washington.  Hence, rather than a central bank, it was born as a system of a dozen regional banks, with a limited focus, to offset the liquidity risk inherent in banking.

Over time the Fed has not stayed that way.  Today, the Federal Reserve is effectively the biggest bank in the world.  Financiers in New York have an outsized influence, but the influence of the politicians in Washington may be greater.  Otherwise, how could a federal republic tolerate a handful of people at a single agency having so much sway over the daily lives and future prosperity of the individuals, families, communities, and businesses in the 50 States of the Union?  Accountability to the elected cannot long be withheld.

A great problem has been that the elected do not refrain from giving the Fed more things to do.  Its one first task has lost its focus by becoming three.  By law, the members of the Board, joined by the presidents of the 12 Fed banks, are to conduct themselves “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

What if they cannot succeed?  Then we fault them for failures while still pretending that they can.  We hide the goal posts in fog.  What is “maximum employment”?  Can it be today’s 62% of the adult population when we began the 21^st Century at 67%?  What are “stable prices”?  Does “stable” mean that the price of food tomorrow will be the same price it is today, or is “stable” the Fed’s official goal that things will cost 2% more each year, so that my young son’s retirement will require nearly twice as much as mine does?  Then there is the third, often forgotten requirement, that interest rates be “moderate.”  For 10 years the Fed kept quiet about that legal mandate, keeping interest rates very close to zero, a huge transfer of wealth from savers to borrowers, Uncle Sam being the world’s biggest borrower.  Is it surprising that the federal government’s debt grew during those 10 years to $30 trillion and still swelling?

What is the Fed to do?  We cannot reproach its current team, because they cannot succeed.  No government agency, regardless of excellent economists and the best computers, can manage it all.  If you read the statements, they carefully admit, essentially, “we don’t know how to succeed, but the law says we have to do something, so we will try this and that and see how it goes.”

Meanwhile, it has not been going so well.  To paraphrase liberally from psychiatrist Anthony Daniels, we should not be so beguiled by the dreamy tasks we have placed on the Fed that we cannot bear to lighten the load merely because it is not working.  

Of Inflation and Borrowing

 

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Inflation is good for borrowers?  Really?  So some say.  The case goes like this:  when the borrower receives his loan for so much, he promises to pay it back with money that would buy so much, but after inflation the money he uses to repay the loan will buy less.  He repays with cheaper money.  The lender gets his money back, but it is worth less than it was when he lent it.  Hold that thought, because that is the weakness in the case.

This inflation “benefit” may work for borrowers who already have loans, with a fixed rate that they can handle.  For all others, however, inflation raises the costs of everything, including borrowing.  How long will lenders be willing to lose value in the loans they make?

Think of it this way.  Does inflation work for people who sell things?  Maybe for their current supply, but their new supply will cost them more, eating into what they earn and raising the cost of what they try to sell to the next potential buyer.  The same reality is true for people who “sell” money, which is what lenders do. 

As we buyers know, inflation does not work well for buyers.  We face ever higher prices for the same things.  The same is true for people who “buy” money, which is what borrowing is.

New borrowers will find interest rates, the price of borrowing, rising with inflation, too.  That could put borrowing out of reach for some, just as it does for buying a house, a car, or work tools.  Businesses that need to roll over their existing loans could find the new loan more expensive, maybe even too expensive.  People who want to refinance their mortgage may find the new rate makes that much less attractive.  Floating rates, like credit card rates, will rise, so the cost of the products charged to the card will not be the only higher costs that card users face.  In short, only some borrowers, a declining some, may benefit from inflation, and only for a time.

Today’s money rests on trust, whether we talk of paper money, coins, or financial accounts.  We sell our time, our goods, our services in exchange for money.  That money is a promise that we can use it in trade with someone else for something of comparable worth.  When we accept money in payment, we in turn are making a loan to someone who has already received our goods, or services, or time.  All we got was a promise, which we trust we can exchange with someone else.  Inflation undermines that trust.  We receive a $100 payment of money which because of inflation may soon buy only what $95 used to buy.

Even governments will face the challenge of higher costs.  Sure, they will be paying back existing government debt with devalued money, but their new borrowings will carry a higher price tag, as will the things that governments buy.  I was going to say, look in the mirror if you want to know who will pay that higher cost of government debt, but if you do, have your children looking with you.

