While it will probably take a few years for the economy to fully recover from the recession of 2008-9, the financial crisis that deepened it and threatened another great depression has passed. With the benefit of hindsight we now have a clearer picture of its causes. Inappropriate government policies and regulations incented and permitted economic agents to undertake too much risk with borrowed money. Following is a big picture overview of what happened and how to “fix it”.

Macro Factors – Global Imbalances

For a variety of reasons, many countries chose to keep their exchange rates low enough relative to the U.S. dollar to facilitate the growth of their export sectors or to accumulate larger foreign exchange reserves (the foreign currency assets owned by central banks with which they can finance temporary external deficits and defend the external value of their currency[1]).

Many developing countries following the earlier example of Japan have adopted
an export lead strategy for development. For some this strategy took the
healthy form of removing trade restrictions that allowed the growth of both
imports and exports subjecting their economies to greater competition and
promoting greater efficiency and productivity. But some, such as China,
promoted exports at the expense of imports. These countries set their exchange
rates (explicitly or via foreign exchange market intervention by their central
banks) below levels that would produce balance between imports and exports.[2]
To prevent the resulting inflow of surplus dollars from depreciating their
currency’s exchange rate in the market, the central banks of these countries
intervened to buy the excess dollars (often sterilizing the domestic monetary
consequences of such intervention to prevent inflation). The result was an
increase, and often a very large increase, the foreign exchange reserves
(ownership of U.S. dollar assets) of these countries.

In some cases, countries wished to increase their foreign exchange reserves for sound prudential reasons. Following the Asian financial crisis of 1997, many Asian countries thought that the conditions imposed by the IMF for its temporary balance of payments financial assistant were too harsh. In order to avoid them, they determined to increase their reserves to levels that would avoid the need to borrow from the IMF when their exchange rates were under attack.

For these and other reasons many countries ran international trade surpluses that greatly increased their foreign exchange reserves. The surpluses of some countries must be matched by the deficits of others. Thus the result of the build up of reserves (largely investments in the United States—largely U.S. government securities) in China and other surplus countries has been an inflow of capital into the deficit countries (largely the U.S.). [3]

Under the gold standard, the international reserve asset was supplied by nature.[4] Under our current system the U.S. dollar is the dominant reserve currency and it is supplied at the discretion of the Federal Reserve, America’s central bank. For other countries to obtain dollars on net the U.S. must have a balance of payments deficit. Under the gold standard, increases in the world’s demand for reserve assets (gold) would increase the price of gold (as its supply is limited by nature) and would produce worldwide deflation.[5]

Under the current dollar standard, the world’s trade surpluses are invested
(largely) in the U.S. The U.S. money supply is not affected, but the demand for
U.S. securities is increased lowering interest rates in the U.S. If surplus
countries have fixed or targeted exchange rates, their central bank must buy
the surplus dollars thus increasing their domestic money supplies. Sterilized
intervention to defend exchange rates is very expensive.[6]

Large global trade imbalances of recent years have lowered interest rates in
deficit countries and when combined with the Federal Reserve’s policy of
domestic price stability in the U.S. (avoiding deflation as well as inflation)
have flooded the world with liquidity. Very low interest rates and excessive
liquidity fueled asset price bubbles, including the real estate bubbles in the
U.S., U.K., Spain, and a number of other countries.[7]

This is the macro environment that fueled other factors that facilitated
excessive risk taking by banks and other financial institutions.[8]

Micro Factors—Excessive Leverage

After centuries of little change, commercial banks have changed dramatically over the last three decades. Traditionally banks took deposits from the public, provided payment services for their depositors using those deposits, and made loans financed by those deposits. Over the last fewdecades, banks increasingly financed loans with borrowed funds, replaced liquid and safe government securities with riskier assets on their balance sheets, and undertook other speculative (trading) activities. They also moved their riskiest assets off their balance sheets into special purpose vehicles and other structured finance products. In short, banks enormously increased their leverage and significantly increased the riskiness of the assets and positionsthey held on and off their balance sheets. Why did this happen?

