One evening in the 1930s, a 13-year-old named William Troeller hanged himself from the transom of his bedroom in Greenpoint, Brooklyn.
William's father was laid up in Kings County Hospital awaiting surgery for an injury he'd suffered on the job at Brooklyn Edison. A federal jobs program was paying William's older brother Harold for temporary work. But the amount wasn't nearly enough to make ends meet. Gas and electricity to the family's apartment had been shut off for half a year. Harold told a New York Times reporter that both hunger and modesty had driven William to act. "He was reluctant about asking for food," read the headline in the paper.
The surprising part of this story is not that it happened; most Americans know that after the 1929 stock-market crash, hard times sometimes led to suicide. The surprising part is that William Troeller killed himself not in 1930, when Herbert Hoover was president, but in 1937, in Franklin D. Roosevelt's second term. The New Deal was almost five years old, but the economy was not back. In fact, the country seemed farther from recovery than before. A new sense of futility was overcoming Americans. The British magazine the Economist sneered that the United States "seemed to have forgotten, for the moment, how to grow."
The date matters, because our new president has made it clear that his model is Roosevelt. Barack Obama has spoken of creating 3 million jobs with his stimulus plan. As a new president in 1933, Roosevelt spoke of creating "one million jobs by October 1" through his spending packages. At about $850 billion, Obama's stimulus represents about 5.9 percent of gross domestic product. The spending programs of Roosevelt's National Recovery Administration amounted to almost precisely the same share. Then as now, the country was in what we might call an "illions" moment, when a nation contemplates federal spending of a magnitude previously unimaginable. The only difference is that today, we're discussing trillions instead of billions.
It's reasonable that a new executive in a downturn would want to evoke Roosevelt the leader. Like no other president, Roosevelt inspired those in despair. He kindled hope with his fireside chats on a then-young medium, radio. The new president gives radio talks, but they are also made available on this era's young medium, the Internet.
But Roosevelt the economist is unworthy of emulation. His first goal was to reduce unemployment. Of his own great stimulus package, the National Industrial Recovery Act, he said: "The law I have just signed was passed to put people back to work." Here, FDR failed abysmally. In the 1920s, unemployment had averaged below 5 percent. Blundering when they knew better, Herbert Hoover, his Treasury, the Federal Reserve and Congress drove that rate up to 25 percent. Roosevelt pulled unemployment down, but nowhere near enough to claim sustained recovery. From 1933 to 1940, FDR's first two terms, it averaged in the high teens. Even if you add in all the work relief jobs, as some economists do, Roosevelt-era unemployment averages well above 10 percent. That's a level Obama has referred to once or twice -- as a nightmare.
The second goal of the New Deal was to stimulate the private sector. Instead, it supplanted it. To justify their own work, New Dealers attacked not merely those guilty of white-collar crimes but the entire business community -- the "princes of property," FDR called them. Washington's policy evolved into a lethal combo of spending and retribution. Never did either U.S. investors or foreigners get a sense that the United States was now open for business. As a result, the Depression lasted half a decade longer than it had to, from 1929 to 1940 rather than, say, 1929 to 1936. The Dow Jones industrial average didn't return to its summer 1929 high until 1954. The monetary shock of the first years of the Depression was immense, but it was this duration that made the Depression Great.
This outcome is worth reviewing, component by component, for what it suggests about individual Obama administration projects. The first of these would be ambitious spending on infrastructure. Obama has said that he wants to "put people to work repairing crumbling roads, bridges and schools." In addition, he would like to modernize 75 percent of government buildings, as well as equip tens of thousands of schools with new technology.
Roosevelt, too, proceeded boldly on infrastructure. The budget of his Public Works Administration was so large that it shocked even the man who ran it, Interior Secretary Harold Ickes. Sounding a bit like Republicans today, Ickes said of his $3.3 billion allowance: "It helped me to estimate its size by figuring that if we had it all in currency and should load it into trucks, we could set out with it from Washington for the Pacific Coast, shovel off one million dollars at every milepost and still have enough left to build a fleet of battleships."
