As is now the practice on many college campuses, I should preface this week’s newsletter with a trigger warning. What you are about to read could give you serious heartburn, especially if you are an economist or a central banker. Or a retiree or just someone who has lived life playing by the rules, and now you find yourself getting no return on your savings, forcing you to save even more and work even longer. Let me be careful to point out that I am not including all economists in my rather sweeping indictments. But if the shoe fits… -
I also know that this special letter is a little longer than the average. But I think the topic requires a whole-cloth approach rather than yet another two or three-part series. [Sorry John, but it is really long so we have split it into two articles. Part 2 will run on interest.co.nz tomorrow].
Before we jump in, I want to note that economic chaos is not my only concern. We face a whole different kind of chaos on the geopolitical front. To a considerable degree it overlaps with the economic problems I’ll discuss today. George Friedman has been calling the Eurasian landmass a “cradle of disorder.” It’s home to 5 billion people, and it’s floundering in a sea of accelerating crises.
Regular readers know that George doesn’t exaggerate. He may be the most fact-driven person I’ve ever worked with. He looks at good evidence and draws sound conclusions. And right now he sees evidence in Eurasia that looks chillingly similar to what happened in the years leading up to World War II. I know that’s a strong statement. George doesn’t issue it lightly. He is genuinely concerned – and I am, too.
We decided the best way to share George’s conclusions with you was visually. So, we’re making a short documentary film titled Crisis & Chaos: Are We Moving Toward World War III? George and a film crew are in New York right now, putting it together.
I devoted my last two newsletters to the Fed’s seemingly unstoppable momentum toward a negative interest rate policy. Here are links in case you missed them:
Those letters brought a lot of responses but one in particular from my friend Newt Gingrich, who forwarded a column from John Crudele with the provocative headline “You’re not imagining things, the economy really is rigged against you.”
Newt asked me a question that was characteristically short and simple: “Where are you on the rigged economy theme and the Fed-big bank alliance against normal people?”
And, as his short questions tend to do, it required a long answer. I sat and thought about it for several days. Crudele has a point, I told Newt when I wrote back, but the issue he addresses is nuanced and the solution far from obvious. And the more I thought about it, the more it seemed that the best way to answer Newt’s question was to write this week’s letter.
Yes, the system is rigged, just not in the way that 99% of the people think it is and not by those they think are doing the rigging. Greed is not the reason for the rigging, nor are any of the other usual “follow the money” reasons. We cannot make a convenient demon out of Wall Street or the big banks and investment banking houses. The real culprits are far less sinister and are actually sincere in their motives, so you won’t see an Oliver Stone movie about the conspiracy to defraud the middle class and strip them of their hard-earned retirement savings.
No, the “bad guys” in the story are just Nobel laureates, tenured professors, and other honorable members of the economic academic establishment, what Ken Rogoff calls the “policy community.” The Occupy Wall Street crowd had a right to be angry, but they should have been demonstrating in front of the economics schools at Harvard, MIT, Princeton, Yale, etc. You know, the school s that many of those Occupy Wall Street protesters themselves attend.
The economy has been rigged through a process that may have seemed innocent enough at any given point but that quickly put us on a slippery slope as ideological forces captured the ramparts of academic economic science. A brief history will bring us up to date.
The creature from Jekyll Island
In 1913, the Federal Reserve was created by the major banks as a way to protect them from crashes. (The disastrous Bankers’ Panic of 1907 was still fresh in their minds). And there is no doubt that the Fed was designed so that the big banks retained as much control as they could convince a skeptical Congress to grant them, while giving in on a few minor points. But sometime in the ’90s power shifted. The servant became the master; and while it is certainly true that Wall Street and large banks and investors currently benefit from the policies of the Federal Reserve, they really are not in control anymore.