Of More Money and Higher Prices

 

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We have a new occupant of the Oval Office.  I did not hear his inaugural address, uncertain who would forget it more quickly, myself or its deliverer.  Inaugural addresses are highly forgettable literature, Lincoln’s first and second addresses (the second especially) the only ones that anyone can seem to remember, and worthy they are as exceptions to the genre.

I have been remembering the mountains of money that the government has been spending that it does not have, wondering where it is coming from even more than where it is going.  It is hard to find anyone who can tell you much with certainty about either.  The current attention is more focused on plans to spend yet another two trillion dollars that the government does not have on things that are not very clearly explained.  This would be on top of the most recent trillion dollars approved by Congress drawn from an empty well to be spent watering many a hidden garden.

I can understand the first round or two of multi-trillion dollar government expenditures.  Since government caused the collapse of a strongly growing economy by shutting down commerce and locking up the population, a strong argument can be made that paying these victims is not exactly a bailout as it is compensation.  To quote Will Rogers, if Stupidity got us into this mess, then why can’t it get us out? 

A serious problem seems to be that once you get into the game of paying people more to stay at home than they can earn on the job, how do you bring the game to an end.  The plan of the new Oval Office occupant seems to be to go into extra innings but continue serving spiritous refreshments well past the seventh inning.  How will the people get home safely once the game is over?

The classic formula for inflation is to have too much money chasing too few goods and services.  The kindling for a roaring inflation would appear to be carefully set. The Treasury and the Federal Reserve have been dramatically expanding the money supply, with the Federal Reserve supporting the market for the government’s electronic debt (not much money is printed on paper anymore) by purchasing gobs of Treasury securities from banks, paying the banks with electronic credits on their accounts held at the Federal Reserve, which the banks cannot find much to do with.  At the same time, many governors continue to issue orders to suppress the supply of goods and services.  As Elon Musk reportedly said last year, if you don't make stuff, there is no stuff.

If this worry is well-founded, then why have we not yet seen any inflation, government spending surges and the Great Cessation having been Federal and State policies for nearly a year?  A very good question, the answer to which may be found in the savings rate.  While a lot of electronic money has been going into people’s bank accounts, people have been shy about spending it.  The personal savings rate jumped in 2020 from about 7% to nearly 35%.  Worried people hoard more than toilet paper.  And a lot of things that people might spend money on, such as travel, suddenly were not available.  I was surprised last year when our car insurance company sent us a rebate:  insurance losses were down because people were traveling less.

The roads are a bit more congested these days, and the economy is showing strong signs of trying to recover.  Even the savings rate is coming down, dropping to about 13% as 2020 approached its close.  More activity is good, but what is the Federal Reserve going to do if more people spend more savings faster than more goods and services are provided?  How will the Federal Reserve respond to another couple trillion dollars of deficit spending to stimulate an economy that is already on a recovery trajectory and families continue draining their savings?  They could allow interest rates to rise, to encourage people to keep some of their money in savings accounts that have paid less than a penny a year per dollar saved.  Recent Federal Reserve comments, though, declare that is not on the table.

In the late 1970s, when Jimmy Carter was president, economists invented the term “stagflation,” as inflation was high and the economy was in the doldrums.  Joe Biden was a relatively new Senator back then.  Maybe he will remember those days.  That economic pattern served no one well.

Of Inflation and Words of Offence

The professional political commentators were all atwitter today about a word. It was one word from a comment that new presidential candidate, Texas Governor Rick Perry, said yesterday in discussion with some likely Republican voters in Iowa. The subject was Federal Reserve Chairman Ben Bernanke and the monetary policies of the Federal Reserve Board. These are the monetary policies that affect the price of everything in the United States and the value of the dollar abroad.

This is what Governor Perry said. Read it carefully, and see if you have any difficulty figuring out what Perry’s message was:

If this guy prints more money between now and the election, I don’t know what y’all will do to them in Iowa, but we would treat him pretty ugly down in Texas . . . I mean printing more money to play politics at this particular time in American history is almost treasonous in my opinion. Because all it’s going to be doing—we’ve already tried this—all it’s going to be doing is devaluing the dollar in your pocket. And we cannot afford that. We have to learn the lessons of the past three years.

