E&PW: Discussion Thread

[softwareNerd]

I just started this book, "Economics and the Public Welfare", by Benjamin M. Anderson

The first chapter simply set the tone about the pre-WW-I world, but some of the commentary reminded me (of all things) of "The Romantic Manifesto" (RM). In RM, Rand speaks of the 19th century as a time when the culture started to view man as master of his fate. This, she says, lasted until the uncontrollable forces of God and King were replaced by "society" or worse! Anderson speaks of the first decade of the 1900's as being a time when men trusted the promises of governments, and when "the ill intentioned feared the condemnation of the well intentioned".

[softwareNerd]

I sometimes like to make an outline-of a time-line while reading a book, so I can jot down events. Since this book is organized chronologically, I made one using each "part" as a section of the time-line. Just in case anyone would find it useful, I'm attaching it to this post.

Edited December 29, 2008 by softwareNerd

[~Sophia~]

Chapter two deals with economic conditions/changes at the outbreak of the WWI.

Author writes: "When there is general confidence in the uninterrupted goings on of economic life, in the legal framework under which life operates, and essential integrity and fairness of governments, men with capital prefer to have their capital employed." In the times of uncertainties, however, there is a rush to liquidity of all illiquid assets. We see this enacted all over the world in 1914.

Various kinds of emergency measures were employed in the major financial centers: drastic governmental intervention in France, a much more moderate in England, and no formal government aid in the US.

In America, by informal agreement, banks refrained from calling on loans made to stock exchange firms against stock exchange collateral instead margined those loans using quotations from the day before the closure of the market. Then the correction was allowed to happen - the market was allowed to thoroughly liquidate.

Author writes: "Stock prices went low but not so low that the banks and brokers could not stand the strain." Why? This means some confidence remained, right? It was mentioned, later in the chapter, that this crisis was unique in that it was entirely due to external causes and the internal situation was liquid and solvent. Second, I think the stock exchanges due to this agreement with banks did not add to the selling (am I right?). Is it possible that it was also due to the anticipation of the increase in the foreign demand for American products for war purposes? It would make sense. Any other reasons?

Author compares the 1914 break in security prices with that of 1937 but I will wait until that chapter with my comment.

I found it amusing how New York bankers had to come to the rescue after the New York government borrowed a large sum, in English sterling, from England and France, and came very close to defaulting on that foreign obligation when sterling increased in value. The amusing part was that the reason NY government borrowed abroad was because they did not want to agree to a condition of financial conservatism/responsibility placed on credit by New York bankers.

The topic of financial risk management throughout history is interesting to me (one of the reasons I picked up this book) and so it grabbed my attention that it was not unusual for a financial center to advance, in a form of bank notes and in exchange for short-term obligations, up to several times their capital.

It is worthy of note that the Federal Reserve Act of 1913 was utilized for the first time during this emergency and that the currency was retired within a year of its release.

Edited January 6, 2009 by ~Sophia~

[~Sophia~]

Anderson attributes money panics that occurred before 1914 to inelastic currency system. He does not mention that the government interference into banking contributed, if not created, those instabilities. Good article: Banking Before the Federal Reserve

Anderson seems be of a belief that some (limited) involvement of the government in banking is necessary or at least can be beneficial.

Edited January 7, 2009 by softwareNerd
Fixed URL

[softwareNerd]

In America, by informal agreement, banks refrained ...

While I have not read past WW-I, one theme in Anderson's descriptions of the WW-I/post-WW-I scenario is this: there were ups and downs, but not so much as during WW-II, even though the Fed (and government) was much more active during the second period. It is interesting to see private bankers rising to the occasion.

I think one principle potentially induce: the presence of a government overseer lessens the initiative shown by the regulated entities. (I say "potentially", because one swallow does not make a spring.) This theme pops up again, in a future chapter where Andersen comments on the reserve-ratio. Good banks used to be careful to keep their reserve ratio high. With the coming of tbe Fed, the (min) ratio was legislated. At one point in history, the Feds reduced the ratio to extremely low levels. Anderson was happy, reasoning hat a very low legal ratio was just like abandoning the law and going back to the old system. Anderson says this was one of the worst predictions of his career. Most banks started to tend toward that ratio.

