Isegoria

Tyler Cowen cites this interesting interview with Warren Buffett on regulation:

Well, it’s really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that’s $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went — wrote 100 page reports, and they said, ‘We’ve looked at these people and their standards are fine and their directors are fine and everything was fine.’ And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350 — 340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn’t have a word in there about themselves, and they’re the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

David Friedman explains that the interest rate is not the price of money; the price of money is what you must give up to get money:

If apples cost fifty cents each, the price of money is two apples. More generally, the price of money is the inverse of the price level — when prices are high, that means that money is not worth very much.

The interest rate is the rent of money measured in money. Suppose you borrow a hundred dollars at ten percent. If the price of a dollar is two apples, you are borrowing the price of two hundred apples and paying the price of twenty apples a year in interest. If the money supply doubles, prices double, including the price of an apple, you are borrowing the price of a hundred apples and paying the price of ten apples a year in interest. If you prefer, you could do the same real transaction as before by borrowing two hundred dollars and paying twenty dollars a year interest, still at ten percent.

As this example suggests, there is no connection between the amount of money in circulation and the interest rate. There is a connection between the rate of change of the amount of money in circulation and the interest rate, but it goes in the opposite of the direction implied by the error I am discussing. When the money supply is increasing and prices are rising, nominal interest rates are high, not low, because lenders must be compensated for the fact that they will be paid back in dollars worth less than the ones they lent.

Much of the confusion here comes from the multiple meanings of the term “money.” When we say someone has lots of money, we don’t usually mean that he has a lot of green paper or a large balance in his checking account; we mean that he is wealthy. His wealth might be in money, it might be in valuable real estate, it might be in stocks and bonds. If there is lots of money in that sense — more precisely, if lots of people have wealth they would like to lend out — that will tend to lower interest rates. But that has nothing to do with the amount of money in circulation.

This confusion becomes a problem when people link the current crisis with the events that led to the Great Depression:

Those events produced a sharp drop in the money supply, due to banks going broke and depositors either losing or withdrawing their deposits. Given the nature of a fractional reserve system, replacing a mix of currency and deposits with just currency reduces the total amount of money in circulation, in that case by a lot. The problem could have been prevented if the Federal Reserve System had kept those banks from failing, which was part of the purpose it had been set up for, a purpose that had been served earlier by the private arrangements among banks that it effectively replaced.

That series of events cannot happen now because the FDIC insures bank deposits. What we are observing is not a drop in the money supply. It is a loss of wealth, as firms discover that their assets, in particular mortgages and securities backed by mortgages, are worth less than they thought. That explains why the proposed bailout is enormously greater than would be required to prevent a run on bank deposits. $700 billion is roughly half the total money supply of the U.S. (M1 — currency plus checking accounts and similar assets) — and about half of that is currency, which isn’t going to vanish whatever happens to the banks. The total wealth of the economy is enormously greater than the total amount of money in the economy, and the bailout is a response not to a reduction in the amount of money but a reduction in the amount of wealth.

That also explains why the bailout has very little to do with preventing another Great Depression. The U.S. money supply at the moment is at or near its all time high, and it is hard to see how anything likely to happen, with or without a bailout, will reduce it by much. The mechanism that set off the Great Depression isn’t happening.

What is happening is the failure of lots of firms — which doesn’t wipe out wealth. Their assets simply get sold to new owners:

All the bailout can do is to shift the loss from some people to others, from the stockholders and creditors of firms that are now effectively bankrupt to the taxpayers.

Meir Kohn examines How and Why Economies Develop and Grow, and he notes that economies don’t typically operate at their full potential:

Let us begin by broadening our definition of economic activity. For the Ricardian theory, economic activity is identified entirely with production — the actual creation of goods and services. But in fact there are two additional economic activities quite distinct from production. One is commerce — trading for a profit the goods and services that others produce. The other is predation — taking by force the goods and services that others produce or trade. Both commerce and predation are economic activities in that each, no less than production, provides a way of making a living.

The existence of these three distinct ways of making a living is particularly clear to students of preindustrial history, because each of the three was then the sole province of a distinct group specialized in that activity. Production was the work of landowners, peasants, and artisans. Commerce was the work of merchants, who were not generally directly involved in production themselves. Predation was the work of specialists in the use of force. Some of the latter were self-employed — various bandits and pirates. But most were agents of governments. Indeed, as we shall see, governments were by far the most important source of predation. Of course, governments also played a vital role in protecting against predation: this too required the use of force. So force, predation, and government were closely intertwined.

The key to a broader and more satisfactory theory of economic progress is an understanding of the effects of these two additional activities — commerce and predation.

Such a theory can be stated quite concisely in the form of two related propositions:

Proposition 1. Commerce promotes production; predation inhibits it.

Proposition 2. Limit predation (get government right), and economic progress will take care of itself.