Several factors combined to shift the balance of risk and return sought by many but not all banks in the U.S. and in many other countries. Adrian Blundell-Wignall and Paul Atkinson, in a very insightful article in the Journal of Asian Economics[9] set out four primary factors: “(i) capital rules and tax wedges set up clear arbitrage opportunities for financial firms over an extended period—these were policy parameters that could not be competed away as they were exploited. Instead they could be levered indefinitely until the whole system collapsed;
(ii) regulatory change permitted leverage to accelerate explosively from 2004;
(iii) systemically important firms in banking with an equity culture emerged;
and (iv) cumbersome regulatory structures with a poor allocation of
responsibilities to oversee new activities in the financial sector were in
place.”

The complex and badly flawed U.S. tax code, with different rates for different people and circumstances, created the possibility to reduce taxation on a given underlying income stream (e.g. a mortgage) by shifting it to investors and/or forms that received more favorable tax treatment through the construction of complex financial derivatives. The tax saving was largely enjoyed by the financial engineers creating these complex financial instruments, with little to no gain for the economy. Modern computers significantly lowered the cost of constructing and monitoring these complex financial instruments, further increasing their attractiveness.

Basel II permitted reductions in capital for mortgage related investments while closing some regulatory holes created by off balance sheet activities of covered banks. Anticipating these changes many banks effectively reduced capital charges to their future Basel II levels by moving them off balance sheet starting in 2004. Some ill advised regulatory changes by the SEC in the U.S. allowed American banks to greatly increase leverage toward the more lax European levels. When combined with accelerating real estate prices in the U.S., and some other countries, some banks increased their leverage and the riskiness of the assets they held significantly. The question remains, why bank shareholders and management accepted to do so.

For the United States, a major factor was the increased dominance of the “equity culture” over the “credit culture” in banks, following the adoption of the Gramm-Leach-Bliley Act of 1999, which allowed the merging of investment banks with commercial banks.

Banks’ deposit customers want a safe place to keep their money and convenient ways to settle (pay) financial obligations with that money. Small savers want safe term deposits with modest, risk free interest rates that can be easily withdrawn when needed. Bank’s accommodated those preferences by lending modest amounts to its depositors or to credit worthy businesses with good track records or collateral. For centuries, bank owners understood the nature of the banking business in this way and expected modest but steady returns on their investment. Blundell-Wignall and Atkinson refer to this as the “credit culture.”

Investment banking has a very different culture. Investment banks earn fees for facilitating complex financial deals and for managing customer funds who generally have a much higher risk tolerance than do typical bank depositors. Investment banks also trade and invest their own fund. The risk preferences of investment banks and their customers tend to be high in pursuit of high returns. While the repeal of the depression era Glass-Steagall Act, removed some harmful restrictions, such as the prohibition against interstate banking, it also removed the barrier between investment banking, commercial banking and insurance. As the risk taking equity culture of investment banking mingled with the conservative credit culture of traditional bankers, risk preferences and standards in many banks shifted toward the equity culture. Conversations with Citibank employees confirm a dramatic change in the institution’s attitude toward risk taking over the last decade as its management was taken over by investment bankers.

The extensive use of bonuses in preference for higher salaries is also more typical of the equity-investment banking culture in which the risks and rewards of performance are shared with employees. From an investment banking perspective, the tax and regulatory arbitrage opportunities of poorly designed tax laws and regulations called for and justified as much leverage as they could get away with. The risks seemed small and the return large if highly leveraged as long as real estate prices kept rising.

Reliance on functional regulation, which certainly has its merits, left cross-functional risks uncovered. ‘‘Multiple specialized regulators bring critical skills to bear in their areas of expertise but have difficulty seeing the total risk exposure at large conglomerate firms or identifying and preemptively responding to risks that cross industry lines.’’[10] Market self-regulation was weakened by the lax enforcement of underwriting standards by agents and brokers who earn fees for concluding deals but have no skin in the game (no financial stake in the ultimate outcome – repayment—of deals). Compliance with already low underwriting standards was sometimes fraudulently ignored or misreported. But the combination of these weaknesses with the presumption of many players that because the government was promoting increased home ownership and the lower mortgage underwriting standards needed to qualify more marginal borrowers, the government would stand behind its policies and bailout participants if they incurred losses. The expectation of many that they could keep large profits from risk taking and pass on the losses to tax payers proved all to true in the end. Obviously, greater risks were logical in this environment.

