Thursday, July 18, 2019

Reflection on Secrets of the Temple: How the Federal Reserve Runs the Country by William Greider


               Now here’s a five-star book. I know that I say good things about almost every book I read, but this one really stood out as an excellent book, written in a way that gives you not only a really detailed look at the Federal Reserve during Paul Volcker’s term (1979-1987) but the whole history of the institution and a deep analysis of its effects on average Americans.
               When President Jimmy Carter appointed Paul Volcker to be the new Fed Chairman in 1979, the country was dealing with high inflation that had not really abated since World War Two. Volcker was determined to end inflation. The inflation had a few different effects on the American economy. Inflation caused prices to continue to increase, which generally has a negative psychological effect on consumers. It also resulted in higher interest rates, because if a creditor charged 5% interest on a loan in an economy with 7% inflation, they would lose money on their loan. It had positive effects, however, because with more inflation, people’s salaries went up and their house values also went up. It also means that debtors/borrowers are favored over creditors since the real value of loans decreases.
               It happened that by the end of the 1970’s, the Democrats were abandoning the liberalism that they had embraced since FDR’s time, largely in reaction to the high inflation that government spending had helped create. They repealed usury laws, allowed interest to be gathered on checking accounts, and abolished interest rate ceilings, all things that helped the financial sector. It was likely because of the shame they felt over the high inflation, and they were trying to “apologize” to creditors. Greider compares the repeal of usury prohibition to the end of sexual and moral taboos that had begun to become more permissive in the 1960’s and 70’s. Usury, however, unlike sexual and moral taboos such as drugs, homosexuality, and the role of women, was allowed with no controversy at all. Creditors would now charge exorbitant rates to their lenders.
               Volcker was concerned in 1979 that the economy was running on borrowed money and wanted to put an end to inflation for fear that it could “heat up” enough to cause a crisis in which the dollar lost its value. There was a big controversy about ending inflation. It had been tried before but had failed, often because the cost was so high. To end inflation would likely mean a recession, as people who had taken out loans will find they can’t pay them back at interest rates that have effectively increased, being that they expected to pay their interest based on a higher inflation rate. The Fed, however, represented large banks, who were major creditors, and wanted higher returns on their loans. In Mach 1980, the Fed announced credit controls meant to reduce borrowing and lower the amount of money moving around the economy. It had a sharp impact. Unlike measures that had been announced the past October, the Fed announcement in March was made in blunt, easy-to-understand language. The nation needed to borrow less and stop using their credit cards so much. Unlike October, the mostly aesthetic changes in March caused Gross National Product to drop 10% in just three months. For the first time in history, a Democrat (Jimmy Carter) put the nation’s economy into recession.
               However, the recession didn’t last. Scared by the effects of what they did, the Fed backed off and allowed inflation to return to 11%, letting the economy grow once again. As I learned in this book, inflation tells you the maximum amount that an economy can grow by. So in 1980, there was a sharp dip and a return to normal growth. However, that same year they would return to the hard-money politics that caused the recession as they tried to beat inflation again. Part of the motivation was political, being that it was an election year. Volcker didn’t want to be seen as helping the president who nominated him. Instead of heling Carter, he would end up crushing him in the second recession of the year.
               In Part 2 of the book, we go back in time and study the history of the Federal Reserve. I really enjoyed learning about the Populist movement and all the lawmaking in the 1910’s that developed the Fed. I also want to know more about the “great contraction” that happened in 1937, that Greider attributes to a reduction in government spending, as well as post WWII Fed actions that kept inflation high. I understand now that JFK and LBJ overheated the economy in the 1960’s and that the Fed needs to “lean against the wind,” meaning higher taxes and lower spending in good times, lower taxes and higher spending in bad times. It’s just like how the Egyptians prepared for a famine by storing grain in the good times to be ready for the bad times. One problem, however, comes up again and again. No one wanted to turn off the proverbial faucet of high spending and low taxes. It was just too tempting and caused huge inflation from the 1940s through 70s. When Reagan came into office in 1981, tried to hit a perfect (and impossible) trifecta: increasing growth, decreasing inflation, and having no deficit. This cannot happen (especially when they also proposed increased military spending) because with less money circulating, growth could only be maintained by people spending that money faster. The numbers didn’t add up, and with the help of tax cuts, the deficit grew. They raised taxes later, but the plan was fundamentally political, not economic.