New Deal public-works spending did have a short-term effect, creating jobs and economic activity during Roosevelt's first term. Americans took heart at the sight of schools, swimming pools and auditoriums rising in nearly every county in the country. FDR so pumped up the federal government that 1936 was the first peacetime year when it spent more than states and towns. A master of timing, he even managed to get unemployment down to a low of 13.9 percent in November of that year, the month of the presidential election. The voters rewarded him by giving him 46 of 48 states.
But many of the jobs that the early New Deal produced were not merely temporary but also limited in economic value. It was in these years that the political term "boondoggle," to describe costly make-work, was coined. It came from "boondoggling," the word for leather craft projects subsidized by New Deal work-relief programs. As was the case for the Troeller brothers, work-relief earnings were usually not sufficient to offset other Depression losses.
After the 1936 election, Roosevelt found himself appalled at the budgetary deficit he had run up and turned frugal. Infrastructure spending slowed. Monetary authorities feared inflation and doubled reserve requirements at banks. The "Depression within the Depression" of the Troellers' time began. This cynical cycle -- spend on construction, hold election, tighten, confront new joblessness -- is familiar nowadays, especially in Latin America. But then, to Americans, it came as a bitter surprise.
Another similarity also stirs concern. Obama is focusing on our country's most promising innovation, one that is among the most likely to generate recovery jobs -- the Internet. He wants to use stimulus dollars to give poorer Americans access to that technology. Specifically, the president wants to achieve the goal of "expanding broadband across America." The listener gets the impression that Obama wouldn't mind if the federal government ran some of this business if such involvement is what it takes to get universal access. Equity first.
In Roosevelt's day, there was also an appealing new technology: electricity. Power was the industry that symbolized growth -- the Dow Jones utilities average was expected to lead the old industrial average into recovery. After all, access to electricity was so desirable that power companies' operating revenue rose even during the Depression. There were also private companies ready to supply power to the rural unwired. One was the Commonwealth and Southern Corp., fashioned by venture capitalists and industry leaders explicitly to raise the vast sums of capital necessary to light the South.
Here Roosevelt, too, combined a stimulus project with his goals for social equity. He created the Rural Electrification Administration to wire the countryside. He also created the Tennessee Valley Authority to provide hydropower. One can picture private and public working together, and that's what Commonwealth and Southern imagined, too, at first. At a tense meeting at Washington's Cosmos Club in 1933, the company's chief executive, Wendell Willkie, begged a TVA officer, David Lilienthal, to strengthen public-private cooperation. Instead, Lilienthal waged war on Willkie, using the TVA's tax-free status to compete for customers and fighting Commonwealth and Southern in the courts. In 1935, Roosevelt signed a utilities law that so restricted private capital raising that it was known as the "Death Sentence Act."
At the time, observers told themselves that the shift caused no economic loss. But the stock indexes told the real story. Instead of matching or outperforming the industrial average, the Dow Jones utilities average lagged behind. The great "stimulator," government, had emerged as an opponent. The effect, beyond the tragic unemployment, was to slow down the creation of new companies. Even the New Dealers despaired. "We have tried spending money," Treasury Secretary Henry Morgenthau said to the House Ways and Means Committee in the late 1930s. "We are spending more than we have ever spent before and it does not work. . . . I say, after eight years of this administration, we have just as much unemployment as when we started . . . and an enormous debt to boot."
What the New Deal record tells us is that it's worthwhile imagining an alternate Washington program. A program that's merely about budget balancing is wrong in an hour when banks are wildly deleveraging. But Obama could put market reform before spending. It's time to keep plans to strengthen the regulation of markets and widen regulators' mandate so that they monitor most of what's traded and derivatives don't slip through the cracks.