The way forward

Economic fluctuations and bubbles have always existed and will continue to exist. However, greater central bank sensitivity to its contribution to asset price bubbles should be able to avoid bubbles as large as the recent real estate bubble. Beyond that, excessive risk taking can be reduced in the future by removing the tax and regulatory arbitrage opportunities that reward it[11] and by strengthening corporate governance so that bank owners have more control
over the salaries of and risks taken by management. Filling some of the
regulatory gaps will also help. The moral hazard impetus to excessive risk
taking exacerbated by government bailouts over the past two years will be difficult to overcome but extending the failing bank resolution powers the FDIC now has for banks (bank bankruptcy laws) to a broader range of financial institutions and requiring firms to develop resolution plans in advance will help. Similarly removing artificially low costs of funds to firms viewed as “too big to fail” with appropriately higher capital requirements will also help restore market discipline of excessive leverage and risk taking. Blundell-Wignall and Atkinson provide an excellent summary of an exit strategy and reformed system needed in the future. I want to focus, however, on the nature and scope of commercial banking itself.

The fractional reserve banking system, which allows banks to lend the money deposited with them, provides commercial banks with their great efficiency as well as fragility and potential instability via bank runs. It has long been the source of much discussion. Strangely perhaps, some strong free market advocates have proposed extreme regulation of commercial banks in the form
of drastically limiting what they may do with deposits. Narrow banking, for
example, would forbid banks to lend, limiting them to investing depositor’s
money in liquid and safe bonds or bills (e.g. marketable government debt). The
deposits of cash with mobile phone companies in Kenya and Afghanistan that can be transferred to other mobile phone customers as a convenient, low cast way to pay bills or transfer cash have a similar restriction. One hundred percent of the deposits with the phone company must be deposited by the phone company with banks. Credit Unions operate under somewhat less strict regulations that allow them to lend to their own, member depositors. Others have advocated what might be called mutual fund banking (as opposed to the “par value” banking we now have), in which depositors acquire a share in the bank’s assets rather than the right to withdraw the amount they deposited[12].
In that regard it is like a normal mutual fund against which checks may be
written for whatever the current value of the depositor’s share of the bank’s
assets are. Mutual funds can lose money but cannot go bankrupt (unless they are allowed to leverage investments). The severity of these regulatory restrictions is accepted by their advocates in the interest of clear, rule-based arrangements within which the banks could operate freely and safely.

While these proposals have some merit, they are extreme and in my opinion unnecessarily restrictive. A more moderate proposal is to restore some version of the separation between commercial banks and other forms of financial services contained in the Glass Steagall Act.

Mervyn King, Governor of the Bank of England, stated the
problem recently as follows: “Why were banks willing to take risks
that proved so damaging both to themselves and the rest of the economy? One of
the key reasons – mentioned by market participants in conversations before the
crisis hit – is that the incentives to manage risk and to increase leverage
were distorted by the implicit support or guarantee provided by government to creditors
of banks that were seen as “too important to fail”. Such banks could raise
funding more cheaply and expand faster than other institutions. They had less
incentive than others to guard against tail risk. Banks and their creditors
knew that if they were sufficiently important to the economy or the rest of the
financial system, and things went wrong, the government would always stand
behind them. And they were right…. It is hard to see how the existence of
institutions that are “too important to fail” is consistent with their being in
the private sector….

“The banking system provides two crucial services to the rest of the economy: providing companies and households a ready means by which they can make payments for goods and services and
intermediating flows of savings to finance investment. Those are the utility aspects of banking where we all have a common interest in ensuring continuity of service. And for this reason they are quite different in nature from some of the riskier financial activities that banks undertake, such as proprietary trading. In other industries we separate those functions that are utility in nature – and are regulated – from those that can safely be left to the discipline of the market….

“There are those who claim that such proposals are impractical. It is hard to see why. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”[13]

Medicare and Medicaid created hug transfers of wealth from
the younger to the older generation. But the elderly on average are much
wealthier than the young. How can we justify taking from the poor to give more
to the wealthy? Throughout history parents have sacrificed to provide a better
life for their children. This generation of old people are demanding the
opposite.  America spends more than
twice as much on health care as European countries (the next highest), with
poorer health results. But the problems will get much worse.

