Monetary Causes of the American Revolutionary War

Milton Friedman The Father of Monetarism

Milton Friedman won the Nobel Prize in Economics in 1976 (more accurately, the Bank of Sweden Prize in Memory of Alfred Nobel), for generating controversial ideas made all the more annoying to his professional adversaries by his knack of asserting memorable slogans. A phrase in question is that "Inflation, always and everywhere, is a monetary phenomenon." Turned around, the converse idea emerged that the great deflation and depression of the 1930s was caused by a global currency shortage. To extend his ideas without his permission, it could equally be argued that British mismanagement of colonial currency had a lot to do with causing the American Revolution.

French & Indian War

Following the French and Indian War, the colonies experienced a major economic depression which seems somehow related to wartime commodity shortages, then post-war surpluses, followed by a need to work off excess inventories. In Milton Friedman's theory, it is the task of any government to maintain stable prices by balancing the amount of currency in circulation with the size of the gross national product. In 1770, the British Exchequer would thus have had to expand and contract the amount of currency in circulation pretty rapidly to maintain economic stability. In the Eighteenth Century there was no understanding of the issues involved. Even if the concept had been crystal clear, there was a thirty-day lag in communication across the Ocean, and comparable lags between the colonies, where differing imports and exports were affected at varying times. So it is a little hard to blame the British for the chaotic result, except to notice that strongly centralized, trans-Atlantic, government was by nature unsuitable for managing a rapidly-changing currency problem. That's what the colonists said, in effect, and their solution for it was Independence.

George III

If you believe Friedman, a shortage of coinage causes a fall in prices, or deflation. To correct that, you need a central banker constantly fine-tuning the currency. But banking in the colonies was too rudimentary to consider such a thing. If you needed a mortgage, you went to a local rich man and borrowed directly from him. That was fine, because prosperous colonists didn't have anywhere to invest their money conveniently, except by loaning money to their neighbors. Indeed, local communities were knit together socially by the mutual assistance of more prosperous farmers directly assisting their less fortunate neighbors. However, pioneer farming

Depression-era Farm Family

communities are far too unsophisticated to remain tranquil when problems arise out of abstractions. Suddenly and without apparent explanation, in 1770 there was no money for anybody to use, and the fellow with a mortgage on his farm couldn't make his payments even though he was otherwise apparently successful. His creditor then couldn't pay his own bills, and eventually even the kindliest ones were driven to foreclose the mortgage. It was said to be common for a farm worth $5000 to be sold to satisfy a mortgage of $100. And in this way, many honest and once-prospering farmers were forced to walk past their old home, now owned and occupied by a formerly friendly neighbor. It all seemed bitterly unfair, no one understood what was happening, evil motives were readily suspected, and old religious and personal grievances were heightened. The country rapidly deteriorated toward class warfare, which is what the division between Tories and Rebels was soon to become, with both sides quite rightly asserting they were not responsible, and quite wrongly asserting the other must be.

From a far distance, it can be perceived that the primitive banking and transportation systems at that time were inadequate to cope with a global empire, and that the only solution readily available was to decentralize the system of governance. It was more the fault of

King George than anyone else, but it would have been hopelessly unreasonable to expect him to understand it, let alone revise his methods of governance to correct it. In the twenty-first century, when the communications, banking, and transportation systems are now almost capable of handling such a situation, we still have many vivid examples of the unwillingness of people to part with power, or for people accustomed to old systems -- to suggest a new one. Even in long retrospect, the American Revolt was nearly inevitable.

Our Federal Reserve (1)

The most enduring, and bitter, controversy in American politics concerns the dependability of the currency. That's not unusual, since as far back as 1000 B.C. the person or group that controls any government of any country has met resistance in raising taxes, and so was tempted to coin more money. Unless you received a big chunk of that coinage, you were opposed to the system, because of the inflation it invariably created. Prices go up.

So people got upset with watered currency, and refused to consider something to be real money unless it was made of gold.Gold doesn't rust,, there's only a limited amount in the world, and everybody agrees it's pretty. Silver was maybe all right, too. Gold dust was weighed in the marketplace, but if you trusted it you took a risk that it had been diluted with something. So coins evolved, with a picture of the king stamped on them, and the edge of the coin serrated, so no one would be able to shave the coin and use the shavings. It didn't matter who stamped the coin, and throughout Colonial times in America, the Spanish piece o'eight was good as gold. But the use of gold and silver coins was cumbersome, and occasionally there were local shortages. One of the important causes of the American Revolution was local discontent with the way the British allowed disruptive shortages of coinage to interfere with commerce in the colonies, at the same time the British prohibited paper currency as too easy to counterfeit.

So, barbarous relic or not, gold was quite effective in restraining governments from their irresistible tendency to promote inflation. The downside began to appear when the Industrial Revolution caused a great increase in trade, because a fixed amount of money in circulation impeded progress. When the economy expands and the amount of gold in circulation remains fixed, the price of gold may remain steady, but the price of everything else goes down. Merchants don't like lower prices, and debtors don't like to repay their debts with money that's scarcer.

It's sort of true that an unstable currency puts rich people and poor people into contention. But the more essential fact is that it puts creditors and debtors in conflict, thereby injuring everybody else by paralyzing commerce. For three centuries, our political rhetoric has enlisted support of "workers" against the "the rich", but that's only acceptable shorthand if the balance of currency has gone too far in one direction or the other, and needs to be corrected. If you really let those slogans polarize society, you won't get fairness, you will get another French Revolution and the guillotine. What's needed is to adjust temporary imbalances, so that the amount of currency in circulation gradually grows in parallel with the economy. During nearly three centuries of struggling with this mysterious issue, we have frequently lost our way with attempts to have "free silver" , with honoring or dishonoring the Continental currency, with issuing Greenbacks during the Civil War, War Bonds during various wars, deliberate national deficits during recessions, going off the gold standard, and a host of other expedients and desperate political gestures. The first person to devise a workable system of matching the money in circulation with the size of the economy, was Nicholas Biddle, of 715 Spruce street.

Our Federal Reserve : Biddle's Bank (2)

Nicholas Biddle

In 1823, the Biddles were prosperous, having made money in real estate (a Biddle ancestor had been a member of the Proprietors), and influential, having been Free Quakers who sided with the Revolution. So, Nicholas Biddle became the president of the Second Bank at 4th and Chestnut. Like all banks, he was given the ability to create money through taking deposits and loaning them out. Since in this process, two people (the depositor and the borrower) think they have the same money, there is effectively twice as much of it -- unless both actually demand it at the same time. If a bank has Federal revenues on deposit, as Biddle did, it is fairly easy for a politically active banker to predict whether that large depositor is likely to withdraw it. Political deposits seemingly make a bank stronger and safer, unless the banker has a fight with a politician. That's banking, but Biddle also became a central banker.

Biddle had ideas, derived in part from Alexander Hamilton. In those days, banks issued their own paper currency, or bank notes, representing the gold in their vaults or the real estate on which they held mortgages. There was a risk in one bank accepting bank notes from another bank that might go bust before you changed their notes into gold. The further away the issuing bank was, the riskier it was to rely on it. So, it was important to be a friendly sort of banker, who knew a lot of other bankers who would accept your money or who were known to be trustworthy.

