Where Did All The Money Go?

How Lower Taxes, Less Government, and Deregulation Redistribute Income and Create Economic Instability

[T]he ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is . . . exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas . . . which are dangerous for good or evil.

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.
Max Planck,

I am a state-school economist. By that I mean I had the privilege of teaching undergraduate economics students at state colleges and universities for some twenty years prior to 1987. I believe this gives me a perspective on the discipline of economics that is somewhat different from those who have not been equally blessed. It also helps that I left academia in 1987 and no longer had to deal with the revolution that had been taking place in the discipline for some time—a revolution that seems to have come to fruition in 2008.

I spent the twenty years leading up to 2008 reading mostly mathematics and statistics books and paid little attention to the real world other than to watch the news. The financial crisis that reached its climax in that year took me entirely by surprise. I knew there was a problem in the housing market and that economic nonsense had been at the center of the political debate in our country for over thirty years, but I assumed, naively it turned out, that cooler heads would prevail, and sound economic policies would always be enforced. I had no idea our financial institutions would be allowed to overextend themselves to such an extent they could bring down the economy of the entire world. After the crash I decided to set aside other pursuits and try to find out what had been going on in the world of economics since I left academia.

When I began this quest I was stunned to find the extent to which free-market ideological beliefs had taken over the discipline of economics. I have a decidedly pragmatic, nonideological view of the world derived from an inductive analysis of history and real-world observations aided by deductive reasoning. I emphatically reject any ideological view that begins with first principles and attempts to deduce from those principles the way the world works aided by inductive analysis when history and real-world observations are consistent with those principles and oblivious when they are not.

My rejection of ideology means, of course, that I totally reject the ideological dogma that has defined freshwater economists since the 1930s. I have always seen their elevation of “economic liberalism and free markets above all else” and their relentless struggle against “government intervention” in the economic system as being incomprehensibly naïve if not outright paranoid.

As for saltwater economists, at least they are not hobbled by the ideological blindness created by the doctrinaire approach of freshwater economists, but their adherence to neoclassical methodology leads to a kind of streetlight effect as personified by the man who lost his keys in the park but looks for them under the streetlight because “this is where the light is.” Neoclassical methodology hinders the ability of saltwater economists to see problems and seek solutions that exist beyond the light shed by their neoclassical models. It seems to me this leads to a problem in their ability to understand how we got to where we are today and in formulating effective policies to deal with the root cause of the economic problems we face. This can be seen in the way their neoclassical models lead freshwater economists to recommend expansive monetary policy combined with increasing government expenditures and decreasing taxes to deal with the economic problems created by the housing bubble bursting. These policies, undoubtedly, would have solved our employment problem had they been forcefully applied, but they offer only a short-run solution to this problem, and they do not come to grips with the fundamental long-run problem we face today.

An extraordinary level of monetary expansion was absolutely essential to maintain the stability of the financial system during the crisis in 2008, but there is little reason to believe the quantitative easing that followed has made much of a positive contribution. Even if this policy is successful in reducing real rates of interest and thereby increasing investment and employment, the redistribution effects of the inflation this policy relies upon will do harm, and, in the end, could do more harm than good. This is fairly obvious even within the context of Saltwater Economics. (Stiglitz Summers)

As for increasing government expenditures and decreasing taxes, this is a formula for increasing government deficits and debt. While this may provide a short-run solution to our employment problem it also means increasing the transfer burden on taxpayers as increasing interest payments are transferred from taxpayers to government bondholders. Since government bondholders tend to be among the wealthiest members of our society, increasing government deficits is likely to have the added effect of increasing the concentration of income at the top of the income distribution. This is a problem that is not clearly understood by saltwater economists.

The fundamental difficulty faced by saltwater economists in attempting to understand the problems caused by an increase in the concentration of income is that the distribution of income does not appear as a variable in neoclassical models in a way that makes it possible to examine the effects of changes in the distribution of income within the economic system. In order to find answers to questions about how an increase in the concentration of income affects the economic system one must move out from under the light shed by neoclassical models and into the non-neoclassical park where the light is not so good. (Stiglitz) That’s where I have been for the past five years.

As I recount my journey through the non-neoclassical park in the pages below I come to the inescapable collusion that it was the ideological faith in the self-adjusting powers of free markets on the part of policy makers over the past forty years that has brought us to where we are today. This faith led policy makers to 1) abandon the managed exchange system embodied in the Bretton Woods Agreement, 2) institute the tax cuts that have occurred since 1980, and 3) deregulate our financial system. These policy changes made it possible for our financial institutions to increase debt beyond any sense of reason. These policy changes also led to a rise in our current account deficits (increasing debt to foreigners) and to the financing of speculative bubbles which, when combined with the tax cuts that have occurred since 1980, led to the increase in the concentration of income at the top of the income distribution that we see today.

The resulting increase in the concentration of income has led us to what I consider to be the fundamental problem we face today. Namely, that 1) given the increased concentration of income, 2) the degree of mass-production technology that exists within our economic system, and 3) the size of our current account deficits it is impossible to sustain the mass markets (i.e., the large numbers of people with purchasing power) needed to fully employ our economic resources in the absence of a continual increase in debt relative to income.