Have you figured out what he was talking about, what his message was? This is not a trick question. His message seemed clear and obvious to me. That message was not what the professional commentators were largely talking about. I guess they missed it. As they interviewed each other, pretending that they were somehow reporting news, they zeroed in on Governor Perry’s use of the word “treasonous”. Was Governor Perry accusing the Federal Reserve Board Chairman of “treason” they all asked?

Having been interviewed by the TV talking heads on numerous occasions, I could not help imagining myself responding to their question. Of course they did not ask me, or anyone like me. They were busy interviewing each other.

But if I had been asked what seems to be the important question of the day—or, like Sesame Street puppets, the word of the day—I suspect I might have answered something like this:

“Are you asking me about a word or about the principle that Governor Perry was emphasizing? My religion teaches me not to make a man a transgressor for a word (see Isaiah 29:20, 21), but it is the principle, his message that we should consider if we want to evaluate his candidacy for President. What principles would likely guide him while in office? That is what we need to know if we want to have an intelligent conversation about who should be president.”

I would then add that it seemed to me that Governor Perry’s message was very clear:

Inflation is a bad policy, an especially bad policy at this time of a weak economy. We have tried it before, and it hurts the nation and the people. It would be particularly wrong for the independent Federal Reserve to choose inflation for political purposes.

That would be my recitation of Governor Perry’s message. I think I got it right. And I think that Governor Perry got it right.

Inflation is terrible. It breaks the promise embedded in money and makes it a lie. Remember that money is just a certificate of a promise between two people: I will give you my labor or goods or service in exchange for a promise that I can obtain something of equal value later. That becomes a lie if inflation means that when I redeem that promise I get something that government has reduced in value by depreciating the money that carries that promise. I provide $20 of labor and only get $18 of value in return. That is what inflation means. It corrupts that value of our goods and services. Even worse it corrupts the value of the promises we make and receive.

Inflation is particularly hard on retired people. These are people who set their money aside for 20, 30, 40, 50 years or more so that they could live off of it in their old age. Inflation cheats them, giving them only a fraction—sometimes only a small fraction—of the value that they set aside and hoped and relied upon for the rest of their lives. They lived a lower standard of living so that they could save for the future, only to find inflation make that future poorer for them. That is a life-time theft, when it is all too late to be reclaimed.

So if you want, go ahead and choose whatever word you want to describe inflation and its effects, especially if that inflation were inflicted on the nation for short-term political gain. Choose your word if that political inflation were to be inflicted by those public servants—the Federal Reserve Board—who took on the legal duty and responsibility to maintain stable prices, to fight inflation.

Whichever word you may choose, the policy of national inflation is wrong. Even if governments throughout history and into the modern era frequently resort to inflation when their national debt becomes too heavy to carry, it is still wrong. It is destructive and undermines the economy and robs the people who rely upon honest money.

Governor Perry was right to say, in very clear language, that it would be a major mistake for the Federal Reserve to choose that road, that the Federal Reserve must guard its independence from political pressure and hold to its legal mandate to fight inflation, not promote it.

If you must choose a word to describe it, go ahead. To quote Gilbert and Sullivan,

I conceive you may use
Any language you choose
To indulge in without impropriety.
(Iolanthe)

Of Government Debt and Historic Ratings

Apologists for the Obama administration desperately wish to make light of the unprecedented downgrading of the credit rating of U.S. Government debt from the virtually riskless category of AAA to the slightly riskier rank of AA. The apologists, when they cannot divert attention from the issue altogether, rely upon one or both of two arguments: 1) it was all a big mistake, an irrational and inappropriate decision; or 2) the downgrading does not really matter, it does not mean much.

Apology 1) merits this observation. Maybe it was a mistake. The other two major rating agencies so far have not taken a similar step, even while making noise about the possibility. That kind of public and open debate and disagreement is important for this land of free speech, most particularly with regard to opinions on government policies and their consequences.

The question of the ability of the U.S. to continue to service its debt is certainly open for debate. What is not debatable is that we are now in a condition where it is debatable. We have not been in a situation—since the emergence of the United States onto the world stage of major nations—where our ability to service our debt was at all in question. That we are is new, historic, and not disputed. Under the Obama Administration a lot of unthinkable things have suddenly become all too thinkable, from socializing medicine, or backing away from our support for Israel, to the government taking over the banking system. Add to that list of unthinkables the riskiness of U.S. Government debt.