Nicholas Biddle himself was well known to be pretty rich, and utterly trustworthy. He had a good instinct for how much to charge or discount the banknotes from other banks, or even other states. It was quite profitable to do this, but it became even more profitable when people began to use Biddle's own bank notes because they were safe. By setting a fair standard, he could control the exchange rate -- and hence the lending limits -- of banks that dealt with him. Sometimes a distant bank would get into cash shortages, and Biddle would help them out; if the other bank had a bad reputation, he might not.

Nicholos Biddle

In this way, the Second Bank was a reserve bank for other banks, with its banknote currency coming close to being the currency for the whole country. Soon, within a few blocks of Biddle's Bank, there were dozens of other banks, making up the financial capital of the country. Although it was a little obscure, and even Biddle may not have completely realized what he was doing, in effect his system automatically adjusted the amount of currency in circulation to the size of the economy. If the correspondent banks prospered, they issued more currency, and if there was a recession, the country had deflation. The volatility of this system was related to the volatility of a pioneer economy, so Biddle made lots of enemies whenever he guessed about the direction of the economy. It wasn't a perfect system, but at least he kept politicians from inflating the currency to get re-elected, and hence annoyed politicians by constraining them. During the great western land rush of those days, all banks were under pressure to issue more loans than was wise, and politicians were under pressure to make them do so.

The worst enemy Biddle made was Martin Van Buren of New York. Van Buren was a consummate politician, one of whose many goals was to move the financial capital of the country from Chestnut Street--to Wall Street.

Our Federal Reserve: Okayed (3)

The 8th President of the United States, Martin van Buren, was born in Kinderhook, New York along the Hudson. He was known as "Old Kinderhook", so in time he initialed his documents "OK", and that's how that slang term originated. It's also of note that his retirement home in Kinderhook was named Lindenwald, although any connection with the terminus of the PATCO high speed line is unclear. His real claim to fame is that he sort of invented what we know as the modern political system, particularly that unfortunate doctrine known as the "spoils system". The full allusion is "to the victor belongs the spoils". The two-party system, the Democratic Party, spinning, log-rolling, and other clever manipulations were of his devising. He must have been pretty shrewd, having defeated De Witt Clinton for Governor of New York, when Clinton was known as one of the most ruthlessly ambitious politicians around. Recognizing he was unlikely to be elected President, van Buren took on Andrew Jackson the war hero and manipulated him into the presidency, with the clear understanding that when Jackson stepped down, van Buren would have the job, next. Van Buren was a cabinet officer during Jackson's first term, and vice President during the second term. During that time, he was the real power running things from the shadows. He ruined the careers of John Calhoun and Henry Clay, regularly taking both sides of a number of disputes over the extension of slavery into new Western territories. What people ultimately thought of all this may be judged from the fact that he ran unsuccessfully for re-election -- three times.

It is therefore not certain just whose ideas were in operation when Jackson blocked the re-chartering of Biddle's bank, but one main benefit, "cui bono?", went to New York. Wall Street had sold stocks under a Buttonwood tree for fifty years, but its real start in the financial world can be traced from Jackson's action.

The Industrial Revolution and the expansions of the United States by the Louisiana Purchase, the annexation of Texas, and the Mexican acquisition caused an explosion of new wealth, and hence an urgent need to make some better financial alignment of three asset classes: land, precious metals, and currency. Everywhere and at all times it is arguable what land is really worth; 19th Century America it was particularly speculative, because there was so much of it. Most of the many bank panics during that century can be traced to excessive borrowing to speculate in raw land. When Jackson closed Biddle's reserve bank, the land speculating public was ecstatic, because any constraints on the lending power of banks made it harder to sell real estate . But what had been done was eliminate the only reasonably effective way of matching the true wealth of the country with its circulating monetary assets, and after a brief boom the almost certain consequence was going to be a national bank panic. It came in 1837, during the first year of Martin van Buren Presidency.

The only imaginable alternative to a market-based monetary system is a government-based one. Van Buren's political behavior was by almost by itself sufficient warning of the danger of allowing politics into this matter. For nearly a century, one warning was enough.

Laundered Money

Judge Edwin O. Lewis finally got his way, the Pennsylvania State Government acquired four blocks of Chestnut Street stretching to the East of Independence Hall, and the Federal Government acquired four blocks stretching to the North. Judge Lewis was determined that a real revival of historic Philadelphia required the clearance of a lot of land. Those who heard him describe it will remember the emphasis, "It must be BIG if it is to serve its purpose."

The open land is rapidly filling in, but for a time the movers and shaker of this town had to scratch a little to find something to put there. That's fundamentally why the historic district has a Mint, a Federal Reserve, a Court Houses, a Jail, and a big Federal Building to house various local offices of the landlord, the federal government. It's where you go to visit your congressman, or to renew your passport, or to argue with the Internal Revenue Service. If you have certain kinds of business, there's an office for the FBI and the U.S. Secret Service. The mission of the Secret Service is a little hard to explain with logic.

The Secret Service is a federal police organization, charged with protecting the President of the United States, and enforcing the laws against counterfeiting money. In unguarded moments, the Secret Service officers will tell you they only have one function: to guard three-dollar bills. The President only comes to town from time to time, but the mandate extends to the President's family, and to the extended family of official candidates for election to that office. So, there is usually always a certain amount of activity relating to running behind limousines with one hand on the fender, or poking around rooftops near the speaker's platform at Independence Hall, or talking apparently to a blank wall, using the microphones hidden in their ear canals. The rest of the time is taken up with counterfeiters, but even then the excitement is only occasional, depending on business.

A few years ago, the buzz around the office was that some very good, even exceptionally good, fake hundred dollar bills were in circulation in our neighborhood. The official stance of The Service is that all counterfeits are of very poor quality, easily detected and no threat to the conduct of trade. Unfortunately, some counterfeits are of very good quality, not easily detected, and when that happens, The Service is made to feel a strong sense of urgency by its employers. These particular hundred dollar fakes were of very good quality.

One evening, a call came in. Don't ask me who I am, don't ask me why I am calling. But I can tell you that a very large bag of hundred dollar wall paper has just been tossed over the side of the Burlington Bristol Bridge, near the South side on the Jersey end. Goodbye.

Very soon indeed, boats, divers, searchlights, ropes and hooks discovered that it was true. A pillow case stuffed with hundred dollar wallpaper of the highest quality was pulled out of the river. By the time the swag was located and spread out for inspection it was clear that several million dollars were represented, but they were soaked through and through. Most of the jubilant crew were sent home at midnight, and two officers were detailed to count the money and turn it in by 7 AM. The strict rule about these things is that all of the money confiscated in a "raid" was to be counted to the last penny, before it could be turned over to the day shift and the last officers could go home to bed. After an hour or so, it was clear that counting millions of dollars of soggy wet sticky paper was just not possible by the deadline. So, partly exhilarated by the successful treasure hunt, and partly exhausted by lack of sleep, the counters began to struggle with their problem. One of them had the idea: there was an all-night laundromat in Pennsauken. Why not put the bills in the automatic drier, so they could be more easily handled and counted? Away we go.

At four in the morning, there aren't very many people in a public laundromat, but there was one. A little old lady was doing her wash in the first machine by the door. It was a long narrow place, and the two officers took their bag of soggy paper past the old lady, and down to the very last drying machine on the end. Stuffed the bills into the machine, slammed the door, and turned it on. Most people don't know what happens when you put counterfeit money in a drier, but what happens is they swell up and sort of explode with a terrible loud noise. The machine becomes unbalanced, and the vibration makes even more noise. The little old lady came to the back of the laundromat to see what was going on.

