Washington, Wall Street and the “Monetary Sin of the West”
By John D. Mueller
Catholic Finance Association Panel,
“Has the culture of Wall Street changed since the credit crisis of 2008?”
New York, N.Y. 31 July 2013
View video of the event here.
I’m grateful to the Catholic Finance Association for hosting this panel asking, “Has the culture of Wall Street changed since the credit crisis of 2008?” I can agree in part with the other two panelists. In fact, I’d like to bottle what Carla Harris has to offer. It’s easy to see why she is such a widely sought inspirational speaker.
I’m afraid that I can’t offer inspiration. Daniel Kahneman, who though a psychologist won the 2002 Nobel Prize in economics for helping pioneer the study of cognitive biases, explained, “When the handsome and confident speaker bounds onto the stage…, you can anticipate that the audience will judge his comments more favorably than he deserves. The availability of a diagnostic label for this bias—the halo effect—makes it easier to anticipate, recognize, and understand.”
Because of multiple sclerosis, I’m afraid I can no longer bound. And my effectiveness as a public speaker has been undermined by annoying quirks in speech, creating a kind of anti-halo effect. I hope that it does not distract from what I have to say.
For the Catholic Finance Association, I plan to speak partly American, partly Wall Street and partly Catholic.
Has the culture of Wall Street changed since the financial crisis of 2008? Emphatically not. The reason is that culture does not exist in a vacuum, and the crisis itself, like every major American financial crisis going back at least to the Great Depression, was caused by a monetary peculiarity which warps the incentives at both ends of Pennsylvania Avenue and on Wall Street.
To put it in American: There are four principles of all successful American economic policy. The first was established by Alexander Hamilton, our first Treasury Secretary, under George Washington—both of whom had recent bitter experience with the feckless Continental Congress and colonial governments. That first principle is, don’t print money to finance the Federal budget.
I’ve made my for-profit living since 1988 by predicting the economic and financial market carnage that results when monetary authorities ignore this principle.
By comparing the change in total U.S. official monetary liabilities with the rates of inflation—or deflation—in the U.S. Consumer Price Index and the Case-Shiller index of home prices, we can see that every major inflation or deflation of the CPI and of housing prices was preceded by a commensurate expansion or contraction of this measure of “high-powered” dollars, which I called the “World Dollar Base.”
Also, our firm has shown that the U.S. stock market’s performance is systematically related to the resulting ratio of producer selling prices to their input costs.
Now I’ll switch to talking Catholic. The monetary arrangement I have just described qualifies as what Pope John Paul II in one of his social encyclicals called a “structure of sin.” In fact, the great French economist Jacques Rueff called it the “monetary sin of the west.”
My friend and business partner Lewis Lehrman, Rueff’s protege, described the results this way earlier this year at the Grant Conference: “Over many inflation cycles, the social effects of financial disorder and undervalued currencies have brought about increasing inequality. The near-zero interest rates, now maintained by the Fed, have primarily benefited preferred banks and their financial clients. A nimble financial class, in possession of cheap credit, can maneuver to protect itself against inflation….
“But the vast population of middle income professionals and workers, on salaries and wages, and those on fixed incomes and pensions, are impoverished by this very same volatile, inflationary process…. Inequitable access to cheap Fed credit was everywhere apparent during the government bailout of favored brokers and bankers in 2008 and 2009, while millions of not so nimble citizens were forced into bankruptcy. This ugly chapter is only the most recent in a very long century of disruption of the international monetary system.”
I noticed that a recent talk by Carla Harris appeared under the headline, “Chaos breeds opportunity on Wall Street.” Well, yes—but it also breeds chaos on Main Street. This graphic from the San Francisco Chronicle summarizes a recent survey on American household finance published by the Federal Reserve Bank of St. Louis. As you can see, those Americans fortunate enough to have invested in the stock market have mostly recouped the losses from the crash of 2008. But those families whose main asset is their home—if they still have one—have not.
So I must part company with anyone who wants to engage in happy talk about how great things are and assure us that apart from a few bad apples Wall Street is maintaining a high ethical standard. Wall Street’s culture hasn’t changed because the current system is a machine for manufacturing bad apples—people behaving badly—at both ends of Pennsylvania Avenue and on Wall Street.
