July 16, 2005
Chapter 8: How Inflation Works (or Why I Can’t Buy an Old Ferrari)
Anyone who has been alive very long is aware that the U.S. government has failed on the inflation front. Soft drink machines that once delivered a bottled drink for a nickel now charge a dollar, a 20-fold increase in price.
Until the Reagan administration indexed the income tax, inflation was a boon to government, because by pushing up wages and salaries inflation pushed taxpayers into higher brackets. This allowed the real tax burden on labor to rise without politicians having to raise the tax rates. Inflation also destroyed the value of depreciation allowances, thus raising the tax rate on capital as well.
It is not easy to make the young aware of the long-term rise in prices. The inflation indices are periodically re-based, resulting in measures over time with different years as the base. The Clinton administration further destroyed comparability by substituting a variable basket of goods for the fixed assortment that had previously prevailed. With the Boskin Commission “reform” adopted by the Clinton administration, the Consumer Price Index (CPI) no longer compares apples to apples. If the price of apples rises, the CPI assumes that consumers switch to a cheaper substitute. The “substitution effect” thus underestimates the rate of inflation and destroys the comparability of the inflation rate from one period to the next.
Inflation is inherent in a fractional reserve banking system based on fiat money. Fiat money is not subject to limits on its supply, and fractional reserve banking permits the banking system to create money by expanding loans.
Aware of the ever present threat of inflation from such a system, Milton Friedman advocated a monetary rule that would limit the growth of the money supply to the long-term growth rate of the economy. For example, if the money supply grew 2 to 3 percent annually in keeping with the increase in real output, prices would remain stable. Perhaps it wasn’t a perfect solution, but at least Friedman thought about the problem.
In the post-WW II period, the U.S. has experienced dramatic increases in the growth of money and credit. One way to demonstrate the erosion of the purchasing power of money is to look at the change in the behavior of the prices of used Ferraris. In the 1950s, 1960s, and even the 1970s, Ferraris depreciated rapidly. Well-to-do playboys attracted by the unique cars wanted the latest model, and few other people wanted the maintenance expense associated with the high-performance machines. It was not out of the question for a person with an ordinary income to become the second owner of a Ferrari.
Excepting a few models of high volume and undistinguished performance, today it is totally out of the question that a person lacking an out-sized income or a large inheritance could acquire a previously owned Ferrari.
For example, in 1973 when I left Stanford University I had an opportunity to purchase a 1967 Ferrari 330 GTS. It was a low mileage car in new condition. The asking price was $10,000 and could have been negotiated down. Unfortunately, the Scottish part of my ancestry prevailed, and I did not purchase the Ferrari. Recently at the Monterey auction a 330 GTS sold for $671,000, 67 times its 1973 used car price.
As an assistant professor of economics in 1967, I cut a road test out of Road & Track magazine and filed it. The test was one of a 1967 Ferrari 275 GTB/4. The new price was $14,500. I intended to find one in a few years at a substantially depreciated price. At a recent Monetary auction, a 1967 GTB/4 sold for $1,925,000.
What has happened to money that causes a 41-year-old used car to sell for 133 times its new car price?
The abundance of money from a fiat money/fractional reserve banking system raises the price of scarce items that are beautiful and unique, such as Ferraris and antiques. Few Ferrari models were produced in numbers greater than several hundred cars. Perhaps the most famous Ferrari is the 250 GTO. Less than 40 were produced. The GTO, which is street legal, dominated racing and won the World Manufacturers Championship in 1962, 1963, and 1964. The new car price was $18,000. In 1989 one sold for $13 million. This year one sold for $28 million. I have a friend who bought a used GTO in Europe in the mid-1960s for $9,000 and sold it six months later for the same price.
Ferraris became collectibles, a store of value, a role that the dollar no longer performs. Today collectible cars have become items for speculation. They are flipped in auctions with bids rising several hundred thousand dollars from auction to auction, just as real estate speculators bid up waterfront condo prices and hedge funds bid up oil futures contracts.
The cars are worth so much now that you will never see one on the road, not even in the playgrounds of the rich and famous. The more than 1,500-fold rise in the price of the GTO over the last 45 years makes gold’s 28-fold price rise seem insignificant. But both prices show the ruin inflicted on the dollar by our fiat money/fractional reserve system.
October 21, 2008
Chapter 9: When Greed is Rewarded:Government of Thieves
Just as the Bush regime’s wars have been used to pour billions of dollars into the pockets of its military-security donor base, the Paulson bailout looks like a Bush regime scheme to incur $700 billion in new public debt in order to transfer the money into the coffers of its financial donor base. The U.S. taxpayers will be left with the interest payments in perpetuity (or inflation if the Fed monetizes the debt), and the number of Wall Street billionaires will grow. As for the U.S. and European governments’ purchases of bank shares, that is just a cover for funneling public money into private hands.
The explanations that have been given for the crisis and its bailout are opaque. The U.S. Treasury estimates that as few as 7 percent of the mortgages are bad. Why then do the U.S., U.K., Germany, and France need to pour more than $2.1 trillion of public money into private financial institutions?