Apology 2) is without merit. The noise from the Obama Administration suggests that it really does matter, a lot. It is important to note that the S&P decision came after the Congress and the Administration very predictably reached agreement on raising the debt ceiling. The issue is not about the debt ceiling. The issue would still exist if there were no debt ceiling. The issue is the natural debt ceiling, the one that comes when the debtor is no longer able to make good on his promises of repayment. The downgrade is advice to all investors anywhere in the world that the safety of U.S. Government debt can no longer be taken for granted. It has moved from being riskless to an investment that carries some risk—you may debate how much, but you can no longer deny that there is some.

Maybe there is great wisdom in that. Maybe all government debt, from any source, should be recognized as carrying risk. There is always political risk. History is replete with evidence that governments lie to their own people and to their investors, so perhaps a Triple-A “riskless” rating should never be given to any government promises. But apart from willingness to pay, to honor debt agreements, the recognition today is that the U.S. government debt is on a trajectory to where the government cannot—to where it will be unable to—honor its debt commitments.

That is not unprecedented. There are several historical examples where governments amassed debts that were too heavy to repay. It has usually led to the downfall of the governments. The Roman emperors tried to manage their uncontrolled spending on cheap popularity by debasing the coinage (a form of inflation) that wrecked the economy and eventually the empire itself. The debts of the English King Charles I led to rebellion that cost him his head in 1649. A similar chain of events brought on the French Revolution. More recently, the Soviet debt crisis of the 1980s set in motion the final events that broke up the USSR. Other sovereign debt crises are unfolding today before our eyes. All that S&P said was that the U.S. Government cannot act like it is immune from joining the sad list without making major changes in spending and borrowing programs.

Which is to say that the S&P decision matters greatly. There will be much debate about how much it matters, but only charlatans or simpletons will maintain that it does not matter at all. Once you have lost your virginity, there is no reclaiming it. It is a watershed to move from perceived risklessness of debt to the recognition of some risk. Risk costs money, as investors have to hedge against the possibility of some degree of non-payment, whether through changes in terms or through repayment in debased (inflated) currency.

Already investors are starting to move some of their money out of government debt—now exposed to greater market risk—into bank deposits where even with interest rates artificially depressed by the Federal Reserve the principal is not exposed to changes in market values. More significantly, an important anchor of certainty in our economy—the assumption of absolute security of U.S. Government debt—has been pulled up, rougher going for any ships that have to navigate an economy already turbulent with uncertainties.

In the early days of the Obama presidency the media and the President himself were eager to point out how this or that development was history-making, that this or that initiative was historic. Downgrading the credit rating of the debt of the U.S. Government is certainly historic. Let us hope that President Obama does not make any more history.

Of Dishonest Money and a Poorer Future

Interest rates in the United States are low, far lower than they would normally be. The Federal Reserve has been pumping hundreds of billions of dollars into the economy to keep them low. Is that a good thing? For the federal government it might be—in the short run—but for savers it is bad. One percent back on your savings is pretty low. The persistent, artificially low interest rate policy of the Federal Reserve Board has become a major transfer of wealth from private savers to the federal government. Low interest paid by the Treasury means low interest earned by savers. Measured against inflation, you may be letting the federal government use your money for less than nothing.

Perhaps even worse, the low interest rate policy of the Federal Reserve is supporting the colossal spending binge of the federal government. The federal government can spend trillions of dollars it does not have, because the cost of government borrowing is so cheap.

It is not naturally cheap. Normal markets would not support the continued massive deficits from Washington. When the government spends more than it takes in it has to borrow from you and me, or more particularly from our pension plans and insurance programs, as well as from banks (and foreigners, a subject for another day). Savers and banks do not, however, have an unlimited appetite for lending to the government, especially at the low rates that the government offers. In past decades, persistent federal deficits would result in rising interest rates, as investors would demand a higher return to keep them willing to buy more government bonds.

Some months ago, when the ballooning federal deficit showed no signs of easing, the Federal Reserve stepped in and started buying up hundreds of billions of dollars of government debt just as investors were backing away. Interest rates on government borrowing would have gone up, but the Federal Reserve bought up the oversupply of debt and pushed interest rates down. Interest rates on government borrowing today remain at historically low levels, six-month Treasury securities going for about one-tenth of one percent. That is way below the rising rate of inflation, which lately is at about 2.5% and going north. That means that many investors in government debt are actually losing money, the return on their government debt falling behind the rate of inflation, the government paying back the money it borrowed with dollars that buy less than the ones that they took in. Federal Reserve policies are helping this go on.