John Mueller response:
Our discussion seems to lead in two directions. One concerns how we can know what’s right when the people around us are behaving badly, while the other concerns why so many more people have behaved badly than they used to.
I’m showing this image of my book’s cover for more than product placement. The image is Gustave Dore’s engraving, “Arrival of the Good Samaritan at the Inn.” The first reason I use the image is that, far from being specifically religious, transcending both religion and culture, the parable describes all the interactions we can have with our fellow man. The robbers beating, robbing, and leaving the man for dead illustrate crime. The priest and Levite passing the beaten man by illustrated indifference. The innkeeper’s exchange of services for the Samaritan’s money illustrates just exchange. And the Samaritan’s devotion of time and money to save the beaten man’s life illustrates a gift. So crime, indifference, just exchange, and gift: this is the range of transactions we can have with our fellow man.
But the second reason I mention the parable is that it was occasioned by the question of a man asking Jesus what he needed to do to inherit eternal life, and when Jesus asked him how he himself read the law, the questioner already knew the answer: He answered, “‘Love the Lord your God with all your heart and with all your soul and with all your strength and with all your mind’; and, ‘Love your neighbor as yourself.’” “You have answered correctly,” Jesus replied. “Do this and you will live.”
I suggest that everyone in this room also already knows the answer about how we should behave in our financial dealings.
Thomas Aquinas helpfully explained how the Ten Commandments are derived in greater detail from the same Two Great Commandments: “There are two main precepts of all the commandments, namely, love of God and love of neighbor. The man that loves God must necessarily do three things: (1) he must love no other God. And in support of this is the commandment: “Thou shalt have no strange gods”; (2) he must give God all honor. And so it is commanded: “Thou shalt not take the name of God in vain; (3) he must freely rest in God. Hence: “Remember that thou keep holy the Sabbath day. But to love worthily, one must first of all love one’s neighbor. And so: “Honor thy father and mother.” “Thou shalt not kill” refers to our neighbor’s person. “Thou shalt not commit adultery” refers to the person united in marriage to our neighbor. “Thou shalt not steal” refers to our neighbor’s external goods. We must also avoid injury to our neighbor both by word. “Thou shalt not bear false witness,” and by thought, “Thou shalt not covet they neighbors goods” and “Thou shalt not covet thy neighbor’s wife.”
As I note at the bottom of the slide, regulation or policing of markets is not rocket science. Most financial infractions boil down to stealing and/or lying (violating the 7th and 8th commandments in the Catholic order). For example, Goldman Sachs settled recently with regulators for a fine of about half a billion dollars, essentially for abetting lying in order to steal.
So we are all responsible and should be held accountable for our own behavior. But the second direction in which our discussion leads is the one I tried to express in my opening remarks: Why has there been so much more pressure to behave badly, or join in bad behavior?
One questioner, citing Joseph Stiglitz, suggested that 4% inflation would be a good thing by inflating away much of recent rise in the Federal debt.
But the facts contradict this notion. Four percent inflation is roughly the average inflation rate since the United States abandoned the last link of the dollar with gold. That’s the second-worst record of any monetary standard in U.S. history. (The worst was the gold-exchange standard between the First and Second World Wars, which was codified in the 1922 Genoa agreeement. Since 1971, the U.S. Consumer Price Index has more than quintupled. With 4% annual inflation, the value of everything expressed in dollars is cut in half every 18 years.
That’s a problem, not a solution. We’ve done much, much better, whether measured by price stability or minimal price volatility of the U.S. CPI, especially under the classical gold standard from 1879 to 1914.
Better to understand the structure of the “monetary sin of the West,” let’s consider in more detail the three major problems that Congress caused by misusing its Consttutional authority over the monetary standard and abandoning the gold standard which Hamilton proposed and Congress adopted in 1790.
Loss of Federal Budget Discipline. First, because it is based on monetizing U.S. public debt, the current monetary system is the main cause of the loss of federal budget discipline.