I take the two examples above, and put them together with common, homely observations about how people act. Sometimes one will see this happen in an organization: someone takes the lead in some matter and others, who might have acted differently on their own, go along, particularly if the leader is considered to have better knowledge or expertise. I think it's a a form of "social proof" and relying on authority". I think banks start to act like a little bit like kids, listening at least a bit to the Fed, about things they would otherwise have to figure out for themselves. Psychologically, the regulator relieves the regulated of some degree of independent thought, over and above what they "relieve" them of legislatively.

Author writes: "Stock prices went low but not so low that the banks and brokers could not stand the strain." Why? This means some confidence remained, right? ... Second, I think the stock exchanges due to this agreement with banks did not add to the selling (am I right?).

A downturn feeds on itself when people have to liquidate positions they do not want to liquidate, in order to raise cash. If banks called in their stock-based loans, they would have helped drive stock-prices down further. Doing so, would have forced even more margin calls. So, even though there was uncertainity about how things were going to turn out in the short-run, I think we have to assume that the confidence in the medium-to-long term remained.

Is it possible that it was also due to the anticipation of the increase in the foreign demand for American products for war purposes? It would make sense. Any other reasons?

Good question. I don't know the answer.

... it grabbed my attention that it was not unusual for a financial center to advance, in a form of bank notes and in exchange for short-term obligations, up to several times their capital.

In the "old days" pre-Fed, banks believed that their assets must consist heavily of short-term "real bills". For instance, a loan might be given for 30-days while the collateral makes its way from farm to market. Truly liquid collateral is turning over all the time, and was seen to be less risky. In those days, banks considered real-estate lending to be risky.

It is worthy of note that the Federal Reserve Act of 1913 was utilized for the first time during this emergency and that the currency was retired within a year of its release.

A minor point, but these notes were issued under a law that pre-dated the Fed. In fact, the Fed Act did away with these notes. However, since the Fed had not yet become fully operational, Congress had extended the legailty of such notes.

It is really interesting to read about the banks -- without a regulator -- rise up to the situation. They judged that things had changed, and called in many loans. Yet, they also judged that the world was not going to end. Rather than out-guess each other or try to hit the exits first, they sat down together and figured out a way to hold fort for the short term.

[~Sophia~]

I think one principle potentially induce: the presence of a government overseer lessens the initiative shown by the regulated entities.

I agree and I think we will see more examples of this. The responsibility to act becomes diffuse rather than personal.

This theme pops up again, in a future chapter where Andersen comments on the reserve-ratio. Good banks used to be careful to keep their reserve ratio high. With the coming of the Fed, the (min) ratio was legislated. At one point in history, the Feds reduced the ratio to extremely low levels. Anderson was happy, reasoning hat a very low legal ratio was just like abandoning the law and going back to the old system. Anderson says this was one of the worst predictions of his career. Most banks started to tend toward that ratio.

I think I would make this into a separate principle: governmental regulation creates an assumption/expectation (often wrong as we know) of safety.

This, I find much more surprising . I understand your example when dealing with someone of better expertise but why would the government know more about banking than the bankers (why would the bankers assume so)? Bankers have seen the government make financial blunders and yet they follow it's "recommendations"? For government officials - it is not their personal prosperity on the line. Government is never run like a business because it is a non-for-profit organization (it's "experts" do not have that kind of mindset and they are not personally responsible for any resulting losses).

A minor point, but these notes were issued under a law that pre-dated the Fed. In fact, the Fed Act did away with these notes. However, since the Fed had not yet become fully operational, Congress had extended the legality of such notes.

The author of the article I linked to in my previous post makes a point that the problems of pre-1914 banking in the U.S. were also created by government restrictions with one of them being the initial illegality of such notes. Canadian monetary system, at the time, was much more stable/much less prone to panics. Aldrich-Vreeland Act of 1908 allowed national banks to act as Canadian banks would under stress, issuing banknotes as demanded and saving their gold and treasury currency for use as a reserve.

It is really interesting to read about the banks -- without a regulator -- rise up to the situation.

Yes it is.