What about spending? The Depression tells us that public works are probably less effective than improving the environment for entrepreneurs and new companies. The president has already put forward a big tax cut for lower earners. He might offer a commensurate one for higher earners. He might expand the tax advantages he is currently offering to companies -- wider expensing of losses, for example -- and make them permanent. A discussion that permits the word "trillion" might also include the possibility of bringing down U.S. corporate taxes, taxes on interest, dividend and capital gains -- again, permanently. The cash that a relatively competitive United States draws from abroad will move the country forward faster than any stimulus.
So the Depression and the New Deal are both worth going back to, but for different reasons than many suspect. We may rely on the best of the New Deal, the matter-of-fact bravery our parents and grandparents showed then, to help us through today's unexpected challenges. But we don't have to repeat New Deal stimulus experiments, because we know that they didn't work.
Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is the author of "The Forgotten Man: A New History of the Great Depression."
Do Worry About the Deficit
By John StosselPresident Obama says don't worry about the federal budget deficit.
"The consensus is this: We have to do whatever it takes to get this economy moving again -- we're going to have to spend money now to stimulate the economy. ... [W]e shouldn't worry about the deficit next year or even the year after; that short term, the most important thing is that we avoid a deepening recession".
It must be music to a politician's ears when a "consensus" tells him not to worry about deficits. He can spend without limit. So Obama talks about a "stimulus package" that he says will rebuild the infrastructure and "green" the energy industry. That won't happen, of course. Government performance consistently falls far short of its goals. Forgive me for again pointing out that President Jimmy Carter's Synthetic Fuels Corporation cost taxpayers at least $19 billion without giving us an alternative to oil and coal.
Obama hasn't put a price tag on his stimulus package yet, but speculation begins at $500 billion, with some people -- like Paul Krugman, the recent Nobel-prize winner -- saying that's way too small. "I'm still not sure ... whether the economic team is thinking big enough".
Krugman is the main cheerleader for a new New Deal, but one done "right" because Franklin D. Roosevelt was too timid: "the truth is that the New Deal wasn't as successful in the short run as it was in the long run. And the reason for FDR's limited short-run success, which almost undid his whole program, was the fact that his economic policies were too cautious."
Krugman echoes John Maynard Keynes's complaint: Roosevelt's budget deficits were too small. Krugman is right about FDR's deficits being relatively small. As University of Arizona economist Price Fishback wrote recently, "Once we take into account the taxation during the 1930s, we can see that the budget deficits of the 1930s and one balanced budget were tiny relative to the size of the problem".
Indeed, the deficits run by Roosevelt were comparable to those run by his predecessor, the allegedly do-nothing, laissez-faire Herbert Hoover. Both administrations spent heavily, but both also raised taxes substantially.
Of course, neither was able to fix the economy. On the contrary, their policies made a depression the Great Depression, extending it many years and even generating a depression within a depression in 1937. As Roosevelt's treasury secretary noted, "After eight years of this administration we have just as much unemployment as when we started".
But Krugman and others suggest that since the New Deal ran moderate deficits and the Depression persisted, then Roosevelt should have run bigger multiyear deficits -- and so should Obama. "[I]t's basically money we owe to ourselves. ... The best course of action, both for today's workers and for their children, is to do whatever it takes to get this economy on the road to recovery," Krugman wrote.
This is the wrong lesson to learn from the 1930s. The New Deal didn't fail because its deficits were too small. As Amity Shlaes shows in "The Forgotten Man," the New Deal failed because it interfered with the market's natural regenerative processes. By raising taxes, hamstringing producers with arbitrary regulations and creating uncertainly about what the government would do next, business people were unwilling to invest and hire workers.
Uncertainty about taxes, regulation and government policy similarly threaten recovery today.
Obama must realize that government has no wealth of its own and that commandeering scarce resources from the private sector only stifles the economy. Deficit spending does this two ways. When the Treasury borrows money, it outbids private borrowers who would have put the money to productive use. When the Fed creates money, it depreciates the dollar, shifts purchasing power from the people to special interests, and -- by tampering with the price signals -- creates an unsustainable recovery that will collapse and throw people out of work when the inflation stops.