These propositions go back to Adam Smith’s Wealth of Nations:

Smith’s famous dictum: “The division of labor is limited by the extent of the market” is the core of Proposition 1. Proposition 2 is essentially a rewording of the Smith quotation taken as this book’s epigraph: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes and a tolerable administration of justice; all the rest being brought by the natural course of things.”

The history of finance is, surprisingly, full of interesting tidbits. For instance, in 1424, Florence created its Monte delle Doti or dowry fund:

A father could invest in the fund in the name of an infant daughter: if the daughter survived and married, the fund provided a specified amount as dowry (if not, the investment reverted to the fund). This was similar to a life annuity in that it enabled a father to provide security for his children. So popular was the Monte delle Doti, that Florence, under Cosimo di Medici, was able to rely on voluntary sales of its shares instead of on forced loans.

That last bit reminds us of the fine line between municipal finance and outright taxation.

Scott Reynolds Nelson, professor of history at the College of William and Mary, says that the parallels of our current financial crisis are not with the Great Depression of 1929 but with what his 96-year-old grandmother still calls The Real Great Depression, the Panic of 1873:

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad. Britain, the biggest importer of wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872 kerosene and manufactured food were rocketing out of America’s heartland, undermining rapeseed, flour, and beef prices. The crash came in Central Europe in May 1873, as it became clear that the region’s assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.

The long-term effects of the Panic of 1873 were perverse. For the largest manufacturing companies in the United States — those with guaranteed contracts and the ability to make rebate deals with the railroads — the Panic years were golden. Andrew Carnegie, Cyrus McCormick, and John D. Rockefeller had enough capital reserves to finance their own continuing growth. For smaller industrial firms that relied on seasonal demand and outside capital, the situation was dire. As capital reserves dried up, so did their industries. Carnegie and Rockefeller bought out their competitors at fire-sale prices. The Gilded Age in the United States, as far as industrial concentration was concerned, had begun.

As the panic deepened, ordinary Americans suffered terribly. A cigar maker named Samuel Gompers who was young in 1873 later recalled that with the panic, “economic organization crumbled with some primeval upheaval.” Between 1873 and 1877, as many smaller factories and workshops shuttered their doors, tens of thousands of workers — many former Civil War soldiers — became transients. The terms “tramp” and “bum,” both indirect references to former soldiers, became commonplace American terms. Relief rolls exploded in major cities, with 25-percent unemployment (100,000 workers) in New York City alone. Unemployed workers demonstrated in Boston, Chicago, and New York in the winter of 1873-74 demanding public work. In New York’s Tompkins Square in 1874, police entered the crowd with clubs and beat up thousands of men and women. The most violent strikes in American history followed the panic, including by the secret labor group known as the Molly Maguires in Pennsylvania’s coal fields in 1875, when masked workmen exchanged gunfire with the “Coal and Iron Police,” a private force commissioned by the state. A nationwide railroad strike followed in 1877, in which mobs destroyed railway hubs in Pittsburgh, Chicago, and Cumberland, Md.

In Central and Eastern Europe, times were even harder. Many political analysts blamed the crisis on a combination of foreign banks and Jews. Nationalistic political leaders (or agents of the Russian czar) embraced a new, sophisticated brand of anti-Semitism that proved appealing to thousands who had lost their livelihoods in the panic. Anti-Jewish pogroms followed in the 1880s, particularly in Russia and Ukraine. Heartland communities large and small had found a scapegoat: aliens in their own midst.

Municipal annuities found a ready market soon after their development in the 13th century, because municipalities received steady tax income — much steadier than territorial governments:

Usually, lenders were given a prior claim on a specific sources of tax revenue. For example, in Amsterdam, collection of the excise taxes on beer, wine, and grain was contracted out each year to tax farmers. The latter, as part of the arrangement, were required to make payments on all outstanding annuities before passing on any excess to the authorities.
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Cities and towns rarely defaulted: municipal government was generally controlled by merchants, a group highly cognizant of the reputational cost of default. Moreover, all citizens or freemen of a city or town were jointly liable for its debts. Consequently, in the event of default, any merchant or property from the offending municipality could be seized for ransom. This recourse was available, of course, only to people living outside the town in question. As a result, municipal debt tended to be held by citizens of other towns, and investors generally avoided the debt of their own towns. To further protect themselves, investors diversified: one individual was recorded as receiving payment from 120 different issuers.
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Territorial governments found it much harder than municipal governments to tap the market for annuities, because their credit was inferior. Government debt was essentially the personal debt of the prince. Like other nobles, a prince could sell rents on his personal or ‘ordinary’ income. This consisted mainly of income on his domains but it might also include traditional taxes and mining royalties. Princes were more constrained in their ability to impose taxes than municipalities: some sort of parliamentary consent was generally required and it was far from automatic. Therefore, for princes, tax revenue or ‘extraordinary’ income was less promising as a basis for annuities than they it was for municipalities. However, the greatest handicap for princes as borrowers was the lender’s lack of legal recourse in case of default: a prince could not be sued in his own courts.