In the 1930s and into the early ’40s, an intense debate ensued among economists about how to best measure the national income and gross productivity. The questions were magnified by the Great Depression. I have written about this debate at length in reviewing a 140-page book called GDP: A Brief but Affectionate History, by Diane Coyle. The book can be read in a pleasant Sunday afternoon, and I highly recommend it. I am going to quote a paragraph and summarize the rest below. Writes Ms. Coyle:
There is no such entity out there as GDP in the real world, waiting to be measured by economists. It is an abstract idea…. I also ask whether GDP alone is still a good enough measure of economic performance – and conclude not. It is a measure designed for the twentieth-century economy of physical mass production, not for the modern economy of rapid innovation and intangible, increasingly digital, services.
So how did this nonsensical measure we call GDP come about? Fact is, you actually do have to try to measure an economy if you are going to be a government and especially a wartime government. Without such a measure, how do you know how much can you actually tax and produce for the war effort, let alone for welfare and other services?
The argument boiled down to debates between followers of John Maynard Keynes and more conservative economists, either the disciples of Friedrich Hayek and Ludwig von Mises or followers of the classical school of economics. Conservative voices argued that the government’s taxing and spending simply took money from the citizens/taxpayers and put it to work somewhere else, so that it was not really contributing to the true productive economy. (The argument was far more nuanced and detailed than that, but I boiled it down to its simple central idea.) Those on the other side argued that you had to know about the effects of taxes, depreciation, and the myriad forms of government spending in order to understand the economic capacity of the country.
But the issue really came down to the political argument: If you do not include government spending in GDP, the economy will appear to be shrinking in the middle of a war or in a recession, even though the government is spending money hand over fist. From the point of view of politicians who wanted the government to spend more on goods and services (and yes, war), including government spending in GDP made total sense, because you want to be able to tell the citizens the economy is growing. Politicians have been spinning data and news for ages. Whether we’re talking about the results of reading sheep entrails or of dicing modern economic data, the information is spun to make the politician look good.
The controversial decision to include government spending in GDP was a political move made by President Roosevelt and the Democrats, who were in charge during the Great Depression.
Within a short time, the inclusion of government spending in GDP was accepted as economic dogma by all major economic institutions. This of course made it easier to argue for and act on Keynes’s assertion that government should spend during recessions, stimulating the animal spirits of consumers and driving up consumption. Who could even question such an assumption? Only troglodytes, the less-educated along, and other sorts of deplorables.
In the ’50s and ’60s, economists succumbed to physics envy. They wanted their less-than-precise discipline to be considered a hard science, too. Theirs was a far cry from the approach of Adam Smith and the classicists. As economics became more and more concerned with data and data analysis, with statistics and statistical analysis, it seemed to academic economists that with enough research they could actually develop models that would tell us how the economy really works.
In the ’70s and ’80s, the current leadership of the central banks of the world were all bright-eyed students at the same schools – the MITs, Harvards, Columbias, and Princetons of this world. The University of Chicago and its “freshwater” economists (as opposed to the “saltwater” economists on the East and West Coasts) held sway for a time, too, but that time has sadly passed.
Keynesian and then neo-Keynesian economics became the driving force in academia. Politicians and bureaucrats courted them because Keynesian economists basically gave them permission to spend money. See for easy reference any of Paul Krugman’s New York Times columns advocating ever more fiscal spending and ever easier monetary policy.
The neo-Keynesian philosophy now dominates the thinking of central bankers worldwide; but before we explore that point further, I want to quote from a brilliant book review by my friend James Grant of Interest Rate Observer fame of Prof. Ken Rogoff’s latest book, The Curse of Cash. I have found this book and the reviews of it disturbing, because Rogoff was one of my heroes for his earlier book This Time Is Different, which is a brilliant tour de force on the problems of debt. Having met Rogoff, I can assure you he is a very pleasant, easy-going man. But his argument in The Curse of Cash is not quite so benign or pleasant.
