The Oser View

The Fundamentals

January 25, 2012

Coaches love to preach the fundamentals. There is a story, possibly apocryphal, about Green Bay Packers coach, Vince Lombardi, addressing his team after a particularly egregious loss. Pointing to an object on his desk, he said, "Gentlemen, this is a football." A player, standing towards the back, is said to have responded, "Uh, coach, could you go over that again."

Still, it's not a bad idea to go review the fundamentals now and then, even for those who are, or are supposed to be, seasoned professionals. Today, the Federal Open Market Committee, the policy arm of the Federal Reserve System, went back to basics in explaining its purposes and actions. Finance professionals may skim past these background parts of FOMC's press releases, issued following a two-day policy meeting. But they are extremely, indeed fundamentally, important. The FOMC, after all, is not talking just to professionals. The Committee is talking to everyone who is affected by monetary policy; which is to say, everyone. "The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision-making by households and businesses…" (emphasis added). "Transparency and accountability…are essential in a democratic society."

It doesn't get more fundamental than that, and we should take the FOMC's announcements at face value. We are so distrustful of public officials and so used to looking behind their words for the real, hidden, meaning that we have all but lost the facility of belief. I am not asking you to agree or disagree with the FOMC's statements. I do urge you to believe the Fed means precisely what it says, and for that reason, consider its points seriously.

The statements continually reference the Fed's dual statutory mandate, "to foster maximum employment and price stability." Every word here is important. The mandate is "dual" because both parts are equally important, and they contain the entirety of what the Fed is empowered to do. It has often been noted that the two goals can be contradictory. Jobs tend to be created quickly when the production of goods and services heat up to meet demand, but ultimately the cycle can turn inflationary as prices spiral out of control. Stable price tend to retard employment because people have less money to spend resulting in less production of goods and services. Here the danger is that the economy will stall and fall into recession. Economies rarely stay in equilibrium for long. But, it's the Fed's responsibility to balance the two mandates. Second, the mandate is "statutory;" Congress has specified by law what the Fed is required to do. Intervening in the economy in other ways would not just be misguided but illegal. In its statements, the FOMC emphasizes its responsibilities and authority with great clarity because it wants you to understand clearly what it can and cannot do.

At present, the Fed believes

1. "The unemployment rate remains elevated" and "the unemployment rate will decline only gradually towards levels that the Committee judges to be consistent with its dual mandate." (Mandate #1), and
2. "Over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate." (Mandate #2)

For the first time ever, the Fed specifically defines the optimum levels of inflation and unemployment. An inflation rate of 2%, as measured by the annual change in the price index of personal consumption expenditures (PCE), will be the Fed's long-term inflation target. Determining an ideal unemployment rate is, surprisingly, more difficult. You might think the best unemployment rate is 0%, but in a healthy economy there are always people changing jobs voluntarily as well as a certain amount of creative destruction leading to involuntary job losses. The economy's health is demonstrated by how quickly people get new jobs. The Fed has established a target range of 5.2% to 6.0% for unemployment, while emphasizing that, unlike inflation, this range can be expected to vary over time.

Directly following on these conclusions, the FOMC announced three actions to achieve its mandates:

1. It will maintain the fed funds target rate—that is, the rate banks pay for overnight loans from other banks—between 0% and 0.25%;
2. It expects to maintain the fed funds rate at these extremely low levels "at least through late 2014."
3. It will continue its purchases, and extend the maturities, of long-term US Treasury bonds and similar securities.

To many people, these actions may seem meager and extraneous to the real problems of the economy. Herein lies the Fed's communication problem. In practice, the actions outlined by the Fed do have a substantial economic effect. Very low short-term interest rates anchor all interest rates at low levels. The announcement that short-term rates will be kept low for three years—virtually a millennium the way the financial markets measure time—encourage a long-term investment horizon at current rates. Investors and lenders need not fear that their assets will lose value quickly due to rapidly rising interest rates. Finally, the Fed's continued purchases of very large amounts of bonds are simply an application of the law of supply and demand. The more the Fed buys, the less other investors can buy. Hence, bond prices are kept high and interest rates low.

The bottom line is that our nation's central bank expects the economy to grow slowly and below its potential for years to come. The Fed's policy makers intend to use the bank's powers to their utmost to lessen and shorten the period of economic malaise. But, as the FOMC points out, we live in a democratic society, not a command economy. All that the FOMC can do is "maintain a highly accommodative stance for monetary policy;" that is, it can use its tools to keep short-term interest rates low. Low interest rates should encourage more borrowing and lending, which in turn should fuel economic activity. But the Fed cannot order economic conditions to its liking. Again, you don't have to agree with the FOMC's opinions or methods. But understand that, today, the Fed has made some fundamental statements, which they will live by and we will all live with.

Looking Backward: 2012-1888

Grover Cleveland, 22^nd & 24^th President              Benjamin Harrison, 23^rd President

In a recent New York Times column, David Brooks complains that members of the Obama administration have been comparing the present political and social environment to the Progressive era. The Progressives came to prominence early in the last century. The movement reached its apogee in the presidential election of 1912, when, as a third-party candidate, Theodore Roosevelt received 27% of the popular vote on a platform of reducing the outsized gap between rich and poor Americans. Brooks repudiates the comparison, pointing to the many differences between America in 1912 and 2012. One distinction he makes is that a century ago "the economy was in its adolescence," whereas now it is in middle-aged doldrums. But the real distinction is moral: A hundred years ago, America "still had a Victorian culture, with its rectitude and restrictions. Back then, there was a moral horror at the thought of debt… In the progressive era, there was an understanding that men who impregnated women should marry them." This is just Golden-Ageism, the notion that life was better in some favorite "good old days." In fact, in 1912-America prejudicial stereotypes of all sorts were taken for granted, capitalists routinely cooked their corporations' books, and violence against organized labor was supported by all three branches of government.

