In Response to Questions 1

My daughter-in-law raised some good questions in her comments to my post- Free Markets - Yes or No (Part 2). Another commentator also had questions regarding similar issues particularly regarding deregulation. It was necessary that I begin another post to try to respond to their questions because of the amount of information. I appreciate the dialogue very much. I think we really need to discuss these issues. They are vital to our future.

Kat said...

Hmmm... I'm going to go a little off topic here, but I hope that this will all tie together.

The rise of populist movements can be traced throughout history with the rise and fall of economies. Recessions always bring populist movements. This recession has been very interesting for me in that it has brought up a conservative populist movement when historically those movements have been to the left of center.

I find it intellectually fascinating how the "pendulum" has swung. During the Progressive Era, the populist movements of unions and other labor/political activists brought about some VERY needed changes in the free unfettered markets in this country. While I understand that some people think that unions have outlived their usefulness; at one time they were needed. 40 hour work weeks are a good thing. No child labor is a good thing. A living wage is a good thing. None of these things were even an option during the early years of Industrialism and before government regulation of the markets.

I would like to throw the idea out there that perhaps we are in the mess we are in because of the opening and deregulation of the markets. I don’t believe that the government should control the entire economy, but I do think that some regulation is necessary.

Denny said...

...wasn't there a fairly regular cycle of booms and busts prior to the great depression and the regulatory controls it inspired, followed by decades of relative stability until deregulation started chipping away in the 80's? would i be wrong to associate a cause and effect there? i appreciate youre creating this blog and enjoy reading youre thoughts and comments

To begin with Kat --I was raised in one of the “steel centers” of our country - the Chicago/Lake Michigan area. My dad took care of his family (that’s us) with his 30 plus years at Blaw-Nox Steel Company in East Chicago, Indiana. For us the collective bargaining of the steel unions was essential. This bargaining made what otherwise would have been an unacceptably dangerous job acceptable and profitable for my dad and for us with benefits we all needed. However the danger of unions is critical to understand. Production is a very important factor in the level of wages. If within an industry production is up because of substantial demand for the product, wages also need to rise. For the employers within that industry unless they raise wages they run risk of losing their workers to other employers who see that there is much profit to be made if they can increase their supply of the product. This whole scenario has a tendency to force wages up to market level. The problem comes when some employers find a way to keep their employees but without raising the wages. In such situations collective bargaining is very useful for putting pressure on stubborn employers.

However the danger comes when labor unions become politically powerful enough to force wages above market. This will cause unemployment and other detrimental consequences. Minimum wage laws also increase unemployment. The balancing of wages has to be tied to production and the wage earner’s part of the production. If laws force employers to have to pay more than market or to pay employees above their productivity, they will lay off employees. As I read economists (not government economists) I find that there are many factors contributing to our present situation of persistent unemployment. The factors include the minimum wage requirements. The finger also must point to monetary policy of our government/Fed Reserve. The devaluing of the dollar has contributed to the loss of production which also results in unemployment.

Deregulation is often viewed with suspicion. Like taking controls off of powerful and wealthy folks seems like a dangerous policy. However, removing regulations and restrictions from markets is essential. But it has to be done with a respect for how markets work and has to be done within a market where its functions have not already been disabled. One of the fundamental functions of the market is price control - either up or down. Most people have no idea how powerful those forces are. I know I did not either. These forces are tied firmly to an industry’s participant’s ability to attain and maintain profitability. It is like a balancing act. On one side is the opportunity for increasing revenues and charging what the market will bear. On the other side are the risks. Risks of misunderstanding the market demand and being beaten out by competition. Sears for many years was the king of department stores. However, the company lingered in upgrading its business model. Lo and behold Sears found itself far down the ladder beneath companies like Best Buy, Home Depot and a host of others. Now Sears is having to hustle - innovate- improve service - to try to regain the lost market share. We (the consumers) are the beneficiaries of this situation that produces better products at lower prices.

So what about the financial markets and the deregulation that Greenspan allowed which resulted in the crisis we now find ours in? NPR covered extensively the recent Senate review/investigation of the financial meltdown we’ve just experienced. They brought in Alan Greenspan to answer some questions. He denied over again that the Fed was any cause of the present situation. He blamed Congress for encouraging Fannie Mae and Freddie Mac to purchase more bundled mortgage securities. They purchased 40% motivating mortgage companies to scramble to find more mortgages to bundle and sell earning significant commissions. In addition Greenspan maintained that the Fed had done everything that experts are suggesting that they should have done. And that because of what they had done, things did not turn out as badly as they could have.

There were comments that Greenspan was warned enough but ignored warnings. Greenspan maintains that the Fed policy of keeping the interests rates low did not encourage risky lending. Others say that this policy was indeed a contributing factor. There are many theories floated as to how this fiasco could have happened and under who’s watch did it occur.

AIG bailed out Goldman Sacks with bailout money orchestrated by the Fed. Goldman Sacks when accused of having a special privileged relationship with AIG enabling them to receive those funds replied that they did not have any such relationship. That their contractual agreement would have resulted in them receiving the funds in any case. Goldman Sacks stated that we should be willing to accept volatility from time to time considering what a valuable service they perform for the country.

All of this discussion, conflict and contradicting opinions among experts in the political and economic fields underscores an aspect of all of this that seems to be constantly overlooked. That is the conflict of interest inherent in the function and mission of the Federal Reserve System. The Fed is chartered as the lender of last resort. That has come to mean that the banking system will always have a way out regardless of any risky activity that backfires. The Fed promotes and supports fractional reserve banking, an age old practice which does not require that adequate reserves be held by any banking institution. When reserves are needed, the banks simply access their line of credit with the Fed.

All of this means that the very existence and mission of the Fed encourages risky behavior. This is clear from the beginning of the Fed. The Fed cannot effectively push for the enforcement of strong regulations without sabotaging its mission to endlessly expand banking, the money supply and credit. So it is clear that there is conflict of interest that cannot be resolved as long as we have our present Federal Reserve System. There is no free market in the banking industry as long as the Fed is there to shield banks from market discipline. Therefore deregulation in this context is suicide. Deregulation can only work when the market participants are fully exposed to risk and have to bear the responsibility for their decisions.

The country of Panama has no central bank. They never have for the 100 years that they have been independent. They have a very successful and stable macroeconomic environment. As s result of having no central bank their money supply has become completely market-driven. They have had some banking problems but nowhere near the crises that we have experienced. They are the only Latin American country that has not experienced a financial collapse or a currency crisis since its independence.

Panama’s inflation is always 1 to 3 points lower than the U.S. And even that inflation is caused by the U.S. Federal Reserve’s effect on world prices. They even have had some years that were deflation years. We have been taught to fear deflation. In reality deflation is a healthy function of the market. It produces adverse correctional activity for the financial markets - they lose profits. But it is good for the rest of us as prices are periodically driven downward. But our Fed manipulates markets in attempts to avoid deflationary cycles. In Panama deflation happens without the terrible consequences predicted by our government Keynesian economists. Presently the Panamanians are in their 4th year of market economic growth well above 7%. Oh well, I can at least dream.

Panama Has No Central Bank
http://mises.org/daily/2533

Regarding booms and busts prior to Great Depression: Yes we had them but I think there is some misunderstanding about them. I am putting together another post to explore our history of bank volatility in more detail.