As soon as she got close, she could see hundred dollar bills plastered against the window, and that was all she stopped to see. She headed for the pay telephone near the front of the door. The secret Servicemen followed quickly with waving of hands and earnest explanations, but within minutes there were sirens and flashing lights on the roof of the Pennsauken Police car. Out came wallets and badges, everyone shouting at once, and then everything calmed down as the bewildered local cop was made to understand the huge social distance between a municipal night patrolman and Officers of the U.S. Secret Service. Now, he quickly became a participant in the great adventure, and was delegated the job of finding something to do with armloads of (newly dried) counterfeit hundred dollar bills. He had an idea: the local supermarket was also open all night, and they carried plastic garbage bags for sale. Just the thing. But who was going to pay the supermarket for the bags? Immediately, everyone was thinking the same thing.

Fortunately for law and order, the one who first suggested the obvious idea of passing one the counterfeits was the little old lady. At that, everyone came to his senses. Wouldn't do at all, quite unthinkable. The local cop was sent off for the bags, relying on his ability to persuade the supermarket clerk. And, yes, they did get the money all counted by 7 A.M.

Making Money (1)

Barbarous Relic

As 2005 turns into 2006, we watch an upward surge in the price of gold for the first time in three decades. The last time the gold price soared, America had gone off the gold standard completely, ending traditional promises that U.S. dollars could always be exchanged for precious metals at a specific price. A brief flutter of the exchange rate ("the price of gold") under floating-price circumstances was to be expected, since it was even conceivable that the price of gold might eventually go down. It didn't, and when things settled out it was roughly true that the price had migrated from about thirty dollars for an ounce of gold to about three hundred dollars an ounce. The conversion price has experienced fluctuations since that time, gradually moving to four hundred dollars an ounce in thirty years. There was reason to see this as a one-time readjustment. The floating prices of precious metals might drift along independently forever, responding to fashions in gold jewelry and advances in dentistry, but a matter of little interest to anything else. No doubt there would be panics in third-world politics, but anyone one who staked life's savings on predictions of wars and famines in the underdeveloped world was imprudent, a nut. A gold bug.

This time, it seems to be different; all is calm. The price of gold now exceeds five hundred dollars an ounce; responsible publications even conjecture it will go to a thousand within five years, perhaps three thousand in fifteen years. You might say wild predictions are thus flying about that our savings will lose ninety percent of their value, but nowadays nobody seems willing to say this is either a crisis or just nutty talk. There is both an absence of alarm that the price of gold is predicting disaster, but also a lack of scorn for dumbbells who would actually believe such a thing. A cynic would say that the columnists in financial magazines all seem to be owners of some gold and are talking up its price. But we were told it didn't matter, so we seem to believe it.

A more reflective view would be that we are experiencing the first real test of the world's new monetary system, at least its first challenge by the marketplace since the convertible link between gold and dollars was officially severed. The value of gold seemingly has little to do with its basic utility for dentists. The value of the dollar seemingly does not attempt to relate to the actual supply in circulation, nor attempt to represent a share of all American assets; those things are too hard to measure. The number of dollars in circulation is governed by watching inflation and unemployment, and having the Federal Reserve create more or fewer dollars as needed to keep inflation and unemployment at some steady, pre-determined level. The price of gold is something else, irrelevant to a civilized society. It's all terribly clever, but it ultimately depends on whether those pre-determined levels of inflation or unemployment are well chosen. And whether politicians might tinker with them.

It would therefore seem likely that the clearing price between gold and dollars is currently putting a high value on gold for reasons other than a current over-supply of dollars or a world shortage of the metal. We must look elsewhere for the cause of the gold-price panic. The Chinese and the Indians are getting richer; perhaps the value of precious commodities somehow reflects that relativity. Or perhaps we are dealing with political predictions; a civil war in China, renewed war between India and Pakistan, a revolution in the Persian Gulf oil kingdoms. Or atomic bomb terrorism directed against the United States. Whatever political upheaval it is that bothers the gold bugs must be pretty big; neither the war in Afghanistan nor the one in Iraq, or the combination of both, was enough to stir up gold prices to the present degree.

In a sense, the worst possibility would be: the gold hysteria has no rational basis at all, like the tulip bulb frenzy of several centuries ago. The immediate question gets raised whether a merely intellectualized value for the currency can withstand cataclysmic world events. But if there is no serious threat of world cataclysm, then the remaining question on the poker table becomes whether hysterical financial commentators can topple the dollar system just by mindlessly stampeding. A monetary system which cannot withstand such a trivial threat is not a viable monetary system. The financial world's eggheads would then be in a war with the financial world's green-eyeshade gamblers. It's not entirely safe to predict who will win.

Making Money (2)

counterfeit money

One of the important provocations of the American Revolutionary War was shortage of cash caused by a primitive currency system. The British government would not permit colonies to print easily counterfeited paper money; while dependence on gold coins regularly caused temporary shortages during seasonal trade imbalances. Colonists became bitter about farm foreclosures when an otherwise prosperous farmer simply couldn't find enough coins to satisfy his mortgage payments. So, from earliest days the monetary system highlighted the important distinction between how much cash you had jingling in your pocket, and how rich you actually were. Electronic banking and funds transfers have now largely eased the cash flow issue; measuring the true wealth of the whole economy still contains much guesswork. When the economy seems to be undervalued (deflated) by the prices collectively set by the marketplace on each of its parts, two common fiscal remedies still provoke political controversy. To inflate the economy, the government can spend money, or it can reduce taxes. The empirical history of the past century seems to show that cutting taxes is quicker and more effective, particularly when taxes were too high to begin with. It may not work when taxes are insignificant, so the political debate between the two parties who have adopted these programs as pets, tends to center on whether taxes are too high or too low and who is paying them.

To a certain extent, this is a tempest in a teapot. Both reducing federal taxes and increasing federal spending lead to increasing federal deficits, which are then covered by issuing federal bonds. Not much difference, there. The important difference on a practical level is that cutting taxes increases money in circulation more quickly than wrangling about what programs might be best, and then painfully organizing them. The choices for spending opportunities are set by the private sector when taxes are reduced, are therefore more effective in stimulating the private economy, less likely to be politically filtered than legislative authorizations are. The fresh funds from cutting taxes go to those who were successful enough to be paying taxes. They personally need them less than poor people do, but they have a better track record in multiplying them. Unless taxes are already too low to make a difference, reducing taxes is clearly quicker and more efficient than authorizing government spending. Finally, the argument about "planning" introduces an unnecessary sour note. Although the Communist Party was famous for five-year plans and the like, the truth is their system of subordinating economic goals to political ones was the main source of their economic collapse. It was the German, Italian and Japanese systems of central planning which can fairly claim a measure of economic success, growing out of their admiration for an earlier era of success by huge industrial corporations, stimulating even in America a spirit of "win the war" top-down organization. We thus have the ironic situation where it is awkward to point out the technical reasons for the post-war failures of the centrally planned Axis nations, since the people who now seem most attracted to central planning are the ones most likely to be offended by the comparison. Somehow, we must hope that the French and Chinese learn this lesson by themselves.