This prevents fiscal discipline because it leaves both Democrats and Republicans free to reward their dominant factions: Democrats to increase spending, and Republicans to grant tax loopholes, to favored constituents.
By President Ronald Reagan’s self-assessment, the Reagan Revolution was incomplete when he left office. “With the tax cuts of 1981 and Tax Reform Act of 1986, I’d accomplished a lot of what I’d come to Washington to do. But on the other side of the ledger, cutting Federal spending and balancing the budget, I was less successful than I wanted to be. This was one of my biggest disappointments as president. I just didn’t deliver as much to the people as I’d promised.”
I’m proud to have played a small role in both of those reforms. But President Reagan’s disappointment can be traced to the unintended consequences of adopting Milton Friedman’s “allowance theory” of federal budgeting under the paper dollar standard. “I have long favored cutting taxes at any time, in any manner, by as much as possible as the only way of bringing effective pressure on Congress to cut spending,” Friedman explained. “Like every teenager, Congress will spend whatever revenue it receives plus as much more as it collectively believes it can get away with. Reducing spending requires cutting its allowance.”
C. Northcote Parkinson famously theorized that “work expands so as to fill the time available for its completion.” Parkinson’s Law was the history professor’s attempt to explain the inexorable growth of bureaucracy. Friedman’s allowance analogy amounts to Parkinson’s fiscal corollary: public spending expands to absorb all available tax revenues. The strategy failed in practice by overlooking Parkinson’s debt corollary: public borrowing expands to absorb all available means of finance. If tax revenues are Congress’ “allowance,” then purchases of Treasury securities by government trust funds, the Federal Reserve, and foreign central banks are its “credit cards.” The congressional teenager’s spending won’t be fazed by a cut in allowance, unless the indulgent parents also cut up the credit cards. Thus, while U.S. public debt jumped by about 30 percentage points of GDP since 2007, debt to the non-bank public debt has barely budged—because most of the increased debt was financed by central banks and trust funds.
Moreover, the Congressional Budget Office (CBO) predicts that under current law, U.S. public debt will roughly double again to more than twice the size of our economy.
Chronic commodity-led inflation and deflation. Given the monetary system, the loss of budget discipline causes price instability. Though Friedman was correct to say that “money matters,” he was mistaken in ignoring the fact that foreign official dollar reserves have the same ultimate impact on the price level in dollars as the high-powered dollars created by the Federal Reserve. The World Dollar Base is the sum of U.S. currency and commercial bank reserves plus foreign official dollar reserves. But the relation of the Federal Reserve’s role is counter-intuitive. While the lagged total World Dollar Base, taking account of differences in supply, is inflationary, the domestic component works in the opposite direction, because it is a good proxy for the current demand for all those high-powered dollars. This is why the Fed’s QE1–more than doubling the total U.S. domestic currency and bank reserves almost overnight–coincided with a sharp deflation of the commodity prices like oil, which had been driven to nearly $150 a barrel, triggering the crisis.
Loss of U.S. competitiveness. The next chart depicts the third problem: The dollar’s official-reserve currency role has eroded U.S. international competitiveness and hollowed out U.S. manufacturing industry. . In 1980, U.S. residents owned net investments in the rest of the world equal to about 10 percent, but by the most recent figures, had become net debtors equal to about 27 per cent, of U.S. GDP. Meanwhile U.S. net official monetary assets—official monetary assets minus foreign liabilities—declined by almost exactly the same amount, while the books of the rest of American residents remained in balance or showed a slight surplus. This comparison proves that the entire decline in the U.S. net investment position has been due to federal borrowing from foreign monetary authorities; and ending the dollar’s role as chief official reserve currency is necessary to end chronic U.S. payments deficits and restore U.S. international competitiveness.
Thus, as Jesus said, woe to him through whom evil comes. But as he also said, evil must needs be–and the facts show that these evils in Washington and on Wall Street will continue until we correct the structure of what Rueff called the “monetary sin of the West.”
John D. Mueller is the Lehrman Institute Fellow in Economics at the Ethics and Public Policy Center and president of the forecasting firm LBMC LLC, both in Washington, D.C.