The Curse of Cash argues that we should get rid of the $100 bill because it hampers the Federal Reserve’s control over the money supply and makes it more difficult for the Fed to employ negative interest rates. Let me quote one paragraph from Grant’s review (emphasis mine):
In a deep recession, Mr. Rogoff proposes, the Fed ought not to stop cutting rates when it comes to zero. It should plunge right ahead, to minus 1%, minus 2%, minus 3% and so forth. At one negative rate or another, the theory goes, despoiled bank depositors will stop saving and start spending. According to the worldview of the people who constitute what Mr. Rogoff fraternally calls the “policy community” (who elected them?), the spending will buttress “aggregate demand,” and thus restore prosperity.
You may doubt this. Mr. Rogoff himself sees difficulties. For him, the problem is cash. The ungrateful objects of the policy community’s statecraft will stockpile it.
I have a problem with Mr. Rogoff’s proposing negative rates, but the problem I want to focus on in this part of the letter is the makeup of what he refers to as the “policy community.” What he means by that is the leaders of the economic community, a kind of self-defining non-organization in which very few non-Keynesians are included.
And now we get to the root of the issue. Economics has been divided into religious camps. It is a field every bit as divided as the Protestants and Catholics were in the 1500s or the Shia and Sunni are today. There are those who are considered orthodox and those who are considered heretics, and there is a priesthood of the believers. When you are anointed as a high priest, you become part of the “policy community.” Yes, the priesthood has its own disagreements. These are, after all, academics, and they make their academic bones by proposing ideas and producing papers (generally with lots of math that’s hard to follow) and then arguing about them.
In general, to be accepted as a high priest in the Keynesian economic religious community you have to agree to a certain set of principles contained within their catechism. And one of the most important principles is that consumption is the driver of economy, a corollary to which is that the twin dials of money supply and interest rates can raise or lower consumption and thus moderate inflation and deflation. Implied within that principle is the assumption that it is incumbent upon the central bank, as an independent figure in the economy, to control the money supply and interest rates in the best interests of the overall economic polity.
Let us look back for a moment, some 2,400 years, to the time of Plato in Athens. Plato was writing his Republic, which has profoundly influenced Western thought across the centuries. In the book he idealized what he called Philosopher Kings. They are the rulers of Plato's utopian city of Kallipolis. If his ideal city-state is ever to come into being, Plato says, “philosophers [must] become kings… or those now called kings [must]… genuinely and adequately philosophize.”
Today’s academic economists would certainly dismiss the notion that they are Philosopher Kings, but that is essentially what they have become. The world’s central bankers have taken upon their sturdy shoulders the mantle of infallibility: they see themselves alone as being sufficiently knowledgeable and competent to be able to determine the price of the single most important commodity in the world, money, and have determined that the setting of that price cannot be left to the hoi polloi of the marketplace. To trust the unruly, unpredictable market with such matters would plunge the world into chaos; and thus the High Priests have assumed responsibility for the general economic wellbeing.
And there you have it. The rigging of the economy against the interests of average citizens is not the fault of Wall Street, nor even of Washington, DC, but rather is the result of a historical process that, step by step and byte by byte, has elevated economics and its leading practitioners to the status of an almighty priesthood.
I have met many of these men and women. As individuals, many are quite humble and personable. But when they assemble in groups and sit around tables at central banks, they consign to themselves the magical ability to divine what is best for an economy of 330 million people in the US and billions around the globe.
Of course, they would resent the reference to magic. They would argue that, far from resorting to hokus pokus, they employ theories and models that are highly mathematical and every bit as valid as anything physics or engineering can muster. The only problem is, these models have proven themselves to be unbelievably incapable of predicting anything about the future and have an unblemished record of failure in describing what is going to happen in the world.
All these models can do is apply economic theory to the data. Data that cannot be readily plugged into the mathematical model must be ignored. Data that is sketchy or incomplete corrupts the output from the model. And the Federal Reserve certainly does not have access to all the data that would be required to model an economy as complex as that of the United States.