Making Money (3)

david altman

Daniel Altman draws attention in the January 1, 2006 New York Times to Ben Page's estimation of compensating rises in federal tax revenue after tax cuts. Page (for the Congressional Budget Office) says revenue increases will only offset 28% of tax loss. The Laffer theory (that tax cuts pay for themselves) may be overstated but it's kind of right. Not only is the full amount of the tax reduction immediately released to the private sector, but only 72% of it ever needs to be borrowed and repaid. Tax cuts may not pay for themselves but they fully stimulate the economy immediately; 28% of the stimulus is permanent.

Mr. Altman then comments taxes could never be cut to zero, because lenders would then refuse to lend; surely no one disagrees. But it's extreme to say tax rates must currently be at a point "on the curve" where reducing them further will not generate worth-while gain in tax revenue to be effectively re-injected back into the economy. All of any tax cut is always a windfall for the private sector; that's its purpose. Ben Page just says that only 72% of this one needs to be borrowed; the other 28% is a permanent cost-free saving for everybody. If you chose to stimulate the economy by increased government spending, all of that would have to be borrowed, all of it would have to be repaid.

But cheers for Mr. Altman, who notices the role of lenders, who place limits on how far you can stretch this idea. You can't cut taxes to zero because lenders won't lend to a government without income. And even as taxes approach zero, lenders will raise interest rates. That gets us to the currently inverted yield curve; why aren't long-term bonds able to command higher interest rates? If they rose, the interest cost would eventually wipe out the free ride for tax cuts.

Well, the big artificiality in this Calder mobile is the fixed exchange rate for Chinese currency. The Chinese are inexperienced, rightly fearing chaos if they allow their currency to float upward against the dollar. When they solve their problem, unless God help us they bungle it, American bond rates will tell us whether it's safe to cut taxes some more. Interest rates on American long-term bonds will rise, perhaps to uncomfortably high levels. At that point, no government -- R or D -- would cut taxes further.

Making Money (4)

If lowering taxes is inflationary, how can it be that several financial columnists refer to buying low priced

china Man

Chinese imports as "importing deflation"? It would seem, in both cases, that consumers end up with more money in their pockets, so both cases must be inflationary. To answer that twister, you also need to consider where the inflationary new money comes from.

chinese labor

When the government lowers its revenue by lowering taxes, it creates a deficit which is paid for by issuing bonds. That's inflationary until the bonds are paid off. If the bonds are ever paid off, the amount of money in circulation then returns to its original level. The public has effectively given itself a loan by lowering taxes, so after a temporary spell of inflation, there is no permanent effect on circulating money at all. By contrast, when Chinese workers agree to work for lower wages than Americans, that causes inflation for the American economy because Americans have more spending power left over . How they spend it is their business; the bonanza may surface as a stock market bubble or a real estate bubble, a credit card bubble or a spectacular Christmas shopping season. But gradually the extra money seeps out into the economy as extra wealth of some sort. Whether you describe it as real added wealth, or just inflation, may be a quibble -- but it clearly is not deflation.

chinese wages

But when a successful financier, betting his own money on his analysis, says that America is "importing Chinese deflation", it's likely he says something important, however imprecise technically. In this case, it would seem to be an observation that the globalization method of creating inflation minimizes some of the usual consequences of inflation. Since the low prices of Chinese products are mainly due to low Chinese wages, they discourage wage demands in this country, even in industries which do not compete against imports. That's politically important, even though there are many more consumers than manufacturing workers, and the nation as a whole is better off for the globalization. In short, inflation is not invariably a bad thing.

Now, just think of the problems that creates for the Chairman of the Federal Reserve, who is charged with maintaining level prices, and defines our whole currency system on doing whatever it takes -- to avoid inflation.

Making Money (5)

lord keynes

Every newly-rich country seems to experience at least one episode of adolescent giddiness, thinking there is no stopping them, their trees will all grow to the sky. America's comeuppance took place in 1929, Japan's in 1990. Sooner or later the Chinese and the Indians will learn that it is unwise to grow faster than human systems can readjust, overcapacity is certain to appear at some point, and the new bumpkin will then appreciate what it means to have a business cycle. After a variable time, deflation reaches bottom, and it is past time to inflate back to normal. Lord Keynes (pronounced "Caine's") advised Franklin Roosevelt to promote government spending, even useless spending, but it didn't help as much as they hoped. The Japanese built bridges and tunnels to nowhere, and that didn't help much either, although encouraging residential construction worked better than they expected. Wars are good for deflation, too, but only if you win them.

America has devised three methods for combating deflation: cutting taxes when other nations maintain fixed currencies, cutting consumer prices at the expense of developing countries, and cutting costs by improving productivity. You could combine these three methods into one principle: if you can't increase the amount of money, you must increase virtual spending power by cutting prices. In a deflation, consumer prices have fallen because of overcapacity, so you must cut consumer costs in those areas which will not respond to overcapacity. Same money, more buying power. Other countries are apt to resort to gold as a way of preserving their buying power; it will be an interesting struggle.

Nevertheless, it will be important for America to spend its affluence on increasing productivity rather than trinkets and junkets; we, too, have our share of adolescents. Computers have helped us reduce transactional costs everywhere; transportation is in fair shape. Education is an expensive mess, simply begging for improvement. Housing is still using 19th Century methods. Entertainment is expendable. We have a huge supply of underutilized labor in the black male community, in the early retirees, and in our comfortable work habits. Fighting wars is a pretty expensive hobby. How well we withstand the next world recession will depend to a major degree on how well we solve the problems that obviously need solving.

The business cycle will continue to cycle, but it is possible to feel pretty good about American ingenuity in relating, globalizing and enhancing productivity. There is even a wicked satisfaction in reminding our British cousins of their little witticism which made the rounds after World War II:

In Washington, Lord Halifax
Once whispered across to Lord Keynes:
"It's true that they have big moneybags,
But we have all of the brains."

Making Money (6): The Laffer Curve

Recall for a moment, the two Republican idols, economists Milton Friedman and Arthur Laffer. Friedman won a Nobel Prize by observing that inflation is "always and everywhere" caused by too much money in circulation. Thus, a potential remedy for inflation was suggested: central banks (i.e. the Federal Reserve) can restrain that by raising short-term interest rates at the first sign of inflation. It certainly seemed to work; by doing so, Federal Reserve Chairman Alan Greenspan was able to avoid inflation for eighteen years.

Arthur Laffer offered a second idea for Presidents to test. Laffer maintained that if taxes were too high, you would paradoxically collect more taxes by lowering tax rates. The younger George Bush took him up on it, reasoning that if tax collections did rise after tax rates were cut, it would be proof that taxes had been too high all along. The appeal to tax technicians in the Treasury Department was that, by observing tax collections, all changes in tax rates up or down might lead to identification of the most efficient possible tax rates. So, although President Reagan had felt warmly about Laffer, while the senior George Bush rudely dismissed such ideas, George W. was eager to test his gut feeling that tax rates were too high. Each year during his presidency, George W cut taxes. Gratifyingly, each year total tax revenue (adjusted for GDP) increased. Eight years are not the same as eighteen, but it certainly looks as though W proved that taxes had indeed been too high. If some future Congress has the courage to raise taxes, and then tax collections go down, the Bush legacy would seem pretty secure. Two iron laws of national economics would be enshrined: The tax rate should be whatever maximizes tax revenue. Interest rates should be whatever restrains inflation. Live with it.