This is a problem because continually increasing non-federal debt relative to income is unsustainable in the long run since it increases the transfer burden on debtors as income is transferred from debtors to creditors through the payment of interest. This means that eventually the system must breakdown as interest payments increase and non-federal debtors eventually find it impossible to meet their financial obligations. This leads to financial crises in which the financial system must be bailed out by the federal government to keep it from collapsing and bringing the rest of the economic system down with it.

Continually increasing federal debt relative to income is a problem because as interest payments on the federal debt grow they must eventually overwhelm the federal budget. This will make it more and more difficult to fund essential government programs such as Social Security, Medicare, Medicaid, and national defense. And most important, as was noted above, an increase in government debt is likely to contribute toward a further increase the concentration of income. This will make the long-run problem we face worse because a further increase in the concentration of income will increase the rate at which debt must increase relative to income in order to fully employ our resources. Even though the federal government has the legal right to print the money needed to pay the interest on its debt, this does not solve the problem since it is fairly certain that doing so on a continual basis will eventually destabilize the economic system.

As a result, I reject the saltwater policy of increasing government expenditures and decreasing taxes that offers a short-run solution to the problems we face in favor of a policy of increasing government expenditures and increasing taxes in a way that 1) reduces the concentration of income and our current account deficits, 2) deleverages the non-federal sector of our economy, and 3) stabilizes the federal debt relative to GDP.

This is the only long-run solution I have been able to find in the non-neoclassical park I have been wandering in for the past five years. It seems to me that if we do not increase both government expenditures and taxes in a way that stabilizes the federal budget and reduces the concentration of income and our current account deficits, our economic situation can only get worse. In the absence of an increasing debt relative to income our ability to produce will be diminished as our employment problem is solved through the transfer of resources out of those industries that produce for domestic mass markets (our most productive industries) and into those that serve the wealthy few. In addition, our diminished ability to produce through the utilization of mass-production technologies portends stagnation or a fall in the standard of living for the vast majority of our population.

This is the story I tell in the pages below, and, given the nature of the debate within the discipline of economics today, I see little reason to believe this story will change anyone’s mind. There is certainly no hope at all that it will change the minds of freshwater economists as this story flies in the face of their most firmly held ideological convictions. There is, of course, some hope it will motivate saltwater economists to include the distribution of income as a variable in their models in a way that allows them to investigate the effects of the concentration of income on the viability of mass-production technology in the absence of increasing debt. The only real hope, however, is with the young who have not yet formed the opinions that will—for better or for worse—serve them for the rest of their lives. It is to the young that I dedicate this eBook for it is with the young that our hope for the future lies.

Chapter 1: Income, Fraud, Instability, and Efficiency examines the policy changes that have occurred over the past forty years and documents the consequences in terms of the increase in the concentration of income, fraud, economic instability, and economic inefficiency that followed in the wake of these changes.

Chapter 2: International Finance and Trade examines the consequences of these policy changes within the context of international trade and finance and documents the consequences of these changes in terms of the resulting increase in international economic instability and the effects of the resulting balance of payment deficits on domestic producers.

Chapter 3: Mass Production, Income, Exports, and Debt examines the historical relationship between the rise of mass-production technologies in the United States over the past one hundred years and 1) the current account surplus, 2) the concentration of income, 3) the creation of mass markets, 4) changes in debt, and 5) economic instability. It also explains the fundamental thesis of this work. Namely, that the extent to which a country is able to take advantage of mass-production technology is limited by the extent of its mass markets—that is, by the numbers of people in its markets for mass produced goods and services who have purchasing power—and that a country’s mass markets are, in turn, limited by 1) the distribution of income within that society, 2) the extent of its current account surplus, and 3) the extent to which it is possible to increase debt relative to income.

The next seven chapters are devoted to explaining 1) how our financial system works, 2) the mechanisms by which an unregulated financial system leads to increases in debt and the concentration of income, and 3) why the increase in debt and the concentration of income lead to economic instability.

Chapter 4: Going Into Debt explains the nature of financial intermediation and examines the relationship between the deregulation of our financial system and the resulting increase in debt that has occurred since 1980. The way in which ideological beliefs came to dominate policy making in the United Sates over the past forty years is discussed along with the way in which the deregulation of our financial system led to the housing bubble in the 2000s, its bursting in 2006, and the financial crisis that began in 2007 just as the lack of financial regulation led to the housing and stock-market bubbles of the 1920s, the Crash of 1929, and the financial crisis that began in 1930.

Chapter 5: Nineteenth Century Financial Crises examines the problems of nineteenth century banking, and explains how a banking system works. This chapter presents the kind of explanation of monetary expansion that can be found in most any economic principles or money and banking textbook, but with a difference. Instead of focusing on how banks create money, the focus is on how banks created debt and on how this debt creation mechanism leads to economic instability in an unregulated financial system.

