Common Cents for March 30, 2018 (I hope it is Common Sense)

March 26, 2018, by John Norris

During the Q & A session of my public speaking engagements, I have been known to be the one asking the questions. There is one in particular I like: “what was the primary cause of the financial meltdown in 2008?” As you might imagine, I hear/get all kinds of responses, usually of the low-hanging fruit variety: predatory lending practices, Wall Street greed, Main Street stupidity, the ratings organizations not doing their jobs, Fannie Mae and Freddie Mac lowering credit standards, an overly accommodating Federal Reserve, asleep at the wheel regulatory authorities, the greater fool theory, herd mentalities, and even ‘evil.’ We have heard them all at some point, haven’t we?

However, more than a few folks in the crowd look at me dumbstruck when I say the primary cause of the financial panic was simply this: “borrowers didn’t repay their loans like they said they would.” That IS/WAS the proximate cause…BUT FOR THAT we wouldn’t have had a problem. Where the reasons listed above contributing factors? To be sure, there is little doubt of it. But how do or should we assign the appropriate weightings? Hmm.

Ever since President Trump announced his tariff proposals, there has been much ringing of hands and gnashing of teeth about the potential economic fallout. After all, free trade is good for overall economic activity, right? Besides, weren’t protectionism and the Smoot-Hawley Tariff contributing factors to the Great Depression and all of that? Haven’t we learned anything from that?

Perhaps.

To my understanding, the Great Depression was a severe, prolonged liquidity contraction brought about by a sharp decline in the money supply caused by the failure of a significant percent of the banking system. What started as a sharp recession turned into a rout when the British went of the gold standard in September 1931. Consider the following passage from a David C. Wheelock during his time as a visiting scholar at the St. Louis Federal Reserve (Monetary Policy in the Great Depression: What the Fed Did, and Why):

“The relative stability of bank reserves ended abruptly in September 1931. On September 21, Britain left the gold standard. Speculation that the United States would soon follow led to a large withdrawal of foreign deposits from American banks and a consequent gold outflow. In the six weeks ending October 28, 1931, the gold stock declined $727 million (15 percent). The Fed raised its discount and acceptance buying rates, hoping that an increase in domestic interest rates would halt the gold outflow by raising the relative yield of U.S. financial assets. This action was hailed as demonstrating the Fed’s resolve to maintain gold convertibility of the dollar, and the gold outflow ceased.

Banks continued to lose reserves, however, as depositors panicked and converted deposits into currency. Member banks were able to partially offset the reserve outflows by borrowing and by selling acceptances to the Reserve Banks, albeit at the recently increased discount and acceptance buying rates. But the Fed made only trivial purchases of government securities, and, in all, Federal Reserve member banks suffered a $540 million (22 percent) loss of reserves between September 16, 1931, and February 24, 1932.”

In another piece, Wheelock (now working at the Fed) added this on the subject:

“One explanation that has stood the test of time focuses on the collapse of the U.S. banking system and resulting contraction of the nation’s money stock. Economists Milton Friedman and Anna Schwartz make a strong case that a falling money stock caused the sharp decline in output and prices in the economy.

As the money stock fell, spending on goods and services declined, which in turn caused firms to cut prices and output and to lay off workers. The resulting decline in incomes made it harder for borrowers to repay loans. Defaults and bankruptcies soared, creating a vicious spiral in which more banks failed, the money stock contracted further, and output, prices and employment continued to decline.

In the 1930s, the United States was on the gold standard, meaning that the U.S. government would exchange dollars for gold at a fixed price. Commercial banks, as well as Federal Reserve banks, held a portion of their reserves in the form of gold coin and bullion, as required by law.

An increase in gold reserves, which might come from domestic mining or inflows of gold from abroad, would enable banks to increase their lending and, as a result, would tend to inflate the money stock. A decrease in reserves, on the other hand, would tend to contract the money stock. For example, large withdrawals of cash or gold from banks could reduce bank reserves to the point that banks would have to contract their outstanding loans, which would further reduce deposits and shrink the money stock.