True, none of this insight casts much light on how to cope with wars and depressions. Raising interest rates seemingly defeats inflation, but lowering interest rates has not always cured recessions. Furthermore, the fiscal and monetary direction of the country may have to be altered when we face war, famine, weather disasters, and demographic shifts. But at least we seem to know how to determine the optimum level of (overnight, interbank) interest rates and taxes, so have a compass for return to those levels after detours around uncertain events. Maybe economists, even Voodoo economists, can suggest some other principles which politicians can test in the real economy. And political science can then start to have some true scientific method in it; propose a theory, test it, revise the theory and test it again.

But there's one more thing that Art Laffer didn't understand when he was drawing his famous curve on the back of a paper napkin. One of the main reasons tax collections rose spectacularly when George Bush finally had the nerve to try lowering taxes -- was that the underground, tax-evading, economy was a great deal larger than anyone had suspected. Laffer made crooks into honest people.

Setting National Interest Rates

A bank has depositors' money in custody, and makes a profit from loans of it. This amounts to borrowing money from depositors at a low interest rate, then loaning it to borrowers at a higher rate. Banks can also borrow from other banks, or effectively loan to the Federal Reserve by buying U.S. Treasury bonds. At one time, banks set interest rates for loans by leaning back in the chair and negotiating with the customer; interest rates were whatever the traffic would bear. After a long and complicated history, which includes the Catholic Church's forbidding interest-bearing loans, Henry VIII of England confiscating Church property, the Medici family in Italy and a political battle between Andrew Jackson and Nicholas Biddle, we got to the point where J. P. Morgan more or less decided which banks deserved to fail and neglected to rescue them in the next bank panic. He was in that position because of European, largely British, banking connections. In 1913, the Federal Reserve system was created, with government officials nominally but not totally in charge. Although it now seems pretty natural for the government to be in charge of the nation's money supply, it must be remembered that Robert Morris personally financed the Revolutionary War, Stephen Girard financed the War of 1812 out of his own bank, and J. P. Morgan financed the Spanish American War -- in each case, because the government couldn't do it alone. On the other hand, the Civil War (and later, the two World Wars) showed that the nation had outgrown the control of a single private banker. We floundered through gold and silver standards, then bimetallism, then off metal standards entirely.

At the heart of it was an important difference of opinion. The banks were private businesses, and didn't want outsiders setting their prices. They particularly didn't want the government to set interest rates after government itself became a permanently big debtor. It it's left to them, banks want higher interest rates, governments want lower rates; neither one is a trustworthy referee for the whole country. The 1913 reform locked the two of them in secret struggles within a marble tomb. After eighty years, with one bad inflation, at least two bad depressions, and a dozen stock market crashes, the two combatants seem to have evolved a workable system of agreement on suitable goals and how best to achieve them.

The problem is this. Interstate business and national politics demand uniform national interest rates. But any national rate will be too high for some regions, too low for others. Such an impossible deadlock can only be solved by choosing between tyranny and payoffs. Just how the regional losers in these endless arguments are pacified is not entirely clear, but a recent remark is interesting. One regional governor of the Federal Reserve remarked that you might expect each regional governor to argue for the benefit of his own region, but in fact there is little of that. No one with experience in politics would conclude from that remark that governors are filled with altruism. But it will apparently take more time before the mechanics of this balancing act are fully understood.

For now, the Federal Reserve can be described as a place where representatives of the regional banks negotiate with a federal appointee, behind closed doors. The question of enforcing a uniform national interest rate was effectively settled for good, shortly after the creation of the Federal Reserve. Texas defied the national rate and lowered Texas rates to meet Texas conditions. Almost instantly, everybody wanted a loan from Texas banks, but no one would deposit money in them. Texas came crawling back to conformity, and the national rate was thenceforth not only legal and ratified, it was seen to be self-enforcing. The European Union has recently gone through the same experience, with everyone learning there is simply no way to cheat the system.

One other thing needs mentioning. Total price control of all interest rates would cause rioting in the streets. India and other countries which tried to nationalize their banks have taken thirty years to recover from the experience. The Federal Reserve only controls short-term interest rates, while long-term bond interest remains set by the marketplace. This seems to work well enough for the purpose of regulating the supply of money, but it affects consumers and small businesses who do most of their borrowing through banks. Large corporations generally borrow money by issuing long-term bonds. This difference in application causes a certain amount of grumbling about fairness. But the wisdom of the arrangement was repeatedly illustrated to President William J. Clinton. We hear it reported that time after time some proposal of his was quashed by his Secretary of the Treasury, Robert E. Rubin, quietly commenting, "The bond market won't let you."

Supply-Side Tax Cuts

Some tax cuts are good, some are bad. Aside from the political truth that cutting my taxes is always better than cutting yours, there's the question of timing. Tax cuts are usually inflationary, so there are times when they should be resisted. Taxes on some things are disincentives; that's been the argument for taxing cigarettes and liquor, maybe it is now an argument for raising gasoline taxes. But the argument for lowering taxes on capital gains and dividends is far more mysterious. It's supply-side economics, and absolutely no one knows what that means.

The place to start is to recollect that the dividends on state and municipal bonds are exempt from federal taxes. Tax-exempts have a lower interest rate than similar bonds issued by corporations, or the federal government, because such tax-free income is more valuable to the purchaser than taxable dividends. But forget about the purchaser for a minute. The state or local government gets enabled to borrow money at a lower interest rate. That's the supply side.

So, although it passes through extra steps, corporations would find it cheaper to issue bonds if the customer paid less income tax on the bond dividends. Not only does the issuing corporation get an interest-rate reduction, all other corporations do too, as the prevailing cost of capital is lowered. There's even an enticement for economic nationalists: only American bond-buyers get an American tax reduction. And all this is true whether you lower the rate from 25% tax to 15%, or eliminate taxes entirely. Corporations get an incentive to borrow more money, which we all pray they will use wisely so good things will happen to jobs and the economy. It's known as lowering the cost of capital.

It doesn't make a bit of difference whether the taxpayer who "gets" the tax cut is rich or poor, and in that sense the argument for doing it isn't political. But in another sense, it may be. State and local governments are already getting cheaper capital, so we have in the past created an artificial incentive for them which disappears if everyone gets it. There's a large segment of the country that believes the country would be better off with less government, based on efficiency, economics, and yes, political grounds.

Inflating and Deflating Japan.

Survivors of the Great World Depression of the Thirties need no convincing about the catastrophe of deflation, but even they would have trouble defining it. Deflation is, well, something that was caused by the 1929 stock market crash, or maybe it was Herbert Hoover's fault, or maybe Hitler's fault. It is enough to know it was bad, that it's all over, and that it is on page six of the newspapers, below the fold. Unfortunately, it has returned again to crush the poor Japanese for the past fifteen years, but still no one seems willing to say what causes deflation, or what will cure it. So, let's venture.

The world acts as though it believes the following one-liner: The main cause of deflation is inflation. Merely keep inflation under control, and you will then avoid deflation, as well as the awkward need to know what to do about it. The main proof of this fragile argument lies in the fact that America has somehow avoided serious recession for almost twenty years by relying on "inflation targeting". It's a little uncomfortable to notice that the main proof that inflation is the only cause of deflation rests on the fact that we have had no recessions during the time we had no inflation. When central bankers are confronted with the lack of logic in that position, they appear distinctly uncomfortable. It may be correct that only inflation can cause deflation, but the proofs are unsatisfying.