To be clear, the health care debate now underway in the U.S.
is not about government provided medical care. No one has proposed that the
government hire doctors and provide care, as in Britain, for example. The
debate is about the government’s role in regulating the private provision of
healthcare and healthcare insurance. Some, but not all, democrats also want to
expand government provided health insurance now available to the elderly and
the poor (Medicaid and Medicare), to the general population so that it competes
with private insurance. We should also be clear that the insurance debate
largely concerns those who have not saved and or provided adequately for their
own insurance. The debate is about what financing the government, i.e.,
taxpayers, should provide and how it should be provided.

The full scope of the problem can only be understood when we
take into account the aging of America’s (and the world’s) population. In 1955
every retired person receiving social security benefits had 8 workers to pay
the tax that financed it (SS is a pay as you go system, it is not a fully
funded savings system in the manor of a private pension). Today there are only
3.3 workers who are and can be taxed to subsidize the elderly who did not
provided adequately for themselves and the Social Security Administration
estimates that the number of workers to support retired beneficiaries will drop
further to 2.1 by 2031. It will simply not be possible to raise taxes enough on
the young to deliver the same level of benefits the elderly now receive. The
medical services for the elderly paid for by tax payers will need to be more
carefully prioritized and limited. The elderly—my generation and older—who resist
this reality are fighting to place an even heavier burden on the backs of our
reduced number of children. Their backs will break. The world has turned upside
down.[1]

Europe has proved that you can get more for less than we do.
Europe’s approaches are diverse and none are necessarily appropriate for us.
The mess our system is in largely reflects incentives that encourage waste.
These incentives need to be changed. Doctors are paid more for doing more
whether it is medically needed or not. As much or most of the bill is picked up
by insurance (government and or private), neither the patient nor their doctor
has any incentive to make wise economical choices. Thus rationing service covered
by insurance must take the form of rules for coverage given by the insurers.
Malpractice litigation adds to the incentives to over test and over provides
services.[2]
The tax subsidy to employers for providing health insurance reduces our choices
of insurance policies (limited options are chosen for us by our employer),
makes it harder to change employers and throws us to the wolves if we become
unemployed. President Obama wants to remove some of that subsidy for the more
expensive insurance options. However, tax deductibility of employer provided
health insurance should be eliminated totally or the same tax treatment given
to individuals who buy their own insurance. The government should remove many
of the other restrictions it has imposed that impede competition among
insurance providers (e.g. mandates and limits on shopping across state lines).

And we elders, I am over 65, must stop embarrassing
ourselves and stop demanding that our poor children give us more of their
incomes to cover our failure to provide for our own insurance. In fact, we must
accept less as part of the overall reduction of huge medical services waste.

Someone sees hope that we might actually have a rational
debate about fixing/improving our health care system. I hope so. We can’t afford
to pay more so we had better find ways to get more for what we pay.  See Steven Pearlstein, "Behold,
a National and Rational Conversation on Health Care" The Washington Post, August 12, 2009,
Page A14. 

My March 19 and 23 blogs on AIG Bonuses hit many nerves. It is a difficult and sensitive topic. Today’s Washington Post has two excellent follow up articles on the subject that I highly recommend to anyone interested in that topic. Just click on the titles.

Brady Dennis and Tomoeh Murakami Tse,  “Pay Czar Quietly Meets With Rescued Companies”, The Washington Post, Sunday, August 9, 2009, Page A01.

Amity Shlaes, “A Better Umpire for Corporate Pay” The Washington Post, Sunday, August 9, 2009, Page A17.

My debate in Las Vegas whether to abolish the Fed: 

http://www.c-spanarchives.org/library/index.php?main_page=product_video_info&products_id=287860-1

 

I would like to share two quick thoughts with you that fall
under the heading of Unintended Consequences.

 

Sectarian strife in
Iraq: Late Monday I attended a presentation at the New America Foundation
by Wadah Khanfar, the director general of the Al Jazeera Network (the Arab TV
news network headquartered in Qatar, now with an English language channel). He
is a very interesting and impressive guy. His first observation was to totally
refute the nonsense that Muslims, Arabs or Arab Muslims dislike American values
of liberty, respect for the individual, religious freedom, etc. (it’s the
policies stupid).