Speaking of inflation, the Federal Reserve announced this past week that it is O.K. with inflation of 2.5%, that in fact the Federal Reserve sees inflation trending toward 3% for the coming years. Some of us who remember back to the Jimmy Carter days when inflation approached closer to 20% than 10% might be tempted to think that 3% inflation sounds pretty good. Keep in mind, though, what inflation means.

Remember what money is. Money is an exchange of promises. I promise that I will give you, say, $100 worth of value, whether my goods, my time, or my services, in exchange for which you give me a certificate—money—that can be exchanged for $100 worth of goods, time, or services with someone else. Money lets me take that promise and put it in my pocket and carry it around to where I think that it will be of most use to me. Money is enormously efficient. I do not work for the grocery store. I work at my job and get paid and then take my money to the grocery store and exchange it for groceries. The store exchanges that money, in turn, for more goods, as well as to pay the salaries of the people who work there. They in turn take that money and use it for what they want.

Inflation makes all of that dishonest. I get paid the $100. If I wait a year to spend it, and there is a 3% inflation rate, that $100 dollars will then only by me what about $97 would have bought when I got paid. Of course, that is an even bigger deal if the inflation rate is 10%, my $100 only being worth some $90 of goods and services in my example. But even 3% can be a very big deal, a far bigger deal than the Federal Reserve seemed to acknowledge this past week.

Consider retirement. Not enough people do, but you should. Perhaps you are an average couple saving and investing and hoping to have a retirement income of say $80,000 per year. You have figured that you can live on that. With an inflation rate of 3%, you had better think again. Your $80,000 retirement income will only be able to buy what $40,000 or less buys today. Setting aside adequate money to save and invest for retirement is hard enough. Inflation makes it all much harder.

Massive government deficits are already driving the Federal Reserve to cheapen the return on your investments (in order to keep the federal deficit from snuffing out the weak recovery). The inflationary pressures that they are building up inside the federal volcano will undermine your retirement even further. The longer we wait to solve the deficit problem, and the interest rate and inflation dangers it spawns, the worse it all gets. Government may not be able to create wealth, but it can surely take it away.

Of Financial Panic and Lessons Learned

Late last month I met with a group of German businessmen. They were on a visit to improve international understanding through cross-Atlantic dialog. As you can imagine, they were most interested in how the economy was doing. The German economy is off to a quicker recovery than is the U.S. economy, but in all fairness the Germans have not had to overcome as much government help as we have (during and following the financial panic of 2008)—although they are very worried about having to swim while being chained to drowning economies like Greece and perhaps others of the European community.

Among the specific issues that they asked to discuss was the question, “Have we learned lessons from the recent world economic crisis?” As I pondered that question, I came up with a list of eight lessons that we perhaps have learned. There are certainly others you or I might add, but here are the eight lessons learned that I came up with at the time, in no particular order of priority:

1. Economic and financial models are not as good as advertised. Much of the financial regulatory program of recent years was based upon the notion that regulators and the firms that they regulated had come up with powerful models to identify how well financial firms and the economy were doing, models that could be relied upon to control the economy. In fact, confidence in models was so high, that policymakers were starting to rely upon them to help predict the future. It turns out that economic reality is far more complex than any models, regardless of how powerful the computers are that run them. Once again we have seen that no group of policymakers, regardless of how smart they are or how much information they have, can control the economy any more than they can control the weather, and we should not fault them for failing to do so. We can only fault them for trying.

2. Fannie Mae and Freddie Mac are not the best run companies in the world. This lesson seems so painfully obvious that it is hard to believe that there was a time when people held them out as examples for emulation of corporate and financial management. But that was their reputation. We now know that the government privileges that they enjoyed allowed them to become sloppy in many crucial ways, especially in the management of their financial risk.

3. The biggest risk to the financial system is regulatory risk. Nearly every one of the financial firms that were strongly “persuaded” by policymakers to take government TARP money suffered market and reputational damage from those investments far worse than any financial challenges that they had. Nearly all of the largest recipients of TARP money paid it back as fast as the Congress and the regulators would let them, at a very expensive rate of interest. While a few have complained of these and other regulatory costs, more would if they were not afraid of the danger of being sent to the cornfield if they did, so they just say that it is “all very good” as their highest new costs today come from government regulations.