The 2009 deficit is projected to be $438 billion. Obama's "stimulus" could take it up to a trillion and beyond. That's just the beginning since the Democratic Congress's spending wish list and Medicare's $35 trillion unfunded liability loom.
We should all worry about the deficit.
Watchman State
How Real Life Superheroes fight crime and help the helpless
Long before Barack Obama incited our movie stars to give up plastic grocery bags in the name of a more righteous America, long before Rick Warren persuaded millions of spiritual seekers to fill their lives with purpose, a growing number of lower profile yet visually arresting altruists began serving their fellow citizens by taking on local thugs, helping stranding motorists, volunteering at soup kitchens and homeless shelters, and participating in blood drives. They call themselves Real Life Superheroes, or Reals for short, and as their name suggests, their inspiration comes not from elected officials, religion, or the Kiwanis Club, but rather Batman, Spider-man, and the countless other icons of spandex-clad virtue who populate our supposedly meaningless and morally corrosive pop culture.
According to the creators of the World Superhero Registry, an online forum and resource center where freelance crusaders network and exchange ideas, an individual who wears a costume, performs heroic deeds, and is not functioning as a paid representative of any organization are the primary characteristics of a Real Life Superhero. Some explicitly position themselves as vigilante interventionists eager to protect their neighborhoods from bad guys; others imitate their comic-book role models in a more metaphorical sense, applying their standards of justice and social responsibility to various community service efforts. They go by names like Fox Fire, Civitron, and Knight Owl, and at least one of them, Superbarrio, an international crimefighter whose domain is Mexico City, has been plying his trade since the 1980s.
Recent feature stories on Reals in Rolling Stone and the Sunday Times have led to a flurry of interest, but much of the media coverage has exhibited a mocking tone, focusing on the ways in which Reals do not quite live up to their better equipped and more physically impressive fictional counterparts. The Sunday Times piece, for example, opens with an anecdote in which one Real is reconsidering his avocation after getting punched in the face by a "tiny girl." Ironically, at a time when the ideals of service, sacrifice, and community are enjoying great cachet in the national conversation, Reals who are doing more than merely talking about such notions are attracting ridicule in large part because the better angels of their nature like to sheathe themselves in colorful, tight-fitting uniforms.
But is it really so wacky what they're doing? After all, soldiers, police officers, milkmen, firefighters, priests, nuns, Girl Scouts, judges, and football referees all use clothing to signify their commitment to virtuous service. Real Life Superheroes are simply putting a contemporary, hyper-individualized spin on the time-honored notion that clothes make the man. Institutions have long capitalized on the transformational power of uniforms—a young Marine recruit donning his Dress Blues for the first time find himself summoning new reservoirs of courage and discipline as he feels compelled to live up to all the values his uniform embodies. A novice in the Catholic Church undergoes a similar transformation the first time she dons her habit.
But what if you're not a member of the Marine Corps or the Catholic Church, and yet you'd still like to experience the magic of sartorial transformation yourself? While there isn't a "virtuous sweater" section at Urban Outfitters or Banana Republic yet, you can get a custom-made BattleSuit from Hero-Gear.net, for the surprisingly reasonable price of only $140. "Once you get suited up, you're a hero and you have to act like one," explained a Real who calls himself Geist to City Pages last year.
Hero-Gear.net was created by Jack Brinatte, a professional wrestler in Minnesota who started making costumes for himself and other wrestlers. When he advertised his wares on the Internet and started getting inquiries from aspiring Real Life Superheroes, he found himself catering to a new niche; eventually, he created a superhero persona for himself, Razorhawk, and now wears his blue-and-yellow uniform while engaging in community service. "We go out there and try to inspire people to do do good things," he recently told Fox News. Volunteer in your regular everyday persona, Brinatte suggested, and it doesn't have as much impact as when you put on a mask and assume a dramatic superhero persona. "People tend to remember that," he concluded. "Kids see it and it sticks in their mind."