 

Mr. Khanfar was the Al Jazeera bureau chief in Baghdad
during America’s invasion of Iraq. At Monday’s presentation he was asked if Al
Jazeera had a Sunni or Shia bias in its Iraq reporting. He replied that Al
Jazeera has strict, professional reporting standards and does its best to
adhere to them. He noted that in 2003 he and his fellow reporters did not even
know whether public figures in Iraq were Sunni, Shia, Christian, Jewish or
something else. Only when the U.S. designed elections requiring a balance of
religious group representation on slates of candidates did these officials need
to state their religious affiliations, thus bringing that issue into public
focus—the opposite of the intended purpose. You can see his entire presentation
here: http://www.youtube.com/watch?v=thg0owasbLw

 

Executive pay and
corporate governance: A cornerstone of capitalism is the belief that the
desire for profit by owners will maximize the prospects over time of capital
being allocated to the uses most wanted by consumers. Long-run profit
maximization is a good thing. Venture capitalists deliberately take large risks
for potentially big gains knowing that they will often fail, but it is their
money they are risking. Owners (shareholders) of established companies are
generally interested in the long-run survival and profitability of the firms
they own and are thus less interested in short-run gains that jeopardize the
long run profits of these firms. If paying high prices for the best talent
contributes to the prospects of greater profits over time, owners will want to
do so.

 

This characterization of capitalism is hard to reconcile
with the rules of corporate governance we now have in the U.S. “New York
Attorney General Andrew M. Cuomo reported that the nation’s nine largest banks
handed out $32.6 billion in bonuses last year even as they ran up more than $81
billion in losses and accepted tens of billions of dollars in emergency federal
aid.”[1]
Do such bonus rules reflect the judgment of owners of how to maximize profits
or the exploitation by management of short-term rents at the expense of
owners?  It may shock you, as it
did me, to learn how little owners can control the remuneration of those who
manage the firms they own.

 

“’Under this bill, the question of compensation amounts will
now be in the hands of shareholders and the question of systemic risk will be in
the hands of the government,’ said Rep. Barney Frank (D-Mass.), who leads the
House Financial Services Committee and who authored the bill.”[2]
Among other things the “bill also gives shareholders the right to reject a pay
package, but their vote would be
advisory.”[3] I always
thought that they had the full authority to approve pay packages. This is
shocking. Corporate governance rules need to be strengthened more than Barney Frank’s timid bill to put owners in
charge of managers.

 Like most things, the use of medical services must be
rationed. But who should do the rationing?

All things that are desired and cannot be provided without
cost (as we used to say about air) must be rationed. This is exactly what
markets do by discovering the price at which buyers are not willing to pay more
for more and producers/sellers are not willing to provide more at that price.
This market-clearing price has the interesting property of maximizing the value
(utility) of each person’s income because a reallocation of that person’s
spending would result in having more of things less valued and less of things
more valued. If you spend more on one thing you will have less income with
which to buy other things (what economists call the budget constraint). Each
person’s tastes and choices are different but each person can satisfy this
utility maximization goal in a free market by tailoring the mix of her
purchases to her own tastes. In short, the market-clearing (equilibrium) price
maximizes the value of each person’s income for each person. Why in the world
do they call this the dismal science?

While I know very little about the health industry, it is
obvious that the necessary rationing of medical services if we are to get the
best value from our incomes faces some challenges. The share of GDP going to
medical care in the U.S. has reached over 16% and is still climbing. This is at
least twice the level of spending of other developed countries, but the result
is not healthier Americans on average. For example, infant mortality rates in
the U.S. are about 40% higher than those in other high-income OECD countries
(World Bank data).

If medical care is provided to users free of charge (i.e. if
someone else pays the actual cost of producing it), those users will consume
medical services until the marginal value of an additional amount is zero (even
though the actual cost is far from zero).
Such users have no need and thus no incentive to restrict (ration) the
medical services they consume in order to save the income for something else
they value more. If insurance pays the full cost of all medical services, the
consumer, at the margin, is getting them free. This is why co-payments are now
usually required and serve the useful purpose of returning some incentive to
the consumer to ration services more carefully (e.g., should you ask for a
simple blood test or a much more expensive comprehensive one?).