[~Sophia~]

Chapter 3 The War Prosperity

America experienced a huge and growing positive balance on trade paid for in gold, securities, foreign government loans (no public credit for Germany), and private credit. There was substantial private credit extended to Germany in the first two years of the war and morally I do have an issue with that (in my mind this was not a matter of "we do not clearly know who the rights violator is here").

This created easy money market - a lot of cheep and easily obtainable credit available. Government passed a decrease in the reserve requirements of the central reserve centers (from 25% to 18%) with further increased the amount of the available credit (because banks followed). America experienced full utilization of labor and resources and an increase in competition.

Some market trends observed:

- Increase in demand increases utilization of labor and resources before a rise in prices.

- Prices of securities respond faster than commodity prices.

- Commodity prices at wholesale rise more rapidly than wages per hour (all other things equal) but in time wages do follow.

The author toward the end of the chapter mentioned railroads and that they came under heavy pressure from rising costs unaccompanied by rising rates (without explanation - as if this was a result of war conditions) and that the crisis was relieved by President Wilson's proposal that Congress "put the government behind the railroads."

I found this a bit misleading as written. The cost of locomotives and freight increased 100% between 1915 and 1918 due to drastic increases in regulation. The government created a crisis and then took over.

I am planning on reading more about the early history of the American railroad industry because it is a great example of cause and effect in terms of government involvement and economic damage.

Edited January 10, 2009 by ~Sophia~

[softwareNerd]

Bankers have seen the government make financial blunders and yet they follow it's "recommendations"?

Yes, I agree that it is a mistake to rely on such dubious "authority", but I think people do make the mistake, and quite frequently.

An analogy that I can relate to is the introduction of huge bureaucratic processes into a company (ISO/9000 software QA, or Sarbanes-Oxley law). Some people who previously took the initiative to think through the question: "what is good quality?", or "what is a good financial-control?", now do less of such thinking in the bureaucratic set-up. They see formal compliance -- rather than true quality -- as their standard. Meanwhile, managers are lecturing people about the importance of formal compliance: so it is a real standard in some sense.

I think something similar happens when there is an organization like the Fed, that is enforcing compliance. It creates "two masters": what the regulator says is right, and what is right. It also allows some people to take the short-cut of compliance, rather than thinking for themselves. In banking, the short-to-medium term incentives to take risks are very high. Human beings have to put in cognitive and emotional effort to keep long-term risks in mind, when faced with short-term benefits. Having an authority figure legitimize the risk adds some weight to the wrong side of the balance.

Also, with the existence of the Fed, bankers might have calculated that they could now afford to take the extra risk. If something went wrong, the Fed would back them up, as long as they were within the statutory ratios.

[~Sophia~]

Yes, I agree that it is a mistake to rely on such dubious "authority", but I think people do make the mistake, and quite frequently.

Yes I know. I just find it surprising. Acting in self interest (not just in intent but in actuality) is a requirement of success in business. Those who are successful are used to that mode of functioning - used to the level of diligence that success requires. And yet they can be so easily influenced and let go of that standard even though all of the usual incentives are still there in place. I am thinking especially about business owners. Again, I find that surprising.

[~Sophia~]

Chapter 4 brings a question in my mind: What would be a proper way of financing a necessary war in a fully free society?

Borrowing from people vs. borrowing from banks? How would a government pay it back if all it's revenue is only enough to cover its very limited function? Maybe a government would have some savings but surely not enough to cover a cost of a very expensive war.

Current income of the people (temporary taxes?) - wars can be very expensive - that can amount to a huge personal financial burden.

Edited January 11, 2009 by ~Sophia~

[softwareNerd]

Anderson credits a Harvard professor named Sprague for pushing the government to finance a significant portion of the war from taxes. Though debt was used as well, taxes played a larger role than previous wars.

Debt ends up as future taxes. So, the decision comes down to: financing from current taxes or from future taxes. If one is going to use taxes, then it seems better to finance as much as possible from current taxes, paid by current voters, who can therefore see the whole impact and decide whether they want to vote differently.

Sidelight, from a different source (economist Brad de Long): Before the war, the U.K. government spent about 9% of their national product (NP), and the U.S. government spent about 9% of its NP. During the war, Britain was using about 30% of NP for the war, which lasted about 5 years. Since the U.S. entered WW-I late, it saw only a two-year spurt, that reached about 25% of NP. In both cases, after the war Government's pulled back spending as a percent of NP.

