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Archive for October, 2011


Blame the Fed

In a recent WSJ editorial, Rep. Ron Paul blames the Fed for the Financial Crisis. Apparently, the Fed “. . . fails to see that the price of housing was artificially inflated through the Fed’s monetary pumping during the early 2000s . . .” {WSJ, Oct. 20, 2011, p. A17}. Elsewhere in the editorial he writes that “Adding new money increases the supply of money, making the price of money over time – the interest rate – lower than the market would make it.”

Let’s consider this Part II of our explanation of the Great Recession. Apparently, Representative Paul distills his wisdom from Hayek and Mises. Nevertheless, his rendition of how money works is a pretty good representation of the Keynesian effect. If money increases more rapidly, then the interest rate falls. I don’t want to discourage this view, but it is a limited view.  Another view is: If the money supply increases more rapidly, there may be an inflation. Inflation causes the interest rate to rise . . . not fall. This is the Fisher effect.

Prior to 2006, the money supply was, in fact, increasing at a modest but steady rate. I’m referring to M1, the least complex measure of the money supply. The facts do not support Rep. Paul’s view. At the beginning of 2006, the rate of increase in the money supply changed dramatically. At this point, the money supply stopped growing. That is, there is a kink in the data. A small growth rate prior to 2006 and no growth after 2006 (and before the Great Recession). So the facts profoundly do not support Rep. Paul’s view.

Why, you may wonder, did the money supply stop growing in 2006? Well, we had new management at the Fed. Chairman Bernanke came in. One could speculate that he may have felt that the economy was overheating and he should apply the brakes, but this would just be speculation. From my experience, it is useless to depend upon the public relations statements that come from the Fed for a sense of their intent. The bottom line is that the posture of monetary policy from the beginning of 2006 was contractionary. This is one of the factors that contributed to the Great Recession.

The Great Recession began to hit in 2007. The first symptom was that housing prices began to dip and this set off a wave of foreclosures. It did so because the housing finance sector had become extremely delicate due to the high loan to value ratios facilitated by government programs. All it took was a slight dip in prices to cause values to fall below the balance due on many mortgages. This is what set off the defaults and foreclosures.

So should we blame the Fed? Yes, in part, but for the exact opposite reason proposed by Rep. Paul.


Leaving the Eurozone

How can a country or countries leave the euro zone with the least possible pain?

The solution must be simple. At a particular moment, not previously announced, chosen by the country, all contracts denominated in euros within the country would be converted to new currencies: new drachmas, new marks, whatever. This includes all existing lease contracts, all credit market contracts, all mortgage contracts, all retirement contracts,  ALL contracts. When parties to these contracts are international, then they will suffer currency risk in the future. But this is a risk that cannot be avoided. There is an issue in terms of locating a contract; that is, how can one tell that a contract is “in” a particular country? First, the contract would be “in” a country if the payer is “in” the country. Second, the payer is “in” the country in which the payer is headquartered or has a principal residence.

How do you do something like this: create a secret moment for conversion? The legislative body would be called into secret session over a weekend. The moment, if the legislature approves, would possibly be at, say, 1:00 a.m. on Monday morning. The legislature would be kept in secret session until that moment if they have approved.

At the moment of conversion and not minute before, the converting country would begin to cause new coins and paper money to be designed, minted and printed; they could do it themselves or contract with private companies for this service. Of course, anyone with euros . . . meaning coins and bills . . . could continue to use them with others who wish to trade in euros.

This raises  the question of what the conversion rate would be between the new currency and euros. I would suggest that the initial rate at the moment of conversion should be one to one. After the moment of conversion, the rate would be determined by the market. This is what would give rise to currency risk. All the contracts with fixed prices would continue to be defined by the initial conversion rate, one to one or whatever is chosen by the country.


The Hallmark of Capitalism

Most people do not understand capitalism. Those who think they love it often do not understand it. People who hate it don’t understand it either. To begin to get a sense of what capitalism is, we should search for its hallmark, the feature that separates it from socialism, and other forms of economic organization. The hallmark of capitalism is failure. It is not extreme profits; let’s call these excess profits. It is not greed.

When a capitalist makes a bad business decisions, he or she can expect to bear losses and to fail. When a socialist enterprise makes a bad decision, the government may just double down. Government bureaucrats will typically say that the reason that their project did not do well is that they did not do enough of it . . . or it is an infant industry and just needs subsidies for a little while longer.

When a capitalist makes excess profits, he or she can expect that these profits will go away. Competitors look at these excess profits and begin to copy the successful capitalist until the excess profits have gone away.

Yes, Virginia, there is greed in capitalism. However, there is greed in every other type of -ism too. I think that it is worth our time to define greed. I’ll define it as desiring benefits that one has not legitimately produced or earned. So there is greed in unions, greed in universities, greed in corporate management, greed in governmental bureaucracies, and the list goes on and on. What economic organization provides a control on greed? It is capitalism. The control is that consumers vote against greedy capitalists with their dollars. Greedy capitalists will fail.

Please do not confuse state-sponsored business with capitalism. A governmental industrial policy is not consistent with capitalism. Too-big-to-fail is not capitalism. Crony “capitalism” is not capitalism; let’s call it crony capitolism (sic).


The Economy and the Price of Oil

This post could be viewed as Part 1 of a series on the reasons for the Great Recession.

The price of oil rose continuously during the last Bush administration until the Fall of 2008. This tax on Americans and others around the world was increasingly difficult to bear. This is one of the forces that set off the recession. Why did the price of oil rise during this period? Was it the OPEC cartel? I want us all to shed crocodile tears for poor OPEC that just doesn’t have the capability to pull something like this off. Cartels are, in the long run, subject to the challenging behavior of their least well behaved members. These members will exceed their quotas whenever and wherever they can. So if it was not caused by a conspiracy of oil producing countries, what was the cause? The cause was on the demand side. The cause was the growth of developing economies like India and China.

Why did the price of oil fall as the Great Recession began? Well, it certainly was not a conspiracy on the part of OPEC to decrease oil prices. The worldwide recession meant a decrease in demand for oil; that caused the decline in its price. What have we seen since? Recovery in some sectors and in some countries caused the price of oil to rise again. But recently, as we are toying with a double dip recession, the price of oil declined again. So we see that oil prices and the world economy are locked in a complex dance. Oil prices rise in recoveries, but ultimately cause the recovery to end.

I do not expect the price of oil to drop dramatically now. We must adjust to higher prices. But how do we adjust to higher oil prices? Ordinary people need to live closer to their jobs. This means that we need a functioning real estate market to properly adjust to higher oil prices. Unfortunately, we do not have a functioning real estate market at the present time.