Of course, it's not just a selfless act for the adults who don the suits. The U.S. Army used to promise new recruits an "Army of One," but when they put on their new uniforms, they looked just like every other soldier. That's part of a traditional uniform's power—it evokes the strength of all who've ever worn it—but in the Internet era of conspicuous self-promotion, it's easy to see why a flashy and unique outfit, coupled with a proprietary brand name, is appealing to potential do-gooders. Just because you want to serve a cause greater than yourself doesn't mean you don't want to be the center of attention while doing it. And have a little fun while you're at it.
Indeed, while we may have entered a new age of service, sacrifice, responsibilty, and hard work, do we have to be so high-minded about it? Take this YouTube clip produced by Ashton Kutcher and Demi Moore, in which a gaggle of casually pompous celebrities promise to help President Obama transform America by smiling more, curing Alzheimers, and foregoing bottled water—wouldn't it be a whole lot easier to swallow if Ashton and Demi had nixed the ridiculously solemn keyboards and required all the participants to wear Spandex skinsuits while delivering their lines?
Stimulus Won't Change the Education System's Status Quo
Throwing money at failing schools won't boost test scores or graduation rates
Lisa Snell |Get ready for the largest transfer of funds from the federal government to local schools in history.
Democrats in Congress are proposing a new infusion of federal cash for public schools through the American Recovery and Reinvestment Act of 2009. In the House version of the stimulus package released on January 15, Democrats suggest allocating $120 billion for K-12 education, almost $22 billion for higher education, and close to $5 billion for early education. It includes a $79 billion block grant for states to help stabilize state and local education budgets, $26 billion in new money for existing Title I and special education programs, $1 billion for technology to provide "21st Century Schools," and a new $20 billion school construction program. All this money will be in addition to the approximately $60 billion a year in taxpayer money that the federal government already spends on education in the United States.
The stimulus package will spend more than double the current total federal education budget, bringing federal funding of education to well over $200 billion. Unfortunately, this huge expansion is unlikely to spur improvements in public education and will continue to encourage states and local districts to spend money with little regard to student outcomes.
In the last 30 years, the United States has doubled per-pupil spending in real dollars. We spend more money on education for K-12 than most other industrialized countries. According to the OECD's 2008 Education at a Glance, the United States ranks number one in all education spending and well above the Organisation for Economic Co-operation and Development (OECD) average for K-12 education. Yet, outcomes for students at the end of their public education career have not kept pace with these large-scale investments. The average reading and math scores for 17-year-olds on the National Assessment of Education Progress (NAEP), the nation's benchmark for student achievement, are no better today than they were in 1971; SAT verbal scores show a decline (from 530 in 1972 to 504 today); and SAT math scores have been essentially flat (from 509 in 1972 to 515 today). U.S. graduation rates were 78 percent in 1972 and are 74 percent today; and U.S. 15-year-olds score below the international average on science and math literacy when compared with 30 OECD countries—American kids rank behind students from Poland, Hungary, and France to name a few.
The biggest chunk of this new education stimulus will be a block grant to cover operational costs for local school districts. The federal government will direct large amounts of aid to states struggling with huge budget deficits aggravated by the economic downturn. For example, New York Gov. David Paterson is counting on $6.4 billion in help for teacher salaries and other operating expenses over the next two years if the education block grant is part of the final economic stimulus package.
As a House Democratic leadership aide told Politico,"When the recession ends, you are still going to need teachers, firemen, policemen, and the question is do we step in now or pay more to rebuild later."
Public schools suffer from some of the same problems as the auto industry. In Detroit, the financial meltdown is partially caused by union contracts that make promises to employees that are impossible to fulfill and also remain economically viable. In schools, automatic pay raises and teacher tenure mean that school districts have very limited flexibility in hiring and firing and prohibit them from negotiating pay-cuts that reflect the country's current economic conditions.