               Early in Reagan’s administration, the Fed, against Reagan’s wishes, caused another recession to reduce inflation. In retrospect, however, this was probably better for Reagan since it meant that it would not come when he was up for reelection. Reagan would manage to pass tax cuts through congress by putting out fake projections, although Reagan himself was not notified, reflecting the distance he had from his own administration. The tax cut would largely benefit the rich, as would the increase in interest rates from 1979 onward. By 1982, those interest rate hikes would generate 148 billion dollars in additional income for the owners of financial assets. That huge increase brought American income from interest payments to $366 billion, almost as much as the $374 billion spent on veterans pensions, Social Security, and welfare combined. It was a redistribution of wealth! However, while people are always talking about whether welfare is worth the cost, you probably haven’t heard as much about interest payments to the wealthy.
               This is all very politically bad. You would think that people would be up in arms about this sort of thing, but they were not. This was largely because they could not understand it. Even the men and women in Congress couldn’t understand it. The Fed had always been mysterious to most, but Volcker purposely obfuscated what he was doing. Following the advice of “monetarists” like Milton Friedman, he decided to stop using interest rates and rather use the money supply to affect interest rates. This further muddled the situation as Volcker claimed that the abnormally high interest rates that plunged the country into a recession were not really his doing, even though they were. The problem with the money supply, however, is that it does not create the stable, non-inflationary currency that monetarists thought it would. It fails to take into account the velocity of money, which is to say how fast it changes hands. This meant that the Fed had to intervene just as much anyway. When Volcker finally let up and allowed reasonable inflation again, the markets responded the opposite of how he thought they would. Inflation did not skyrocket back up. The policy had its effect and interest rates went down even with inflation.
A good metaphor Greider uses is that Congress cannot control the economic brakes—money and interest rates, and the Federal Reserve can’t control the accelerator—federal spending and taxes. This creates what Greider calls a car with two drivers, a problem that continues to exist today as the nation struggles to achieve a coherent national economic plan. Something else fundamental at the Fed that seems wrong is the ideology that banks must be saved. The Fed consolidates banks by bailing out the largest ones who are “too big to fail.” This is because any rational investor would rather put their money in a giant bank that the government will not allow to fail rather than a small bank that can fail.
Something really critical that helped shape the 80’s was the fact that while both interest rates and inflation fell, inflation fell more than interest rates, leaving people with higher real interest rates. This meant huge earnings for the financial sector while normal people suffered, especially all across what would become known soon after as the “rust belt” of the United States as major manufacturing companies failed due to pricey capital. It was also hit with a second punch- the appreciation of the dollar by 50% in just four years (!), meaning a big reduction in the ability to export goods. In the 1980’s, interest rates exceeded growth rates, meaning that loaning money was more profitable that actually making something, a huge reversal of the way things need to be for an economy to work.The “misery index,” conceived of by economist Arthur Okun, who added the unemployment rate to the inflation rate, hit 19 percent in 1980, but managed to decline to just 11 percent by 1984. However, the “hardship index,” invented by David Eastburn, former President of the Philadelphia Fed, may have been a better descriptor. The hardship index combined the real interest rate on home mortgages to the inflation and unemployment rates. That revealed two years, 1980 and 84, that were essentially identical at 21 percent. So even if people had jobs and inflation was low, it was still very hard to settle down and buy a home (or a car). During the Reagan Presidency, for the first time in history, home ownership went down. Climbing steadily from 40% in 1940 to 66% in 1981, homeownership fell to 63.9% by 1986. Car ownership also declined, and young people couldn’t settle down as easily as the generation before them.
Anyway, those are my thoughts on the book. The book was long and I want to move on to other ones, so this blog post is not particularly “organized” and is really just whatever I thought of as I went through my notes. The main takeaways for me are that the Fed is dangerously undemocratic and views its constituency as big banks. The 1980’s were not good times for America. We need to get the Fed under control and get it to stop triggering recessions.

No comments:

Post a Comment