4. Economic reality always catches up with you, eventually. By the laws of economics, housing prices cannot long continue to exceed the rate of economic and population growth, but during the housing bubble the myth was that housing prices do not go down, at least not by much and not for long. The same was said about oil prices, by the way, as they grew even faster than housing prices. All came down, and all who believed and acted as if they would forever go up paid for expensive lessons. The same lesson is true today about government deficit spending. In spite of economic reality, too many policymakers act as if there is no limit to how much debt the government can put into the market. That false notion will crash on the rocks of economic reality, eventually.

5. Accounting rules, especially mark-to-market rules, are highly pro-cyclical. Accounting rule makers are on a multi-year crusade to force all companies to value practically everything by what you can sell it for in the market place right now. That means that in times of exuberant markets everything will look great and better than it really is, transferring market manias onto the financial books of companies. It also means that in times of panic, all things will look worse than they really are, accounting rules making sure that panic prices are written onto companies’ financial books. Mark-to-market financial rules were the amplifiers that helped puff up the housing balloon, just as they helped feed the subsequent financial panic.

6. You can hide risk, mask risk, but you cannot avoid risk. All economic growth comes from someone taking a risk. There is risk in whether a new invention will be well received in the market place, or whether a new store will succeed in its new location, or whether the new employees will do a good job, and on and on. There is a natural human tendency to want to harvest the rewards of investment without being exposed to its risks. So people try to get others to take that risk, or try to pretend it is not there, but the risk will be there, and the less obvious it is the less likely that people will take precautions to manage it. The biggest problem from the housing boom was that people thought that building houses and lending people mortgages to buy them were riskless, when in fact they are loaded with risk. A variety of things masked that risk. When it finally asserted itself, people who thought that they had made no-risk investments panicked. The same is happening today with people who invest in “no-risk” government securities. You might be able for a time to hide the risk; you cannot avoid it.

7. Bad underwriting is bad. When a lender decides to lend money he first evaluates the ability of the borrower to repay the loan. That evaluation is called underwriting, it is the lender making the determination that the loan is a good investment. Lenders and others will make mistakes: borrowers will get into unforeseen troubles, their new invention might not work as well as thought, their business might face a new and better competitor, some tax or new regulation might eat away anticipated profits. The lender expects that some small portion of loans will run into repayment problems, and the lender plans for that by setting aside reserves for loan losses. But when the lender does not pay attention to the risks that he can see, then he engages in bad underwriting, and no amount of reserves can absorb those losses. Would we have had a housing bubble and then a housing crash if so many mortgages were not provided to people who could not afford the houses that they were buying? Not enough lenders looked carefully enough into that question.

8. Financial firms cannot long offer products that policymakers and the public do not understand. Recent legislation and regulations are aimed at curbing some of the most successful financial products and practices, largely because policymakers and the public do not understand them. In times of financial turmoil, policymakers look for something to do, and one of the first things that they try to do is stop what they cannot understand. The public is vulnerable to the rants of people seeking to deflect criticism from their failings to products or practices that the public does not understand. The credit default swaps market was one of the few financial markets that worked extremely well throughout the recent financial turmoil, never freezing up while other markets pretty much stopped. As another example, bank investments in the securities markets—other than loans—were an important source of diversified income for banks, helping keep banks afloat when bank loans were suffering heavily from people and businesses that defaulted. Recent legislation and regulations are placing heavy new burdens on these profitable activities, and in some cases banning them entirely, because policymakers do not understand them. Financial firms have to be more active in explaining everything that they do, or they will continue to find many of their newest and best financial activities curbed in times of regulatory fear.

As I say, you can probably add to this list, as could I. As I ponder now the question that the German businessmen put to me, the actual lessons that we have learned seem to me less important than whether we will remember the lessons.

Of Recovery and Renewed Recession

The economic developments up to this early stage of the new year have reaffirmed the resilience of the American banking industry. After more than a year of recession, bank earnings are rebounding. Non-bank financial firms have dramatically declined or disappeared. Government bailout programs have come and gone in rapid succession doing little better than stimulating panic and sowing confusion among customers and investors—and wasting taxpayer funds. The vast majority of banks have survived all of that.