School districts have also continued to hire more teachers as enrollments have declined. The National Center for Education Statistics puts the current average teacher-student ratio at 1 to 15. There is little evidence that class-size is correlated with student outcomes, yet districts continue to favor small class size as school reform.
This stimulus plan would also prolong the practice of generous defined-benefit retirement plans, which guarantee teachers specific retirement payments despite school districts ever-increasing unfunded pension liabilities.
School Construction
The stimulus package put forth by House Democrats proposes to spend $20 billion on school construction. But there is no indication new school construction cash will do anything to make the process more efficient or cost-effective. School construction projects are notoriously behind schedule, over budget, and more expensive than other types of construction projects.
Dr. Jay Greene, an education researcher at the University of Arkansas, has noted that building schools costs much more than other types of construction. According to the 34th Annual Official Education Construction Report, the median new school built in 2007 cost $188 per square foot for elementary schools; $211 per square foot for middle schools; and $175 per square foot for high schools. By comparison, the median cost per square foot to build a three-story factory in 2007 ranged from $83 in Winston-Salem to $136 in New York City, with most major metro areas hovering around $100 per square foot.
These stimulus plans contain no incentives for schools to cut costs or reform the school construction bureaucracy by using innovative practices such as public-private partnerships to more efficiently build new schools.
Internet Access
President Barack Obama announced in a recent radio address that his administration would seek to expand broadband access in schools. The House stimulus package contains $1 billion for technology programs and $6 billion to bring broadband access to underserved communities that may include schools. Before moving into the White House, Mr. Obama said, "Here, in the country that invented the Internet, every child should have the chance to get online, and they'll get that chance when I'm president—because that's how we'll strengthen America's competitiveness in the world."
But that's close to being accomplished. The 2007 report "Internet Access in U.S. Public Schools and Classrooms: 1994-2005" that in the fall of 2005 nearly 100 percent of public schools in the United States had access to the Internet. In 2005, 97 percent of public schools had high-speed broadband, with a ratio of 3.8 students per 1 computer with Internet access.
Billions have already been spent through the federal "E-Rate" program to give students Internet access. Like most large-scale government giveaways, the federal E-rate program, which collects $2.5 billion a year in telephone taxes to hook up schools and libraries to the Internet, has produced a huge amount of waste.
Puerto Rico has spent $101 million in federal grants to wire 1,500 public schools for Internet access. Yet the island-wide school district warehoused most of the equipment for more than three years, and only nine schools were actually connected to the Internet. The Chicago public schools have more than $5 million in E-rate computer equipment sitting in a warehouse. In San Francisco, school officials discovered that a $68 million project should have cost less than $18 million.
A huge new federal investment in broadband technology will likely do little to expand broadband access while opening up the potential for even more waste and incompetence. More money for Internet access is a duplicative funding stream to solve a non-problem.
Early Education
The House version of the education stimulus package includes $2.1 billion for Head Start, the federal preschool program for poor children, and $2 billion for additional child care grants. But how will students be helped or what will taxpayers get for the money?
Consider Oklahoma, a state that has spent millions implementing universal preschool. Oklahoma's fourth-grade NAEP reading score in 1998, when it adopted universal preschool, was 219—six points above the national average. Last year, it had dropped to 217—three points below the national average. Similarly, Oklahoma's fourth-grade NAEP math score was on par with the national average in 2000. Last year, it had dropped two points below. Since employing universal preschool, not only is Oklahoma doing worse compared with the nation, but also its own prior performance.
It's also important to note that 70 percent of 4-year-olds are already enrolled in preschool. States with government-run universal preschool programs also enroll about 70 percent of students, so it is not clear how many more kids the stimulus will result in enrolling.
Education Bailout Should Revolutionize Public Schools
The bottom line is that more than $147 billion in federal "education stimulus" will prolong the dysfunctional qualities of the United States education system. It is one of the most expensive and most mediocre K-12 systems in the world. Throwing more money at public schools without addressing the problems inherent in the system—lack of accountability and lack of competition—will simply drive up education costs with little to show for the money.