In contrast, the US government budgets today are roughly 2.5 trillion at the Federal level and 2.5 trillion for all local and state governments put together. US GDP is about $14 trillion. That means 18% is direct Fed expenditure (including "transfer payments") and another 18% is State and Local government expenditure. The incoming administration is talking of taking control of an additional $750 billion, which will mean another 5%!

Edited January 11, 2009 by softwareNerd

[softwareNerd]

Summary of Part 1 (World War I) [Chapters 1 through 5]

Before WW-I, England was a creditor country, providing investment and short-term financing to many others. It was also the world's financial center. The U.S. was a debtor country sending interest and profit payments to England.

WW-I came as a surprise, but U.S. banks collaborated to stop a panic -- issuing new currency for a few months, and being slow to call in some loans.

Within six months, the downturn had begun to swing upward. Increased demand for U.S. exports to Europe led to a boom. Gold flowed into the U.S., in payment, increasing the money supply significantly. Also, Europe paid for some goods by selling investments in the U.S. and by using loans provided by the U.S. government. At the end of WW-I, the U.S. was a creditor country.

Prices began to rise in the U.S.: first the stock market, then commodities, then wages. Still, real production volumes rose. Between 1914 and 1917, it rose 25% (about 7% p.a.).

The U.S. entered the war in 1917. Government share of national product jumped from 7% to 25%(^*1). Laws were put in place to divert some goods to war-time use. Real production flattened out from that point on, till the end of the war. Construction activity dropped sharply. (The stock market also dropped.)

The government used a fair amount of taxation, rather than pure debt, to finance the war.

Another thing going on in this period was growing unionism in U.K. (with membership doubling during WW-I). Also, in 1917, right in the middle of the war, we had the Russian Revolution. This set the stage for a post-war era of growing socialist influence in the U.K. ^*2

*1,*2: Source: economist Brad de Long (Slouching Towards Utopia?: The Economic History of the Twentieth Century. 1997)

[softwareNerd]

Summary of Part 2 (POST WW-I) [Chapters 6 through 5]

Right after WW-I (Nov 1918), there was a sharp fall in commodity prices, as war production disappeared. However, by 1919 export orders were up again. A lot of these exports were financed by US government loans and by currency inflation by European central banks.

European manufacturing did not return rapidly; labor unionism was a factor; and, the governments were not being fiscally responsible. This realization ended the post-war boom between 1920 and 1921, resulting in a bust. Like at the start of WW-I, private banks did a good job of not reacting with panic. Some large banks told country banks that they would back them up, as long as they would triage their loans and keep only the better ones. For instance, a farmer who needed a loan for seed might be given a loan, but if he wanted it so he could hold on to his cattle for another 6 months hoping that beef prices would go back up, they may not speculate with him. Anderson points to one strength in the U.S. banking industry's numerous [20,000] small banks. This meant that each tried to be profitable, where a larger bank might have tried to subsidize some branches with others.

From late 1921 things turned around, as credit was cleaned up. Also, the drop in some costs -- notably construction costs -- acted as an incentive to bring back some business activity. Anderson notes that the government did not pursue any wildly "stimulative" agenda, and instead ran surpluses between 1920 and 1923. The Fed was acting, but it was not the primary factor in the revival of business.

Anderson criticizes the protectionism, particularly the raised tariffs in 1922. He points out that if foreigners can sell less goods to the U.S., it also means that they cannot buy our goods, except with US government loans, or some other still worse credit. In Europe, the Austro-Hungarian empire was broken up, creating protectionism between smaller countries, where there was once a single market.

Anderson criticizes the reparations that were demanded of Germany. While the allies -- particularly France -- appeared to have the moral case, he says that the reparations were way beyond Germany's capacity to pay. Part of Germany's gold was taken, as was its merchant marine, and much of its railroad stock. So, to start off, Germany's capacity to repay had been severely hurt. Germany ended up with hyper-inflation. Anderson says that the mishandling of the German reparations issue finally led up to WW-II.

Footnote: The attachment shows German postage stamps in times of hyperinflation. From 1919 to 1924, the mark dropped as low as 16 trillion marks per US$, "stabilizing" at 4 trillion per US$.