Chapter 6: The Federal Reserve and Financial Regulation explains 1) the way in which the Federal Reserve controls the amount of currency available to the economy (i.e., the monetary base), 2) how this system evolved in the United States during the Great Depression, and 3) why the experiences of the 1920s and 1930s led to a rejection of the failed nineteenth century ideology of Free-Market Capitalism in favor of a pragmatic regime of regulated-market capitalism.

Chapter 7: Rise of the Shadow Banking System (and the following chapter) examine how our financial system changed with the revival of the failed nineteenth century ideology of Free-Market Capitalism that began among policy makers in the 1970s. The nature of various kinds of financial instruments is explained in this chapter along with the way in which collateralization led to the rise of the shadow banking system.

Chapter 8: Securitization, Derivatives, and Leverage explains the way in which income streams are securitized, the nature of financial derivatives, and the way in which financial derivatives increase leverage and, hence, in the absence of an exchange or clearinghouse, increase instability in the financial system.

Chapter 9: LTCM and the Panic of 1998 chronicles the events that occurred during the Panic of 1998 when a single hedge fund, Long-term Capital Management, posed a threat to the financial stability of the entire world. It is shown that all of the dangers implicit in the way in which our financial system had been deregulated were apparent to those who investigated this incident at the time but that ideological blindness inspired by an almost religious faith in free markets on the part of policy makers and elected officials made it impossible to heed the General Accounting Office’s warnings and regulate shadow banks and the over-the-counter markets for derivatives.

Chapter 10: The Crash of 2008 chronicles the financial crisis that began in 2007 and culminated in the near meltdown of the world’s financial system in 2008. It argues that, given the way in which our financial system had changed in the wake of the financial deregulation that had occurred in the proceeding forty years, this crisis unfolded in a very predictable way. It also argues that it was the size of the government and its active intervention in the economic system that kept the system from collapsing. It further argues that if the government had not been able to intervene in the way it did in the wake of the Crash of 2008 we would have suffered the same kind of fate we suffered in the 1930s.

Chapter 11: Lessons from the Great Depression examines the government’s response to the economic crisis during the Great Depression and shows how the conservative monetary and fiscal policies advocated by free-market ideologues today are the same policies that drove the economy into the depths of the Great Depression in the 1930s just as they have had a similar effect on Europe since 2010. It also argues that the kind of stagnation we experienced in the 1930s, and are in the midst of today, requires decisive government action and that tax increases played an important role in stabilizing the growth of federal debt during the depression and following World War II.

Chapter 12: Coming to Grips with Reality argues that today we face the same kind of situation we faced in the 1930s when, given the degree of mass-production technology available in the economy, the existing distribution of income and current account surpluses could not provide the mass markets needed to achieve full employment in the absence of an increase in debt relative to income. The only way we can create the mass markets needed to achieve full employment—and sustain the degree of mass-production technology that exists in our economy—in this situation is by 1) increasing our current account surplus (i.e., reducing our current account deficit), 2) increasing debt relative to income, or 3) by reducing the concentration of income.

Given the size of our economy, we cannot solve our employment problem entirely by increasing our current account surplus, (Stiglitz) and since we have apparently reached a point at which further increases in non-federal debt is no longer possible, this leaves only 1) continually increasing federal debt relative to GDP or 2) reducing the concentration of income. Since continually increasing federal debt relative to GDP is, at best, only a short-run solution and is likely to increase the concentration of income further, this leaves reducing the concentration of income as the only long-run solution that allows us to take full advantage of the mass-production technology that is available to us.

If we do not reject the kind of ideological nonsense that has guided economic policy for the past forty years and face this problem head on with a substantial increase in government expenditures and taxes that are specifically designed to 1) reduce the concentration of income, 2) achieve a reasonable balance in our current account, 3) deleverage the non-federal sector of the economy, and 4) rebuild the physical infrastructure and social capital that we have allowed to depreciate over the past forty years our economic situation will continue to deteriorate, and the standard of living of the vast majority of our population will continue to stagnate or fall as our ability to take advantage of mass-production technologies is diminished.

Endnotes

[1] The reason for the stability from the end of World War II through the 1970s and why this changed in the 1980s is examined in detail in Chapter 5 through Chapter 7 below.

[2] The reasons for the need to regulate the markets for derivatives are examined in detail in Chapter 8.

[3] The basic mechanism by which securitization is accomplished is examined in detail in Chapter 8 below. For an in-depth explanation of securitization that is quite readable see the Financial Crisis Inquiry Commission’s Preliminary Staff Report Securitization and the Mortgage Crisis.

[4] Mortgage-Backed Securities are explained in detail in Chapter 8.

[5] In a case study of Moody’s Investors Service the Financial Crisis Inquiry Commission’s Report concluded:

The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their down- grades through 2007 and 2008 wreaked havoc across markets and firms.

From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple-A that year ultimately were downgraded.

You will also read about the forces at work behind the breakdowns at Moody’s, including the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mort-gage-related securities could not have been what it became.

Real-World Economics

Endnotes

Real-World
Economics