The best outcome would be to avoid a federal education bailout altogether. However, if an education stimulus is inevitable, it should at least demand some concessions from the education establishment before doling out $120 billion.
Here are a few suggestions:
- Only give money to school districts whose labor unions agree to "flat contracts" that offer flexible employee practices such as firing for "just cause" and are willing to suspend seniority and tenure in exchange for merit-pay.
- Only give money to school districts that will report transparent budget numbers at the "school level" so parents and taxpayers can see how much money a school spends on education in real dollars and not district averages. It is important to know how much money is siphoned off at district offices and for administrative costs—and how much money actually makes it into the classroom.
- Prioritize money for, or give incentives to, districts that attach per-pupil funding to the backs of children, letting parents choose the public school (or dare I say charter or private school) that best suits their child.
Lisa Snell is director of education at Reason Foundation.
A Classic Hayekian Hangover
By Roger Garrison and Gene Callahan
Are investment booms followed by busts like drinking binges are followed by hangovers? Dubbing the idea “The Hangover Theory” (Slate, 12/3/98), Paul Krugman has attempted to denigrate the business-cycle theory introduced early last century by Austrian economist Ludwig von Mises and developed most notably by Nobelist F. A. Hayek.
Yet, proponents of the Austrian theory have themselves embraced this apt metaphor. And if investment is the intoxicant, then the interest rate is the minimum drinking age. Set the interest rate too low, and there is bound to be trouble ahead.
The metaphorical drinking age is set by—and periodically changed by—the Federal Reserve. In our Fed-centric mixed economy, the understanding that “the Fed sets interest rates” has become widely accepted as a simple institutional fact. But unlike an actual drinking age, which has an inherent degree of arbitrariness about it, the interest rate cannot simply be “set” by some extra-market authority. With market forces in play, it has a life of its own.
The interest rate is a price. It’s the price that brings into balance our eagerness to consume now and our willingness to save and invest for the future. The more we save, the lower the market rate. Our increased saving makes more investment possible; the lower rate makes investments more future oriented. In this way, the market balances current consumption and economic growth.
Price fixing foils the market. Government mandated ceilings on apartment rental rates, for instance, create housing shortages, as is well known by anyone who has gone apartment hunting in New York City. Similarly, a legislated interest-rate ceiling would cause a credit shortage: The volume of investment funds demanded would exceed people’s actual willingness to save.
But the Fed can do more than simply impose a ceiling on credit markets. Setting the interest rate below where the market would have it is accomplished not by decree but by increasing the money supply, temporarily masking the discrepancy between supply and demand. This papering over of the credit shortage hides a problem that would otherwise be obvious, allowing it to fester beneath a binge of investment spending.
An artificially low rate of interest, then, sets the economy off on an unsustainable growth path. During the boom, investment spending is excessively long-term and overly optimistic. Further, high levels of consumer spending draw real resources away from the investment sector, increasing the gap between the resources actually available and the resources needed to see the long-term and speculative investments through to completion.
Save more, and we get a market process that plays itself out as economic growth. Pump new money through credit markets, and we get a market process of a very different kind: It doesn’t play itself out; it does itself in. The investment binge is followed by a hangover. This is the Austrian theory in a nutshell. (Ironically, it is the theory that Alan Greenspan presented forty years ago when he lectured for the Nathaniel Branden Institute.) We believe that there is strong evidence that the United States is now in the hangover phase of a classic Mises-Hayek business cycle.
In recent years money-supply figures have become clouded by institutional and technological change. But in our view, a tale-telling pattern is traced out by the MZM data reported by the Federal Reserve Bank of St. Louis. ZM standing for “zero maturity,” this monetary aggregate is a better indicator of credit conditions than are the more narrowly defined M’s.
After increasing at a rate of less than 2.5% during the first three years of the Clinton administration, MZM increased over the next three years (1996-1998) at an annualized rate of over 10%, rising during the last half of 1998 at a binge rate of almost 15%.