If consumers don’t pay, other mechanisms for rationing are
required if gross over provision of medical services is to be avoided and it is
obvious that the escalating costs of such services (without a commensurate
increase in benefits) arise in part for this reason. Insurance companies
themselves ration by establishing what they will pay for and how much they will
pay for it. Ideally consumers would choose insurance plans that ration in ways
that match their own preferences as closely as possible. However, competition
among insurance providers over such cost/benefit decisions is limited by the
fact that since World War II employers have generally provided health insurance
to their employees (because the government subsidizes employer provided
insurance by exempting that form of employee remuneration from taxation). Thus
the employers rather than the actual consumers of medical services decide which
insurance plans to provide. This restricts competition among insurance
companies to provide the mix desired by consumers. Employer provided health
insurance also makes it harder for workers to change jobs and increases the
hardship of unemployment because it also result results in the loss of
insurance coverage.[1]  A national Insurance Exchange through
which everyone could chose competing insurance programs, as is now being
considered, would also increase competition for insurance plans.[2]

One problem with insurance (including Medicare) deciding how
to ration services is that they often do not know as well as trained and
experienced doctors which services (treatments, medications, and technology)
are most cost effective for each situation. So if consumers have little
incentive to ration, maybe doctors should make such decisions for them. Indeed
they are surely the most knowledgeable for making good judgments about the medical
services that are most appropriate and cost effective and in fact we rely
heavily on their judgments in this area. Unfortunately, doctors have several
strong incentives to over supply expensive services. Most doctors in the United
States are paid on the basis of the tasks performed (fee for service) rather
than on the basis of the services rendered (treating pneumonia, or setting a
broken bone) or the results of their efforts (curing a back pain). The more
they do the more they are paid whether they make the best choices or not. Some
medical practices, such as the Mayo Clinic have obtained good cost containment
with high quality service by making their doctors employees rather than paying
them fees for services. If the Mayo Clinic, or Doctors Inc. charge a fixed fee
for treating a particular ailment, they have an incentive to find the most cost
effective ways of doing so for each patient. But then they might have an
incentive to cut too many corners to save money.  HMO’s are another approach to rationing in an effort to deliver
good service at a reasonable cost. They have been unpopular with many people,
but might be the best choose for some if offered as one of many options.

The oversupply of services by doctors has another cause as
well. American malpractice liability laws encourage lawsuits by offering very
large damages, sometimes in cases of reasonable judgments that proved wrong.
Malpractice insurance, often costing individual doctors several hundred
thousand dollars per year, has added considerably to medical costs directly. But
the threat of such suits has also added considerably to such costs indirectly
(with no real benefit) through the defensive, over use of extensive diagnostic
tests by doctors to ensure that they are protected from nuisance lawsuits. Most
professional practitioners (lawyers, engineers, directors, etc.) are protected
from such suits if they have adhered to established norms (protocols) of
decision making even if in retrospect their decision was wrong or not the best.
Reform of malpractice law for medicine along similar lines is needed.

Individual doctors rely on medical boards to establish
protocols for what is best practice in treating each disease and condition.
President Obama wants to establish professional boards to set such standards
for insurance coverage and to evaluate and propose the most cost effective
treatments. It is clear that individual doctors do not have the time and
resources with which to do so and still practice medicine. The American Medical
Association develops such protocols, but it also restricts medical practice in
ways that limit competition among doctors and techniques (e.g., phone or
internet consultations across state lines). As with other services, progress
comes from competition and experimentation. If doctors can never try new
techniques or technologies because they are dealing with human beings, medicine
would be frozen where it is (or where it was).

All of the above reflect failures or weaknesses in
traditional market rationing of medical services. They have contributed to the
high cost of these services in the United States in relation to the quality of
these services. In some cases services are expensive but produce superior
results (new medicines and machines) but in many cases they are wastefully
expensive without providing better results. As in other areas of providing
goods and services, financial and other incentives need to be properly aligned
to provide the best serve at the least cost, which is the level of service and
related cost desired by each consumer from the offered options. And all
services need to be competitively provided (insurance, doctors, labs,
hospitals, etc.). Currently medical services are not being properly rationed. I
wish I knew the answer to the best way forward. Generally the best approaches
result for experimentation and the survival of the best in the market place.
Medical care to too regulated for this traditional approach to work well, but
keeping in mind the importance of getting the incentives right will be part of
improving our system of delivering medical services in the U.S.