If, as the government tells us, the crisis stems from subprime mortgage defaults reducing the interest payments to the holders of mortgage backed securities, thus driving down their values and threatening the solvency of the institutions that hold them, why isn’t the bailout money used to address the problem at its source? If the bailout money was used to refinance troubled mortgages and to pay off foreclosed mortgages, the mortgage-backed securities would be made whole, and it would be unnecessary to pour huge sums of public money into banks. Instead, the bailout money is being used to inject capital into financial institutions and to purchase from them troubled financial instruments.
It is a strange solution that does not address the problem. As the U.S. economy sinks deeper into recession, the mortgage defaults will rise. Thus, the problem will intensify, necessitating the purchase of yet more troubled instruments.
If credit card debt has also been securitized and sold as investments, as the economy worsens defaults on credit card debt will be a replay of the mortgage defaults. How much debt can the Treasury bail out before its own credit rating sinks?
The contribution of credit default swaps to the financial crisis has not been made clear. These swaps are bets that a designated financial instrument will fail. In exchange for “premium” payments, the seller of a swap protects the buyer of the swap from default by, for example, a company’s bond that the swap buyer might not even own. If these swaps are also securitized and sold as investments, more nebulous assets appear on balance sheets.
Normally, if you and I make a bet, and I welsh on the bet, it doesn’t threaten your solvency. If we place bets with a bookie and the odds go against the bookie, the bookie will fail, as apparently happened to AIG, necessitating a $185 billion bailout of the insurance company, and to Bear Stearns resulting in the demise of the investment bank.
Credit default swaps are a form of unregulated insurance. One danger of the swaps is that they allow speculators to purchase protection against a company defaulting on its bonds, without the speculators having to own the company’s bonds. Speculators can then short the company’s stock, driving down its price and raising questions about the viability of the company’s bonds.
This raises the value of the speculators’ swaps which can be sold to holders of the company’s bonds. By ruining a company’s prospects, the speculators make money.
Another danger is that swaps encourage investors to purchase riskier, higher-yielding instruments in the belief that the instruments are insured, but the sellers of swaps have not reserved against them.
Double-counting of assets is also possible if a bank purchases a company’s bonds, for example, then purchases credit default swaps on the bonds, and lists both as assets on its balance sheet.
The $185 billion Treasury bailout of AIG is small compared to the $700 billion for the banks, and the emphasis has been on banks, not insurance companies. According to news reports, the sums associated with credit default swaps are far larger than the subprime mortgage derivatives. Have the swaps yet to become major players in the crisis?
The behavior of the stock market does not necessarily tell us anything about the bailout. The financial crisis disrupted lending and thus comprised a threat to non-financial firms. This threat would reflect in the stock market. However, the stock market is also predicting a recession and declining earnings. Thus, people sell stocks hoping to get out before share prices adjust to the new lower earnings.
The bailout package is a result of panic and threats, not of analysis and understanding. Neither Congress nor the public knows the full story. If the problem is the mortgages, why does the bailout leave the mortgages unaddressed and focus instead on pouring vast amounts of public money into private financial institutions?
The purpose of regulation is to restrain greed and to prevent leveraged speculation from threatening the wider society. Congress needs to restore financial regulation, not reward those who caused the crisis.
October 17, 2008
Chapter 10: A Nation of Waitresses and Bartenders
The Bureau of Labor Statistics payroll jobs report released May 5, 2006, says the economy created 131,000 private sector jobs in April. Construction added 10,000 jobs, natural resources, mining and logging added 8,000 jobs, and manufacturing added 19,000. Despite this unusual gain, the economy has 10,000 fewer manufacturing jobs than a year ago.
Most of the April job gain—72 percent—is in domestic services, with education and health services (primarily health care and social assistance) and waitresses and bartenders accounting for 55,000 jobs or 42 percent of the total job gain. Financial activities added 26,000 jobs and professional and business services added 28,000. Retail trade lost 36,000 jobs.
During 2001 and 2002 the U.S. economy lost 2,298,000 jobs. These lost jobs were not regained until early in February 2005. From February 2005 through April 2006, the economy has gained 2,584 jobs (mainly in domestic services).
The total job gain for the 64 month period from January 2001 through April 2006 is 7,000,000 jobs less than the 9,600,000 jobs necessary to stay even with population growth during that period. The unemployment rate is low because millions of discouraged workers have dropped out of the work force and are not counted as unemployed.
In 2005 the U.S. had a current account deficit in excess of $800 billion. That means Americans consumed $800 billion more goods and services than they produced. A significant percentage of this figure is offshore production by U.S. companies for American markets.
The U.S. current account deficit as a percent of Gross Domestic Product is unprecedented. As more jobs and manufacturing are moved offshore, Americans become more dependent on foreign made goods.
The U.S. pays its current account deficit by giving up ownership of its existing assets or wealth. Foreigners don’t simply hold the $800 billion in cash. They use it to acquire U.S. equities, real estate, bonds, and entire companies.
The federal budget is also in the red to the tune of about $400 billion. As Americans have ceased to save, the federal government is dependent on foreigners to lend it the money to operate and to wage war in the Middle East.
