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When Finance Turns Into a Calamity

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The United States has always had a stellar scientific establishment. American researchers and scientists lead the world in Nobel Prizes, scientific discoveries and technological inventions. However, in the 1970s their patents gathered dust, while Japanese electronics companies ran a successful business buying rights to American innovations and implementing them commercially.

Not anymore. American inventors put their own patents to work, setting up startups and creating a highly competitive environment in which technological innovation thrives.

What Changed?

We hear a lot about lower taxes and the winner-take-all economic system which is responsible for fostering an entrepreneurial culture. But America has always had great entrepreneurs, going back long before Thomas Edison, and the founders of Apple and Microsoft created their companies under the bad old high-tax regime. The Beatles in the 1970s continued to write songs and sell records even though some of their earnings were taxed at rates approaching 100%.

What is different now is the financial system. In the final decades of the 20th century, deregulation and hands-off government supervision created a vast, diversified shadow banking system which, among other things, was able to fund generously all kinds of technological innovation.

As a result we have an extremely dynamic, robust economy with intense competition and rapid technological progress. On the other hand, this freewheeling financial system is prone to run amok and create bubbles, since finance—besides being the lifeblood of economic activity—tends to seek opportunities for speculation.

This system is inherently unstable, and rapid growth is punctuated by periodic crises when speculative bubbles deflate. This has happened twice over the past 15 years. Ironically, to counteract financial crises—and to make up for sluggish demand growth in an economy with widening income differentials—the monetary authorities are constrained to keep pumping liquidity into the financial system and to hold interest rates extremely low, thus funding ever faster technological progress and stoking additional speculative bubbles with cheap money.

But the alternative to this dynamic economy is a return to much stricter financial regulation, breaking up too-big-to-fail banks and introducing more controls over offshore capital movements. A regulated economy may be more stable, but it is also far less dynamic and flexible. In the postwar decades, the U.S. economy could not sustain strong growth and technological innovation. In the end, sluggish growth, lack of flexibility and excessive income redistribution led to inflation and stagnation, the main features of the second half of the 1970s.

Catalog of Errors

Both the Roaring Twenties and recent decades saw technological progress stoked by plentiful funding and the emergence of new companies and brands. In both periods, stocks rallied strongly and speculative bubbles emerged in various asset prices. Eventually, there came the Great Depression and, in our own times, the Great Recession, unleashed by the bursting of the U.S. housing bubble.

In his new book “Hall of Mirrors,” economist Barry Eichengreen, a student of international monetary systems and the Depression who teaches at the University of California, Berkeley, examines those parallels from the viewpoint of policy issues: why major crises were allowed to develop and how various actors responded to them. Although heavy on historical detail—and two-sentence Wikipedia-style portraits of major players, from Charles Ponzi to Bernie Madoff—its relevance to investors probably comes from an analysis of how policy-makers used lessons of history to prevent another Depression in 2008, and why they nevertheless failed to avoid another protracted slump.

First, “Hall of Mirrors” faults central bankers and government officials for erring on the side of caution in their response to the crises, which in turn stemmed from too much respect for economic dogma. Worries about inflation, debasement of currency and falling exchange rates, are misplaced when the financial system is under threat, says Eichengreen. Once the crisis happens, it has to be doused with massive infusions of liquidity, throwing money from helicopters if need be. Large banks such as Lehman Brothers should be saved while arguments about moral hazard should be rejected out of hand.

Second, in this view, a major financial crisis should always be expected to spread into the real economy, even if initially there may be no sign of it happening. Hopes to isolate a major financial debacle are nothing but self-delusion. Consequently, monetary ease should be supplemented with fiscal stimulus to support aggregate demand. Worries about budget deficits and rising public sector debt should be put aside. Fiscal and monetary ease should be kept up until the economy is completely righted and returns to running at full capacity. Placating fiscal conservatives and economic dogmatists merely leads to deeper recessions.

Eichengreen claims that this is what happened in the Depression, when the gold standard limited or delayed monetary stimulus and when FDR’s efforts to balance the federal budget triggered a second economic dip in 1937. In 2008, the authorities benefited from extensive analyses of the Depression made by Milton Friedman and Ben Bernanke. But then, too, not all the lessons of history had been learned to Eichengreen’s satisfaction. Moral hazard kept the authorities from rescuing Lehman and supporting mortgage lenders. While injections of liquidity into both banks and, more importantly, nonbank actors helped prevent another Depression, the recovery was hampered by a less-than-generous fiscal stimulus. Worries about inflation—which proved misplaced—capped government spending and limited stimulus to here-and-now projects rather than long-term investment into infrastructure.

Back to the Past?

Eichengreen concludes that saving the U.S. economy from another severe economic slump actually prevented more substantive reforms. In the Depression, the Roosevelt administration created a large number of institutions and programs that now act as automatic stabilizers. For instance, unemployment insurance supports consumer demand when millions of people suddenly lose their jobs, and Social Security payments go on in a recession just as they do in economic booms. No new programs of this sort were introduced by the Obama administration.

Nor does Eichengreen believe that the Dodd-Frank Act, the main piece of legislation to come out of the housing crisis, goes far enough to correct excesses in the financial system. Indeed, the Glass-Steagall Act separating investment and commercial banking has not been re-established, big banks have become even bigger—while the government has issued an effective too-big-to-fail guarantee to the largest—and regulatory oversight has not been substantially tightened.

This will certainly preserve instability and lead to financial bubbles—which we are already seeing in stocks, bonds and selected real estate markets, such as New York City and San Francisco. The alternative, however, is a return to a much more rigid, regulated economy that the New Deal eventually created. Let’s not forget that banks were not only limited to the low-margin, capital-intensive business of collecting deposits and making loans, but their interest rates were capped and lending standards were highly restrictive. Moreover, the post-World War II economic system limited labor supply and supported trade unions in their wage demands, effectively capping profitability of private companies.

Even more to the point, “Hall of Mirrors” treats the 2008 crisis as a done deal. I’m inclined instead to see it as a marker of a freewheeling economy that emerged in the 1990s. Each successive financial crisis elicited “never again” declarations from financial players and the authorities, only to see an even worse bubble starting to inflate almost immediately. Thus, the next debacle is probably only a matter of time and, just as all previous ones did, it will blindside everyone by coming from what everyone believes is a very safe market.

The fact that we have learned the lessons of history well, and central bankers, unencumbered by the precepts of conventional economics, are now able to keep the party going indefinitely, merely means that imbalances in financial markets will not be corrected and that the speculative ante will be raised ever higher.