Sean Corrigan, a principal in Capital Insight, a UK-based financial consultancy, has recently detailed the consequences of the expansion that came in "…autumn 1998, when the world economy, still racked by the problems of the Asian credit bust over the preceding year, then had to cope with the Russian default and the implosion of the mighty Long-Term Capital Management." Corrigan goes on: "Over the next eighteen months, the Fed added $55 billion to its portfolio of Treasuries and swelled repos held from $6.5 billion to $22 billion… [T]his translated into a combined money market mutual fund and commercial bank asset increase of $870 billion to the market peak, of $1.2 trillion to the industrial production peak, and of $1.8 trillion to date—twice the level of real GDP added in the same interval" (http://www.mises.org/fullarticle.asp?control=754).
The party was in full swing, and the Fed kept the good times rolling by cutting the fed funds rate 100 basis point between June 1998 and January 1999. The rate on 30-year Treasuries dropped from a high of over 7% to a low of 5%. Stock markets soared. The NASDAQ composite went from just over 1000 to over 5000 during the period, rising over 80% in 1999 alone. With abundant credit being freely served to Internet start-ups, hordes of corporate managers, who had seemed married to their stodgy blue-chip companies, suddenly were romancing some sexy dot-com that had just joined the party.
Meanwhile consumer spending stayed strong—with very low (sometimes negative) savings rates. Growth was not being fueled by real investment, which would require forgoing current consumption to save for the future, but by the monetary printing press.
As so often happens at bacchanalia, when the party entered the wee hours, it became apparent that too many guys had planned on taking the same girl home. There were too few resources available for all of their plans to succeed. The most crucial—and most general—unavailable factor was a continuing flow of investment funds. There also turned out to be shortages of programmers, network engineers, technical managers, and other factors of production. The rising prices of these factors exacerbated the ill effects of the shortage of funds.
The business plans for many of the startups involved negative cash flows for the first 10 or 15 years, while they "built market share." To keep the atmosphere festive, they needed the host to keep filling the punch bowl. But fears of inflation led to Federal Reserve tightening in late 1999, which helped bring MZM growth back into the single digits (8.5% for the 1999-2000 period). As the punch bowl emptied, the hangover–and the dot-com bloodbath–began. According to research from Webmergers.com, at least 582 Internet companies closed their doors between May 2000 and July of this year. The plunge in share price of many of those still alive has been gut wrenching. The NASDAQ retraced two years of gains in a little over a year.
During the first half of 2001, the Fed demonstrated—with its half-dozen interest-rate cuts and a near-desperate MZM growth of over 23%—that you can’t recreate euphoria in the midst of a hangover.
It all adds up to the Austrian theory. As a final twist to our story, we note that Krugman, who before could only mock the Austrians, has recently given us an Austrian account of our macroeconomic ills. In his "Delusions of Prosperity" (New York Times, 8/14/01), Krugman explains how our current difficulties go beyond those of a simple financial panic:
We are not in the midst of a financial panic, and recovery isn't simply a matter of restoring confidence. Indeed, excessive confidence [fostered by unduly low interest rates maintained by rapid monetary growth?–RG & GC] may be part of the problem. Instead of being the victims of self-fulfilling pessimism, we may be suffering from self-defeating optimism. The driving force behind the current slowdown is a plunge in business investment. It now seems clear that over the last few years businesses spent too much on equipment and software and that they will be cautious about further spending until their excess capacity has been worked off. And the Fed cannot do much to change their minds, since equipment spending [at least when such spending has already proved to be excessive—RG & GC] is not particularly sensitive to interest rates.With Krugman on the verge of rediscovering the policy-induced self-reversing process that we call the Austrian theory of the business cycle, we confidently claim that current macroeconomic conditions are best described as a classic Hayekian hangover. The Austrian theory, of course, gives us no policy prescription for converting this ongoing hangover into renewed euphoria. But it does provide us with the best guide for avoiding future ones. ____________________
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