Still, I agree that with Brooks that the comparison of 2012 to 1912 is not especially apt. A more useful comparison is to 1888, when Republican Benjamin Harrison narrowly defeated Democrat Grover Cleveland for the presidency. One similarity between the campaigns of 1888 and 2012 is the role of corporate finance. The coming election marks a turning point in which corporate money, after years of at least partially successful limits, can now be spent with few restrictions on pro-business candidates. There were no political spending restrictions at all in the 19th Century. By 1888, the necessary preconditions of increased corporate wealth and improved nationwide transportation and communication were in place to make large-scale fund-raising possible. Of course business had contributed to campaigns before and would exercise a much greater influence in the years ahead, but 1888 was a turning point. In that year, Philadelphia department store magnate John Wanamaker toured the country, selling business groups with a pro-Republican pitch. He successfully lobbied for substantial campaign contributions by likening support for his party to buying insurance, "If you were confronted by from one to three years of general depression…what would you pay to be insured for a better year?"

But the essential similarity between 1888 and today is the disparity between the small number of the very rich and the large number of those for whom daily life is a financial struggle. Today, the battleground is whether to raise taxes on the highest earners. Then, the battle was over the tariff, which was the income tax equivalent of the day. Tariffs and excise taxes—that is, sin taxes on tobacco and alcohol—were the main sources of federal revenue from the country's founding until the First World War. Income taxes had been assessed briefly during the War of 1812 and in the Civil War, but a peace-time attempt to impose them was ruled unconstitutional in 1895. It took the 16th amendment to Constitution to validate them in 1913.

Tariffs are taxes on imported raw materials and manufactured products designed to raise their costs to consumers and thereby make domestic materials and products more competitive. The traditional rationale is that tariffs nurture "infant industries" until they are strong enough to hold their own in free markets. The Democrats of 1888 pointed out that US industries were no longer infants; indeed, our industrial might even in the 1880s, let alone 30 years later, was well past adolescence. Trusts, near monopolies that controlled all phases of the extraction, manufacture, and distribution of key commodities, ruled nearly all major fields of commerce. The steel industry was actually more competitive than most, yet the Carnegie Steel Company produced a quarter of the nation's steel. Its annual profits exceeded $40 million (something like $800 million in today's money), a fantastic sum back then.

The Democrats also pointed out that tariffs, far from protecting ordinary working people, were an extremely regressive tax. It's easy to see why. If the tariff on an imported product in everyday use caused its price to rise by 50%, a domestic manufacturer of the same product would simply raise his price to just under the foreign price. Moreover, the excess profit did not trickle down to the American workers who made it. An 1888 Bureau of Statistics report gave many examples of this sad fact. For instance, a pound of domestic sewing silk could be sold for $5.66 a pound. Thirty percent of the price ($1.69) was a result of simply coming close to the tariff-adjusted price of imported silk. American workers were paid just 85¢ a pound. In summary, the Democrats' position was that high tariffs enriched capital through windfall profits and impoverished ordinary citizens by raising their cost of living. Reducing tariffs would shift the economic burden from those who could least afford it and to those who could most afford it.

Republicans defended the tariff with equal fervor. Ohio representative William McKinley claimed that protective tariffs were a job-creation machine for American workers. "Every pound, every bushel, every ton, every yard of foreign product that comes into this country to compete with ours deprives American labor of what justly belongs to it." To the extent that tariffs reduced the influx of foreign goods, they strengthened American industries, provided markets for American producers, and work for American wage-earners. The Republicans argued that Democratic attacks on the tariff were no more than attempts to stir class warfare, designed to pit one group of Americans against another. Reducing tariffs would harm employers and thereby workers as well.

The denouement is instructive. The argument that Wealth should not be hampered in its mission to create jobs convinced enough laboring men to put Harrison across over the incumbent Cleveland. The Republicans emerged with small majorities in both the House and the Senate. A bill raising tariffs and named for its guiding spirit, McKinley, became law in 1890. Its effect could have been foretold—in fact, was foretold by the Democrats. Consumer prices soared, and disillusioned voters rolled back the Republicans' congressional majorities in the 1890 mid-term elections. Then, in 1892, Grover Cleveland became the first and only person to serve two non-sequential terms when he was elected the 24th President of the United States.

Unfortunately for Cleveland, his vindication soon turned bitter. Almost immediately, the economy plunged into the Panic of 1893. This catastrophe, called the Great Depression, until the 1930s, lasted all through Cleveland's term. He left office lamented by none, especially as prosperity returned soon after the inauguration of Cleveland's successor, William McKinley.

The notion that the well-to-do should be left relatively undisturbed by restrictions on their earnings dies hard. The common argument is that the American Dream, that everyone can get rich in our egalitarian society, makes even the non-rich resistant to steeply progressive tax rates. The Republican victory in 1888 did not usher in an era of high wages and cooperation between employers and employees. In fact, several of the bloodiest labor-management confrontations, including the Homestead steel strike and the Pullman strike, happened in the next few years. Lowering tariffs would not have been a panacea in 1888, and higher tax rates on incomes over $1 million won't eliminate the deficit in 2012. But policies of high tariffs then and low income taxes did nothing but exacerbate disparities in wealth. They benefited a small section of the economy for a while and hurt nearly everyone in the long run. Lincoln said, "You can fool some of the people all of the time." Will the same arguments that fooled people in 1888 work in 2012?