So let's retreat to a little safer ground. Let's say that massive shifts of currency can topple the stability of any government or national economy; inflation is the main cause of massive currency movements. However, it's like the old children's game of paper, rock and scissors; you can't be sure in advance whether you want diversification, strength, or flexibility. Stability rests on long term financial commitments, like long-term bonds, or mortgages, insurance, or pension schemes. But maybe you don't want strength, you might want agility. Then, if you are in a position to anticipate currency disruption, you will shift from long-term to short-term. Panic like that undermines the people who are locked to thirty-year commitments, but may not have thirty years to ride them out. The value of a national currency is tied to shifts in interest rates; that's the same thing, one within borders and the other across borders, like pushing on a balloon.

If you think government action can rescue a real panic, look at Japan. The Japanese sold good cars and cameras, acquiring a lot of foreign currency. That should have caused their own currency to increase in value, but instead the Japanese just printed more of it to maintain the low international price of cars and cameras. All that resulting loose cash, confined within their borders, caused a serious inflation of Japanese real estate and stock market prices; when this inflation shifted around, it capsized their boat. Long-term debts defaulted, eventually bringing the banks down with them.

Perhaps the Chinese have learned a lesson from Japan's experience, but don't count on it.

Paying Bills Electronically

perry

Commodore Perry "opened up" Japan in 1854, but Ronald Reagan opened up the banks and finances of that country more than a century later. Because his chief of staff Don Regan had been in charge of Merrill Lynch, the Japanese let that company in, and because of some favors by J. P. Morgan in the 19th Century, they also admitted Morgan Stanley. Although several Japanese banks had grown to be the largest in the world, the Japanese never adopted the popular American habit of personal checking accounts. One of the surprised observations of the new American pioneers was that a bank could be pretty successful, without all that expensive nuisance of processing checks. Twenty years later, American banks are starting the long and difficult job of weaning their customers away from paper checks.

There's even a personal story of an early American expatriate sent to work in Tokyo for Morgan Stanley, taking his shirts to be ironed by the local Japanese laundryman whose English was poor. Each time he collected his shirts, the American would pull out a blank check, signed with a flourish, accepted with much bowing and murmuring of delight. After several months, an English-speaking Japanese was summoned to one of these ceremonies, and the expiate was politely asked what he was planning to do about paying his bill. His highly venerated checks were all neatly stored in a lacquered box under the counter, but had never been taken to the bank.

Americans are now engaged in a frenzy of using credit cards. Something has to change in that system, which is proving to be a very expensive substitute for checks, since it amounts to giving short-term loans to and from a lot of people who don't need, and didn't ask for, a loan. Given an open choice of paying the invisible extra cost of using a plastic card, or just waiting until the end of the month to complete the transaction, most sensible people would prefer to wait. The plastic card system just can't continue in its present form, and one possible substitute is to use a personal computer to pay bills electronically. That's a step better than using plastic, but as we will describe, it needs to become two steps better before it is really satisfactory.

To do electronic bill-paying you of course need to have a computer, and you have to go through the laborious process of entering a lot of information about each person who is going to get paid. Once that is done, and security precautions established, paying bills is a much simpler task than it used to be. The helpless consumer even has the occasional experience of finding that some creditor billed him twice, or inaccurately; my computer caught your computer making a mistake. It's now hard for me to imagine going back to paper checks and bank stubs.

However, I've become spoiled and demanding. There are four deficiencies in this system which irritate me enough to bring me to a open bidding process: I'll switch my accounts to any bank that fixes them.

Morgan

1. Invoice memo entry. The entry screen you use when you prepare a check should contain a block to enter some kind of a notation, such as the biller's invoice number. When that block is completed, the material should be printed on the check. The memo might say "Girl Scout Cookies", or "Hedge trimming", or "Invoice # 123456". Any programmer ought to be able to make that change in half an hour, and it could transform the average consumer's box of cancelled checks into a meaningful set of accounts. More importantly, returning the invoice number to the biller would allow him to match the payment to the item, an important step in keeping your accounts straight with a regular counter-party. You are of course saving your creditor some trouble; but if he gets your accounts scrambled, it soon becomes your trouble, too. The inability of any bank I've asked, to make this simple change, is a clear sign that they are using a software vendor for this process, and everybody has stopped engineering the product once a sale has been made.

2. In Process, Processed, Paid. When you pay a bill, the item is noted to be "In Process". An impatient creditor can be told to be patient, it takes a day or so to get this work done. When the bank sends the check, the notation is changed to "Processed". But then, there is a limbo. The bank has sent the check, it washes its hands of it. Six months later, if the postman lost the check in the mail, it will still say "Processed", the creditor is dunning you, you tell him you paid it, he says he never got it, you call the branch bank to get an 800 number to stop payment. On the other hand, if the bank would change the word to "Paid" when the check clears, you would know that the problem is entirely different and act accordingly. If a check is still "In Process" after say two weeks, you stand alerted. Fixing this problem is somewhat more difficult, involving a matching process between the bill paying and the check clearing. The fact that this isn't already done is a strong indication that the bill paying is being done by an outside vendor, and two parties have to come to agreement about how to match records. If, on the other hand, both steps are run by two departments in the same bank, then it may be time for management shuffling.

3. Your bank balance. Once you recognize that this internal reconciliation isn't being done, you see that your bank balance is inaccurate to some unknowable degree. If your bank balance is debited when the check is issued by you, you will have an uncertain balance to the degree that checks haven't been cashed, and you will be less likely to be alert to lost items. If the balance is only debited at the time the item is cashed by the recipient, you can easily be misled into thinking there is more money in your account than there really is. You will then be tempted to overdraw your account, thinking the stated balance is available to spend. If the third possibility is followed, the balance is debited when the bank puts the check in the mail, and you will never be sure just where you stand. So, although an argument can be made for each of the three methods, all three mislead the customer. There is no escaping it, the bank needs to post two different balances, or at least add a third notation for "items in process". A fourth item would be still better, "overdue items", for checks that have been sent but not cashed within a reasonable time. Let's even consider going big-time: put an asterisk beside items in process, and two asterisks beside overdue items. And then total the asterisked items at the bottom of the page. Now, is that so hard?

4. Yearly Bank Statement. My present bank purges these records every three months, and even tells me of the big savings it makes by reducing dead storage space. That's a pain, because everybody pays income tax once a year, making it a big convenience to have all deposits, payments and pending items totaled for the year. For about a hundred dollars, I can buy enough disk space to hold about 10,000 yearly statements of average size, so yearly statements could be stored for a year at a cost of about a dime. It's pretty hard to believe there wouldn't be more savings than that, for the bank, in reduced telephone inquiries. If not, here's my dime.

And here's my checking account, with gratitude, for any bank that has the moxie to do these things for me. It would be well worth the nuisance of re-entering the account information to switch to a bank that seems to care what its customers would like. And if that new, imaginative bank gets as many customers as I think they would get, they will need an automated program to transfer all that account information.