The early recovery of the banking industry this Spring was publicly interrupted by a set of phony stress tests, subjecting banks to evaluation under hypothetical future conditions that not even the Treasury officials who imposed the tests believed to be realistic. That is, they could not be expected to believe in the hypothetical conditions of the tests, since the conditions assumed that the Obama economic program not only would not work but would actually make things worse. For example, the hypothetical stress tests asked banks how they would do if loan losses became worse than at the deepest point in the Great Depression. We all must believe that the Treasury has better hopes than that for its own economic programs.

Even against those unrealistic measures the banking industry came off well. Despite the fear mongering of short sellers, the obtuseness of accounting standard setters, and the vivisection experiments of policymakers, the bank panic is over and the industry is poised for economic recovery.

The sky ahead, however, is not blue and cloudless. There are three major dangers on the horizon that could play havoc with the economy, the banking industry not excepted. The good news is, that all three are subject to government action. The bad news is that government leaders are showing little sign of even recognizing the dangers, let alone taking action to avoid them.

The three dangers are ballooning inflation, rising interest rates, and increased taxes. The three are related. Any one on its own could stifle recovery.

The Federal Reserve has pumped more than a trillion dollars into the economy, increasing the money supply dramatically. With fewer goods and services to buy with all that extra money we would be in a major inflation now if most people and businesses were not instead hoarding the money. Once coffers and savings accounts get full and people and businesses start spending again inflation can be avoided only if the Federal Reserve can mop up all that extra money and do so precisely as it comes gushing out into the economy. Success with such a delicate maneuver may not be impossible, but it would be astonishing.

The chief baggage from Federal Reserve efforts to reduce excess money supply is higher interest rates. High interest rates are both a tool for encouraging people to save their money rather than spend it, as well as a reflection that the program is succeeding in pulling money out of the system. But high interest rates also depress the economy, making business investment (think new machines and buildings) and consumer purchases (including houses and cars) more expensive.

Complicating this nearly impossible task for the Federal Reserve is the problem that the trillion dollar overspending by the Federal Government—well on its way to more than two trillion dollars—will be demanding hundreds of billions of dollars in borrowing from the public just when the Federal Reserve may be wanting to reduce the money supply. Foreigners are showing reluctance to lend to the Treasury, so domestic savers will have to choose more and more among spending their money, lending it to business, or lending it to the Federal Government.

Treasury debt auctions have already been soft. Interest rates are creeping up to keep Treasury debt attractive. The Federal Reserve may soon be stepping in to buy Treasury debt to keep the auctions from collapsing. If the Federal Reserve did so, it would be pushing more dollars into the economy just when it needed to pull them back to hold off inflation. The Federal Reserve would be in a no-win situation, and so would the rest of the country.

We could overcome both inflationary and interest rate risks to the economy by dramatically reducing taxes, particularly taxes on capital gains—making investment and new business activity more attractive by letting people keep more of what they earn. Instead, the Obama administration is proposing a host of major new taxes. Some are hidden as part of new environmental and health care programs. Others are more overt, such as plans to raise taxes on businesses and the wealthy, the very sources of job creation and investment.

The Franklin Roosevelt administration well earned the condemnation of history by taking a deep economic recession and making it last for a decade—encouraging enemies of freedom all around the world. President Obama would do well to avoid that example.

Of Bubbles and Treasury Debt

Over the last decade our economy has been buffeted by what appears to be an accelerating series of economic bubbles. It is more than coincidence that this has occurred while government interference in the economy has increased.

That is not to deny that free markets are fully capable of producing economic bubbles, as market participants miscalculate investment risks and rewards and copy-cat each other as they do so. These market participants, however, if left to their own devices will also pay the price for their mistakes. Knowledge that they are at risk acts as a moderator and corrector, limiting the degree of risk investors are willing to take in the first place (and the willingness of lenders to provide money to support the bubble), and leaving the way clear for other investors to come in and pick up the debris (at a profit) when the bubble bursts.

When government is involved non-economic factors are inserted into the calculation of risk, and they affect who pays for the risk. With the existence of federally-supported mortgage guaranties, investors paid very little attention to whether mortgage lenders verified the ability of borrowers to make payments. A government guaranty always means that risks will be undervalued and that someone else (usually the taxpayer) gets to pick up the tab for the miscalculation.