I have noted on several occasions (most recently “State Ownership of Businesses) the growing threats to America’s economic productivity of ever greater government involvement in the economy. This productivity is the basis of our high standard of living and of our influence in the world. It is almost impossible for the government to get involved, especially as a shareholder without replacing commercial judgment and considerations with political considerations. Rather than better goods and services at lower prices we get more expensive goods that provide employment or profits for the benefit of a congresswoman’s constituents at tax payer expense. Today’s Washington Post has an article that so clearly illustrates this corrosive danger that I must pass it on: "Time to Click and Drag Car Sales into the 21 Century". The government’s involvement in the economy reduces its productivity but of equal if not greater importance it erodes the integrity of government.

On Friday in Las Vegas I debate whether we should get rid of the Federal Reserve as part of FreedomFest. If interested, you can see it on C-SPAN.

Best wishes,

Warren

Whatever you think about the necessity of the various government bailouts of banks, insurance companies, investment banks and now auto makers, we should all clearly recognize the inevitable consequences of state ownership and thus ultimately control of enterprises. When governments own enterprises, they have an obligation to the tax payers to ensure that their oversight of the companies they finance serves the public interest. History is full of examples of how this has worked out in practice around the world—bloated work forces (how can a caring public official say no to unemployed relatives); thus high cost, uncompetitive outputs; misdirected investments (how can a caring public official say no to constituents in his home town); thus low productivity and losses; thus lower growth and per capital income—but our Congress has wasted no time in demonstrating how it works.

 

This morning’s Washington Post reports that "Lawmakers Chide Automakers Over Dealership Cuts". Surely no one imagines that Congressmen have better judgment about the contribution to the profits and thus the financial viability of GM of its dealer franchise arrangements than GM does itself. Congressmen are responding to the complaints and pressures from GM dealers in their congressional districts. Why would these dealers go to their congressmen to try to pressure bankrupt GM to give them a better deal with tax payers’ money? Well, of course, because the U.S. government and thus Congress now own a significant share of GM and thus have a say in its business decisions. You might hope that your congressman puts the national interest first (the restoration of a viable profitably GM), but you will generally be disappointed (unless you are a GM car dealer). It is our representative’s local congressional district voters who put and keep him/her in office and whose interests must come first. This is the nature of and the way government works and is one of the many reasons it should not own enterprises.

In yesterday’s Post Steven Pearlstein gave one of many specific examples of this behavior: “For sheer hypocrisy, however, you can’t beat Republican Sen. Bob Corker of Tennessee. Last November, Corker took to the Senate floor to denounce the Bush administration’s proposal for bailing out domestic auto manufacturers, saying it didn’t force the companies to do enough to restructure their costs and their operations. Among his big concerns: oversize dealer networks that prevented even the strongest dealerships from making a decent profit.

“Fast forward to today, as Chrysler and GM are finally undergoing the radical downsizing and restructuring that Corker had long demanded. And what does Corker have to say about that? He’s outraged at the way the discontinued dealers have been treated and is pushing legislation to ensure that they get at least six months to wind down their operations and receive full refunds from the automakers for any unsold cars or parts.”[1]

From across the isle Rep John P. Murtha (D-Pa) says it all (in connection with his investigation for favors to and from the “military industrial complex?): "If I’m corrupt, it’s because I take care of my district."[2]

When President Bush first proposed bailing out GM and Chrysler, I argued that if they could not raise the money they needed in the market they should seek the protection of bankruptcy, which provides a well defined and orderly process for restructuring (if warranted) under Chapter XI. A year later both have declared bankruptcy, but the new Obama administration has managed to make mush of the legal bankruptcy process (e.g. treating junior creditors better than senior credits[3]) further politicizing our economy and eroding the rule of clearly defined property rights, which provide the basis on which investors act. I still have confidence that most policy makers of both parties understand the risks of moral hazard and the importance of incentives in guiding behavior, but if they ever get out of hole they dug in crisis mode to start rebuilding a sounder long run, they will have many steps to climb to get out of the policy mess we are in. But for the sake of the country we need to reclarify what should be rendered unto Caesar and what is ours.