Further, models are created from assumptions. And the assumptions behind them are just simply wrong. Though today’s economic Philosopher Kings have Nobel prizes and PhDs, though they understand all sorts of mathematics that I will never get my head around, the simple fact is that their models have been proven to be consistently wrong. Any business that operated according to models so demonstrably bad would be bankrupt overnight, and the wizards who created those models would be fired. Yet central banks continued to crank out models that don’t work and then endlessly tweak them without ever challenging their core assumptions.
Nearly all economic models assume the theoretical existence of some sort of dynamic equilibrium state. That’s because you can’t model a system that is complex and chaotic in an Excel spreadsheet or even in the latest and greatest statistical software. To even begin to reliably model the economy, you would have to apply complexity economics, a field that is still in its infancy.
George Gilder’s great insight is that knowledge is the currency that has real value, a fact that he derives from Claude Shannon’s information theory. Knowledge is the signal in the noise that lets the markets know how to respond and helps each of us to decide what to buy and sell, whether to go to work or to stay home, every day.
And that understanding of the economy, with knowledge and the informed decision making of economic players at its core, is not going to make it into any mechanistic model that the Priesthood of Economists concocts to determine what the price of money should be. Because we simply do not have the tools to model that kind of complexity.
As an aside, I want to make clear that not all of the high priests agree with a move to negative interest rates. There are actually some notable economists (including Nobel laureates) who think negative rates are a very bad idea; but in general, what we heard out of Jackson Hole is that they are quite an acceptable idea. The masterminds who hatched the philosophy that is used by the Fed are clearly planning to apply negative interest rates to the world’s reserve currency when the next recession hits. They would of course deny this and say that that negative rates are just another tool in the toolbox, which we should have ready just in case. Then in the same breath they’ll turn around and say, “Look, negative rates are working quite well in Europe and Japan.” You have got to wonder what they are smoking.
At the beginning of the letter I offered links to the two previous letters I have written on the problems with negative interest rates. Let me repeat those links right here:
You will read in the second letter my reaction to some truly outrageous comments by Federal Reserve Vice Chair Stanley Fischer, who shared a moment of perfect candor with Bloomberg’s Tom Keene, not realizing that some of us out here in the real world might take offense. Keene asked him about the impact of negative interest rates on savers (emphasis mine).
DR. FISCHER: Well, clearly there are different responses to negative rates. If you’re a saver, they’re very difficult to deal with and to accept, although typically they go along with quite decent equity prices. But we consider all that, and we have to make trade-offs in economics all the time, and the idea is, the lower the interest rate the better it is for investors.
That’s about as clear as it gets. The Fed has no interest in helping savers earn a decent return on their bank deposits or money market funds. Dr. Fischer thinks “decent equity prices” are wonderful and lower interest rates are good for investors. They are willing to trade off your returns on fixed-income for a rising stock market. Charitably, Dr. Fischer is looking at the economy as a whole rather than the specifics of individuals. He clearly sees his mandate as responsibility for the entire economy. The fact that some have to make “sacrifices” is part of the process. This is the burden of a Philosopher King. Someone has to make the difficult choices.
Is it even true that ultra-low or negative interest rates are better for the overall economy than rates that more accurately reflect unfettered market dynamics? There is a mountain of research to the contrary. By lowering rates to the zero bound, the Fed has stacked the deck in favor of a relatively small number of people who own the vast majority of financial assets. In so doing, it has created the conditions for moribund economic growth, persistent unemployment and underemployment of working-class citizens, and impoverishment of savers.
Further, the FOMC becomes breathless at even a hint of wage inflation, wondering if it will force them to raise rates; but the massive inflation they have caused in the stock market and other asset prices is somehow seen as a good thing. Bernanke and other central bankers have actually bragged about the effects of Federal Reserve monetary policy on the stock market. As if the stock market is something that the Fed should be focused on. I always kind of thought the focus was supposed to be on Main Street and the average guy out in the real world.…