European Common Currency

Christian Noyer

Philadelphia had the recent pleasure of a visit by Christian Noyer, the Governor of the Banque de France, offering to a Federal Reserve Bank audience a view from inside the Eurosystem's monetary policy. Mr. Noyer was a designer of the Euro, or common currency of Europe. A charming and polished man of education, he brought along a document which hangs in his office, dated June 5, 1779, signed by John Jay on behalf of the Continental Congress, sent to Benjamin Franklin to give to Caron de Beaumarchais. Since Independence Hall is visible from the upper windows of the building where he was speaking, it was a charming touch.

European Central Bank

The European financial system consists of one monetary policy, set by the European Central Bank, but twelve (soon to be twenty-five) fiscal policies, set by the various governments. This was once thought to represent a major difference from the American Federal Reserve, but in fact it hardly matters. Our fifty component states are not permitted to run deficits, but our federal government runs deficits, plenty of them, and it turns out to make little practical difference if a Central Bank must float bonds to pay for a deficit arriving in one envelope or twelve. What matters is the size of the total. From that starting point, the central bank struggles to modify matters to restrain inflation, or combat unemployment. The main tool at the bank's disposal relates to the fact that governments no longer fear to print more money than they can redeem in gold. They print money, all right, but the spigot is now turned down when inflation begins to appear. In theory, at least, inflation is not possible if the central bank is able to maintain this policy. Of course, if money created in the past comes flooding in from abroad or out of mattresses, there might be a problem. Central bankers seem like terribly powerful people, until you count up the people they can't control. The first are the politicians who create those deficits.

Taxes

European politicians believe their constituents prize security above all else, a condition known as socialism. High taxes, high unemployment, and slow economic growth are considered more tolerable in Europe than sacrificing pensions, health care, and other features of the social safety net; out of this come government deficits, then maybe inflation. The central bank is told to make the best of it.

Then, there is the long-term bond market, which in the past responded to a flood of money by reducing the value of outstanding bonds, which results in higher interest rates.

Euro

Recently, however, long-term interest rates have failed to rise in response to rising deficits, and speculation abounds as to why that should be so. It creates uneasiness to hear that the finances of the world are simply a "conundrum". And finally, foreigners will flee from an inflated currency, eventually triggering a devaluation. A few years ago, Argentina refused to devalue, but the result was a devastating recession when their foreign trading partners refused to deal with an unrealistic currency.

A government which refuses to respond to these "signals" from the bond market and foreigners, will be forced to take some undesirable actions. In Europe, it is to oppose globalization of the economy, thereby hurting everybody but especially poor nations. And the internal European unemployment is shifted as much as possible onto the backs of immigrants, even migrants from within the European community. Take that far enough, and you get serious threats to world peace. Even within the European community, many of the policies which protect the welfare state will consciously injure their own economic growth. Reform is resisted.

Many needed reforms are obvious to policy makers in Europe, and the American example would often seem to be convincing. But it isn't, because Europeans terrified of losing their welfare state recognize that the American model includes a large amount of contempt for socialism, no matter how otherwise successful it is. The interesting thing has been that the Scandanavian countries have an equally extensive welfare safety net, but have nevertheless prospered by adopting free-market reforms. There are signs that this experience is beginning to convince Europeans it is possible to work their way out of the dilemmas.

After his talk, which avoided mention of many of these concerns in the mind of his audience, Governor Noyer was even more charming in cocktail-party mode, but one thing made his face turn beet red. When asked what the John Jay letter was all about, he had to admit he hadn't the foggiest. It was just something hanging on his wall that seemed appropriate for a trip to Philadelphia.

The Economic Power of Laws

Philadelphia is tucked down in the Southeast corner of Pennsylvania, right next to Delaware and New Jersey. All three states once belonged to William Penn, and started out Quaker dominated. In time, they settled down to a life of independent states, and with the growth of population plus speed of transportation, they are all getting smudged together again. The Quaker influence is there if you look for it, and rather fierce, even hostile, political competition between the states is there, too. But if you were a foreign visitor who doesn't look at maps, you could drive around the metropolitan area without knowing which state you were in. To a large extent, the Rand-McNally lines are a hindrance to commerce and convenience, but they have their value. The quirks of political jurisdiction give the Philadelphia metropolitan area six U.S. senators, and the opportunity to take shrewd advantage of the three legal systems. You can buy things without a sales tax in Delaware, and estate tax lawyers tell me that if you must die, die in Delaware. At one time, New Jersey was a great place to get an uncontested divorce, Pennsylvania a better place to start an unincorporated business. More recently, the New Jersey doctors are complaining that malpractice rates are unbearable, but they are not as bad as they are in Pennsylvania, and it is rapidly becoming true that if you are going to be born, you will need to be born in New Jersey because the obstetricians have all moved there. That's also true in the Dictrict of Columbia; obstetrics has just about entirely fled to Virginia. Better watch out where you have your auto accidents, too. Neurosurgeons and orthopedists have also responded to the local disincentives to live near certain types of juries.

Long ago, James Madison designed things this way on purpose. The main author of our constitution hated taxes and oppressive government as much as any other founding father, and argued it was a good thing to let neighboring states have differing laws. Corporations which do interstate business hate the complexity of course, but as Madison argued, people do shift their business, their businesses, and even their residence if the neighboring states become too extreme in their differences. It's still worth a thirty minute drive to buy silverware and china in Delaware, and if you are driving to the New Jersey shore, you ought to fill up your gas tank on the Jersey side of the bridge. At one time, there was a thriving resort town in the Jersey woods, mostly entertaining people who needed a spell of New Jersey residence to be eligible for New Jersey divorces.

These things respond to local circumstances fairly rapidly. I once met a man from the Delaware Chamber of Commerce who boasted that the Chamber could get a Delaware law changed over a weekend if it had some particular commercial advantage. Governor du Pont saw the bigger advantages of this flexibility, and got some laws enacted which drew most of the big credit card companies to Delaware, and at least a branch of all the big national banks. Delaware is starting to emulate Lichtenstein , and fairly successfully.

The effect on Philadelphia banking has been disastrous. Once the banking center of the whole continent, Philadelphia now does not have the headquarters of a single major bank. True, banking is becoming an obsolete industry whose products no one really wants, but the particularly severe effect in Philadelphia comes from the fact that if you were going to have a big bank in the metropolitan area, you would have it in Delaware.

The location of so many corporate headquarters in the little state attracts lots of outside lawyers, of course, and it puts a heavy burden on the Delaware Court of Chancery , the court for corporate disputes. The judges are appointed by the governor, and it doesn't take all that much outside money to lean on the governor, so the nation's giant corporations are at the mercy of a very small group of local politicians. The politicians, on the other hand, operate freely in an environment where comparatively few of their constituents have any interest in the goings-on of major corporations from far away.

It's an interesting thing that the legislatures of all three formerly Quaker states are torn with sectional disputes. In Pennsylvania and Delaware, it's the cities against the farmers. In New Jersey, it's the North versus the South. All states are having a hard time balancing their budgets in a recession, but somehow New Jersey has worse deficits than the others, and therefore more quarrels about taxes. The northern politicians dominate the legislature, and the south feels it is often the victim of state laws designed to help the North in its constant war with New York City. Ever since 9/11 , the financial district of New York has been sending its subsidiary employees to safer cheaper regions. That might have meant going to New Jersey, but the tax flounderings there have led to many of those relocations going on a few miles to upstate Pennsylvania. You don't ordinarily think of Scranton as a financial center, but take another look. Madison, no doubt, would smile at the tendency, but wrinkle his brow at all the unintended consequences. At least, everyone in the region speaks English more or less, otherwise the European Common Market could learn a lot from studying our local scene. About fifteen years ago, there was actually an unsuccessful provision on the ballot for South Jersey to secede.