Our defense budget, like any other budget, is finite. Our resources are limited. To get the maximum value from limited reserves, their deployment must be carefully directed and prioritized.

Defense Secretary Gates, along with the Secretary and the Chief of Staff of the Air Force, want to end production of the F22 in order to shift limited resources to other more pressing needs. "The Air Force’s top two leaders explained … that … they couldn’t justify spending billions more on stealth fighters when other higher service priorities exist and money is tight. The $13 billion for the 60 additional fighters could be better used to repair the service’s nuclear enterprise, ramp up its unmanned aircraft fleet and better fight irregular wars.”[1]

I cheered when I read this and said to myself, we will now see how deeply the military industrial complex President Eisenhower warned us about is entrenched in defense policy making, just as Wall Street is currently demonstrating its power to influence the government’s financial policy (and what a mess that is). Lockheed Martin and Boeing have scattered their F-22 plants widely around the country, but “strangely” concentrated them in the states of the congressional members of the defense appropriations committees. This has nothing to do with economic efficiency and everything to do with political support for keeping the money coming.

“Lockheed Martin Corp. is lobbying the Obama administration to purchase additional F-22 fighter jets by arguing that continued production of the plane would preserve nearly 100,000 jobs across the country, including 19,500 in California…. The F-22 program is directly responsible for 25,000 jobs at Lockheed and its major suppliers. But Lockheed officials say when jobs from sub-suppliers are added in, the F-22 program maintains 95,000 jobs in 44 states.”[2]

Shame on Lockheed. If jobs were the reason for keeping up the production of the world’s best jet fighter (designed to out maneuver Soviet Migs), we would do better (and for less) to hire several million people to sweep streets with brooms. But it should be obvious that the nation’s output available to be shared around and consumed one way or another, not to mention the nation’s defense capability, would be much less in that case. So “jobs” is not the right criteria for choosing the government’s expenditure priorities. In the case of the military budget, the goal should be to produce the maximum defense possible from a given level of expenditures (determined by defense needs relative to the needs for other government services and the fact that the more government takes from us in order to provide these services the smaller and weaker our economy, which builds these things, will be). Budgets are about priorities, and trade offs, and hopefully efficiency.

The private market produces efficiency by forcing low priority and/or inefficient producers from the market, thus freeing up the resources (including workers) they used for better things. Fortunately, the government is demanding increased efficiency from GM and Chrysler as a condition for the injection of additional taxpayer money. This means fewer jobs at GM and Chrysler as the price of the prospect to survive (eventually) on their own. It was a mistake (by the Bush administration) for the government to interfere in the first place rather than to allow the existing tools of bankruptcy to clean up and restructure these firms if need be, but at least Obama has drawn a line in the sand on the use of additional tax payer bailout money (at least with regard to GM and Chrysler).

We are a wealthy nation, able to support the strongest military in history AND to enjoy a very high standard of living for the average person, because each person is able to produce a lot. This results from the very careful allocation of our resources (people, capital, and technology) to their most productive uses (minimizing the number of people needed for each activity so that they may engage in other activities thus increasing our overall output). With changing tastes and technologies this needs to be a very dynamic process. If the jobs to produce no longer wanted products are artificially preserved, the value of our output will decline.

The profit incentive of the private sector rewards good resource allocation decisions and punishes poor (or unlucky) ones. Government is needed to establish and enforce reliable and predictable rules of the game for private interaction, but government over reach can undermine the virtuous workings of the profit incentive in competitive markets. Competition and consumer sovereignty in the private help direct man’s natural greed (i.e. self interest) toward the social good and help keep it in check. Government has a more difficult time of it. It is difficult for an individual congressman to uphold the national interest against the interest of his constituency to preserve their jobs. But our national defense and general well being demand it. Good luck Mr. Gates.

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[1] Robert O’Harrow Jr., "An Era Begins Closing On F-22", The Washington Post, April 13, 2009.

[2] Julian E. Barns, "Lockheed Lobbies For F-22 Production on Job Grounds", Los Angeles Times, February 11, 2009.