American consumers are heavily indebted. The growth of consumer debt is what has been fueling the economy. Social Security and Medicare are in financial trouble, as are many company pension plans. Decide for yourself—is this the economic picture of a superpower that can dictate to the world, or is it the picture of a second-rate country dependent on foreigners to finance its consumption and the operation of its government?
No-think economists make rhetorical arguments that the decline of U.S. manufacturing employment reflects higher productivity from technological improvements and not a decline in U.S. manufacturing per se. George Mason University economist Walter Williams recently ridiculed the claim that U.S. manufacturing jobs are moving to China. Williams asks how the U.S. could be losing manufacturing jobs to China when the Chinese are losing jobs faster than the U.S.: “Since 2000, China has lost 4.5 million manufacturing jobs, compared with the loss of 3.1 million in the U.S.”
The 4.5 million figure comes from a Conference Board report that is misleading. The report that counts was written by Judith Banister under contract to the U.S. Department of Labor, Bureau of Labor Statistics, and published in November 2005 (www.bls.gov/fls/chinareport.pdf). Banister’s report was peer reviewed both within the BLS and externally by persons with expert knowledge of China.
Chinese manufacturing employment has been growing strongly since the 1980s except for a short period in the late 1990s when layoffs resulted from the restructuring and privatization of inefficient state-owned and collectively-owned factories. To equate temporary layoffs from a massive restructuring within manufacturing with U.S. long-term manufacturing job loss indicates carelessness or incompetence.
Banister concludes: “In recent decades, China has become a manufacturing powerhouse. The country’s official data showed 83 million manufacturing employees in 2002, but that figure is likely to be understated; the actual number was probably closer to 109 million. By contrast, in 2002, the Group of Seven (G7) major industrialized countries had a total of 53 million manufacturing workers.”
The G7 is the U.S. and Europe. In contrast to China’s 109,000,000 manufacturing workers, the U.S. has 14,000,000.
When I was Assistant Secretary of the Treasury in the Reagan administration, the U.S. did not have a trade deficit in manufactured goods. Today the U.S. has a $500 billion annual deficit in manufactured goods. If the U.S. is doing as well in manufacturing as no-think economists claim, where did an annual trade deficit in manufactured goods of one-half trillion dollars come from?
If the U.S. is the high-tech leader of the world, why does the U.S. have a trade deficit in advanced technology products with China?
There was a time when American economists were empirical and paid attention to facts. Today American economists are merely the handmaidens of offshore producers. Apparently, they follow President Bush’s lead and do not read newspapers—thus, their ignorance of countless stories of U.S. manufacturers moving entire plants and many thousands of U.S. engineering jobs to China.
Chinese firms, including state-owned firms, have numerous reasons, tax and otherwise, to understate their employment. Banister’s report gives the details.
Banister points out that the excess supply of labor in China is about five to six times the size of the total U.S. work force. As a result, there is no shortage of workers in China, nor will there be in the foreseeable future.
The huge excess supply of labor means extremely low Chinese wages. The average Chinese wage is $0.57 per hour, a mere 3 percent of the average U.S. manufacturing worker’s wage. With First World techno-logy, capital, and business know-how crowding into China, virtually free Chinese labor is as productive as U.S. labor. This should make it obvious to anyone who claims to be an economist that offshore production of goods and services is an example of capital seeking absolute advantage in lowest factor cost, not a case of free trade based on comparative advantage.
American economists have failed their country as badly as have the Republican and Democratic p
arties. The sad fact is that there is no leader in sight capable of reversing the rapid decline of the United States of America.
May 8, 2006
Chapter 11: Their Own Economic Reality (Or Why Even Jobs at McDonald’s Aren’t Safe)
Who can forget the neocons’ claim that under their leadership America creates its own reality? Remember the neocons’ Iraq reality—a “cakewalk” war? After years of combat, thousands of casualties, and cost estimated at over $1 trillion, real reality must still compete with the White House spin machine.
One might think that the Iraq experience would restore sober judgment to policymakers. Alas, neocon “reality” has spread everywhere. It has infected the media and the new Federal Reserve Chairman, Ben Bernanke, who just gave Congress an upbeat report on the economy. The robust economy, he declared, could soon lead to inflation and higher interest rates.
Consumers deeper in debt and fresh from their first negative savings rate since the Great Depression show high consumer confidence. It is as if the entire country is on an acid trip or a cocaine trip or whatever it is that lets people create realities for themselves that bear no relation to real reality.
How can the upbeat views be reconciled with the Bureau of Labor Statistics’ payroll jobs data, the extraordinary red ink, and exploding trade deficit? Perhaps the answer is that every economic development, no matter how detrimental, is spun as if it were good news. For example, the worsening U.S. trade deficit is spun as evidence of the fast growth of the U.S. economy: the economy is growing so fast it can’t meet its needs and must rely on imports. Declining household income is spun as an inflation fighter that keeps mortgage interest rates low. Federal budget deficits are spun as letting taxpayers keep and spend more of their own money. Massive layoffs are spun as evidence that change is so rapid that the work force must constantly upgrade skills and re-educate itself.
How the Economy Was Lost: The War of the Worlds (Counterpunch) Page 5