Did Tax Cuts Invert the Yield Curve?

For those who just came in, let's explain an inverted yield curve. In plain English, it means that interest on short-term bonds (set by the Federal Reserve) is larger than interest on long-term bonds (set by the public in the bond market.) That's the opposite of the normal situation, and regarded as an ominous signal of impending economic troubles. But suppose it doesn't have much to do with economic forecasting at all. Suppose it just reflects tax cuts.

After all, when federal taxes are reduced, you eventually approach the point where bond interest is essentially tax-exempt. Everyone knows tax-exempt bonds pay less interest than taxable ones. For this purpose, it doesn't much matter whether income tax, capital gains tax, or dividend taxes are reduced. This creates a small problem for the argument, because several taxes have been cut by differing amounts and thus it isn't possible to calculate the precise level by which interest rates on government bonds should have been effectively reduced. It's clear, however, that cutting taxes will lower bond market interest rates in the general direction of tax-exempts. Since the yield curve is just a ratio of these rates, compared to the short-term rates set by the Federal Reserve, the yield curve is distorted and eventually "inverted".

If there is anything to this idea, the yield curve might have inverted without a tax cut. That's because a majority of U. S. Government bonds are lately being purchased by Asian governments. The Chinese government doesn't pay U.S. taxes, so to them all American bonds are tax-exempt. Federal bonds are a little safer than municipal government bonds, so they should command a little lower interest rate, and may eventually invert the yield curve still further.

By this line of reasoning, the inverted yield curve is not a portent of trouble, because it no longer primarily reflects American owners of the bonds dumping them. It does, however, have some important consequences. If interest rates are lower, retired people, insurance companies and pension annuities are going to be financially worse off. Borrowers, however, are going to be better off, and within limits the economy will be favorably stimulated. One can be uneasy about the overall effect on the real estate and insurance markets, and on the temptation to governments to borrow more than they can repay.

There are lots of mixed consequences to be expected from a general readjustment of the tax rate. But it shouldn't be a mystery that tax consequences affect yields and yield curves. It may not even be a conundrum.

Do-It-Yourself Globalization

Chinese Factory Workers

Computers, whether small or mighty, could be described as modified telephone switches. In any event, almost every computer is attached to the telephone system with wires. It once required an electrician to splice the ends of copper wires together in a way that would hold, but now the ends are held together by a little plastic clip that slips into the fitting, and then is held in place by a small plastic dongle. Unfortunately, these dongles break off easily and you get a wire that keeps falling out of its attachment. The plastic dongle surely costs less than a tenth of a cent, but a multi-gigabyte Internet system is useless without it. Solution: go buy a whole new telephone wire, with new clips at both ends.

The other evening that approach offended my sense of frugality , self-reliance and home repair ethos sufficiently that I went to an electronics store to buy a bag of clips and a special tool to apply them. After considerable discussion with several employees, all of them quite sympathetic to my repair- don't- replace motive, the equipment was located. I was half-way to the check-out counter when the arithmetic began to emerge. It would cost exactly three times as much to repair as to replace the whole wire with a new one having a clip already fastened to both ends. So, naturally I bought the new wire instead, and will not have the repair tool and bag of spare clips to clutter up my drawer. To get lost before I need them again, or else forget I have them and buy a second set. It all makes sense, it's modern and increases productivity, but the clerks and I had a moment of bonding. Our way of life has taken another step out the door. We are just a little further from the self-reliance of the frontier, and a little closer to dependence on those starving wretches in China who make dongles.

On the way home with my new wire, I saw something I hadn't noticed as I went out shopping. Two hardware stores going out of business. Everything must go, the signs said.

Marty Feldstein Forecasts the Future

Martin Feldstein

With increasing frequency, the op-ed pages of the Wall Street Journal are opened to important people, or important ideas. On April 28, 2006,Professor Martin Feldstein of Harvard wrote an article which purports to show how it is possible to have the American currency fixed for Americans, but float for foreigners. After reading it twice, I conclude he is saying something rather different, and softening some startling announcements with circumlocution. It is my view that he says the following:

Inflation is not a worry; targeting 2% inflation with adjustments in short-term interest rates will take care of it.

International trade deficits need not be a worry, either, if only the Treasury Department (Could he mean nice old John Snow?) would allow the dollar to float on the international market. Not pure floating, of course, because it is a dirty world out there. The necessary dirty floating might hurt at first, especially American global businesses, but the sooner the boil is lanced, the better we will be. American exports of capital goods, consumer goods, and industrial supplies will especially benefit. Those who worry that trade deficits will weaken the dollar have got it backward a weaker dollar will correct the trade deficit. Yes, some people will be hurt by this.

In particular, high-wage countries like Europe, Canada and Japan will be hurt, possibly severely hurt.

You will be able to tell that this plan has been set in motion when you see an international conference called among low-wage countries. The main purpose will be to reassure them that the U.S. Treasury won't punish them for strengthening their currency.

You will be able to tell this proposal has been rejected, probably for political reasons, if nothing soon happens to soften housing prices. And the word soon is emphasized. Because if they don't soften, they will break.

Alexander Hamilton, Celebrity

He had the kind of taudry private life and flashy public behavior that Philadelphia will only tolerate in aristocrats, sometimes.

It comes as a surprise that most of the serious, important things Alexander Hamilton did for his country were done in Philadelphia, while he lived at 79 South 3rd Street. That surprises because much of his more colorful behavior took place elsewhere. He was born on a fly-speck Caribbean island, the "bastard brat of a Scots peddler" in John Adams' exaggerated view, was orphaned and had to support himself after age 13. The orphan then fought his way to Kings College (now Columbia University) in New York in spite of hoping to go to Princeton, and has been celebrated ever since by Columbia University as a son of New York. He did found the Bank of New York, and he did marry the daughter of a New York patroon, and he was the head of the New York political delegation. As you can see in the statuary collection at the Constitution Center, he was a funny-looking little elf with a long pointed nose, frequently calling attention to himself with hyperkinetic behavior. Even as the legitimate father of eight children, Hamilton had some overly close associations with other men's wives, probably including his wife's sister. Nevertheless, he earned the affection of the stiff and solemn General Washington, probably through a gift of gab and skill getting things done, while outwardly acting as court jester in a difficult and dangerous guerilla war. There is a famous story of his shaking loose from the headquarters staff and fighting in the line at Yorktown, where he insolently stood on the parapet before the British enemy troops, performing the manual of arms. Instead of using him for target practice, the British troops applauded his audacity. Harboring no such illusions, Aaron Burr later killed him in a duel as everyone knows; it was not his first such challenge.

Columbia University President Nicholas Murray Butler told other stories of celeb behavior to reinforce Hamilton's New York flavor. But in the clutch, General Washington learned he could always trust Hamilton, who wrote many of his letters for him and acted as his reliable spymaster. When the first President faced signing or not signing the fateful bill to create the National Bank, a perplexed Washington had to choose between: the violent opposition of Thomas Jefferson and James Madison, or the bewildering complexity of Alexander Hamilton's reasoning in arcane economics. On the one hand, there was the simple p