It is neither exaggeration nor hyperbole to recognize that for more than a year the government has been handing out guaranties at a rate never before seen in the history of mankind. That is to say, that mountains of financial risk miscalculations have been made and are being made every day, and the unavoidable consequences are accumulating.

Perhaps the most dangerous miscalculations are those involving the debt issued by the U.S. Treasury. Investors are mistakenly acting as if there is no risk in placing their money in Treasury securities. These investors overlook the risk that buying Treasury securities--with an effective interest rate of 4 one-hundredths of one percent (the rate last week for 1-month Treasuries)--puts investors at risk if interest rates rise even a little bit and exposes the investors to even mild inflation.

Inflation is unlikely to remain mild. Along with all those government guaranties there has been a mountainous accumulation of new money provided by the federal government. All that money has to go somewhere. Right now it is awaiting some slight shock to send it avalanching down on the economy. Much of that money is for the moment being hoarded by investors and businesses afraid to spend it or put it to work while economic prospects remain unsettled and policymakers keep confusing the markets with one economic policy, regulation, restriction, or plan after another. No one wants to play the game while the referees are adjusting the rules.

So the government money makers keep pushing more money out to fund investment even while they toy with new disincentives to investment. People park the money instead in bank deposits (which are growing at record levels) and Treasuries (driving Treasury interest rates down to almost nothing).

That will not continue. At some point, the willingness of investors to hold dollars in accounts earning practically nothing will have played out. They will get their fill of Treasury securities. Foreign investors are already there, in recent weeks reducing their holdings of U.S. Treasury debt. Treasury interest rates will have to rise to attract investors, but as Treasury interest rates rise those who invested in Treasuries at very low interest rates will be on the losing side of their investment. They will start unloading their Treasury investments, further driving Treasury prices down and interest rates up, causing even more losses to those who invested in recent months in the Treasury bubble.

The spiral will be hard to stop, particularly as the Administration will be desperately trying to borrow more money, unheard of new amounts of money, to fund their planned multi-trillion dollar deficits. Interest rates will have to go up very high very fast in order to fund that voracious new appetite of the government for debt. The high interest rates will choke off many new sparks of economic recovery, leaving a lot of money around chasing after fewer goods and services for sale.

The Treasury bubble will likely end in a race that we have not seen for more than a quarter century. The race will be on for which will go higher, inflation or interest rates.

Of Presidents and Training for the Job

There are some jobs you just cannot safely do without proper training and experience. Flying an airplane is one that comes to mind. Driving a bus is another. I would put being President of the United States in the Twenty-First Century on the list, too.

President of the United States was a tough job in the days of George Washington. It was even a challenge in the days of Millard Fillmore. It has not become any easier in recent years, and next year it will be a very big job. Considering the global responsibilities of the United States, with several irresponsible oil-drunk regimes threatening peace and freedom (ours and other’s) around the world, can we afford to enroll our new President in a foreign policy on-the-job-training program?

Economically as well, there is little room for error. So far we have gone through a year and a half of the housing market bust without falling into a recession. But our economic growth is anemic. A small false step or two can put us into a full-blown economic decline, exploding banking and financial markets that will then take years to recover. It is important that economic policy next year be led by someone who understands economic growth and how to promote it. The formula for growth—low taxes and steady prices—is well known to those who have learned the lesson; we do not need a novice who does not have enough experience to know that you cannot tax and spend your way to prosperity. We cannot afford his experiments with our jobs and livelihood.

That is why it is breathtaking that a major political party is on the verge of nominating for President someone so inexperienced as Barack Obama. I am unable to recall a single nominee for President, by any major party, less prepared for the office than Barack Obama. Really, there is the challenge for you. Name a nominee—Republican, Democrat, Whig, Federalist—less prepared than Obama.

Barack Obama likes to liken himself to Abraham Lincoln. I cannot claim to have known Abraham Lincoln or assert that he was a friend of mine, but I do say, Barack Obama is no Abraham Lincoln. Even liberal exaggerations of Obama’s undistinguished career cannot make it compare favorably with the long and grueling life experiences that schooled Lincoln for the White House.

In short, Obama does not have the training for the job. It may be that the Democrats’ talent pool is so thin that he will be nominated. But the job of President is too important—to all of us—to be extended to someone so unready.