Because banks hold only a fraction of the value of their customers’ deposits in the form of reserves, a sudden, unexpected attempt to convert deposits into cash can leave banks short of reserves. Ordinarily, banks can borrow extra reserves from other banks or from the Federal Reserve. However, borrowing from other banks becomes extremely expensive or even impossible when depositors make demands on all banks. During the Great Depression, many banks could not or would not borrow from the Federal Reserve because they either lacked acceptable collateral or did not belong to the Federal Reserve System.

Starting in 1930, a series of banking panics rocked the U.S. financial system. As depositors pulled funds out of banks, banks lost reserves and had to contract their loans and deposits, which reduced the nation’s money stock. The monetary contraction, as well as the financial chaos associated with the failure of large numbers of banks, caused the economy to collapse.”

 

This makes a lot of sense to me. If deposits and reserves are falling, so are loans and, by definition, the money supply. If the money supply is contracting, each currency unit becomes more valuable, meaning people are less apt to spend and more likely to hoard the stuff. This was a near perfect storm. BUT FOR banks closing, the Great Depression probably wouldn’t have been a worse than average recession.

The Smoot-Hawley Tariff? While it undoubtedly didn’t help matters much, it just so happened to come about at roughly the same time the US banking system had begun to unravel. You have to understand, there wasn’t any deposit insurance back then, and a ‘run on deposits’ could ruin a bank in an afternoon. It is Accounting 101.

Have you ever seen “It’s a Wonderful Life”?

I will cut to the quick: trade is a good thing, and anything which inhibits the free flow of resources across the global economy is anathema to economic growth. President Trump’s proposed tariffs would, could, or should slow the movement of goods and services to some small degree. This is basic freshman year economics….an artificially set price on the X axis higher than the market equilibrium (which a tariff would be for all intents and purposes) will result in a decrease in demand, all other things being equal.

Of course, a high enough tariff CAN led to increased domestic production and, obviously, government revenue. You might call this a producer and/or government surplus. On the flipside, the consumer surplus, if you will, will decrease due to the tariff…since it causes the good or service to be greater than the market equilibrium. Essentially, IF the powers that be can find a tariff which increases the producer surplus at a higher level than the decrease in the consumer’s (so-called) surplus, it could be economically beneficial short-term for the importing country.

Intuitively, if you think about such things, this might be effective if and when the exporting country (of a product subject to a tariff) doesn’t have a meaningful comparative advantage over the importing one. However, it wouldn’t be effective otherwise. In fact, the tariffs will actually hurt overall well-being in the name of protecting local industry.

It is kind of like taxation in that regard. IF low income and property taxes alone were the key to economic growth, Alabama would be as rich as Connecticut. IF higher tariffs were truly good for the local economy, places like Pakistan, Nepal, Gabon, The Gambia, Bhutan, and Iran would be among the wealthiest countries in the world…which they aren’t.

So, why is the Administration doing this? Frankly, because it resonates with a lot of people. After all, it has been within recent memory the United States dominated the world in terms of economic output, and I mean dominated. From what I can tell, the USA accounted for roughly 40% of global GDP in 1960, or thereabouts. ‘We’ stamped our name on just about everything back then, didn’t we?

Now fast forward to 2017. Last year, the US represented about 24.5% of total global economic output. Clearly, that is a pretty sharp decline in relative output. What is that? Close to a 39% decline? And you know what? Just about everything is made elsewhere these days. I mean everything says made in China or Mexico or some other place. Right? If what I have seen is accurate, we ain’t much better than the Chinese these days, if at all.

Perhaps.

The second half of the 20th Century was extremely good for the USA. We exited Word War II relatively unscathed when compared to the rest of the ‘developed’ world. Europe, Russia, China, and Japan lay in ruins, with a huge percent of its working aged men either dead or maimed….much, much higher than our totals. Further, for centuries, if not millennia, up until the middle of the 19th Century, China and India had the world’s largest economies…by far.

As such, we wax nostalgic for an extremely unusual time when our country was extraordinarily blessed. While we are still truly exceptional as a people and nation, it is highly unrealistic to assume ‘we’ would be able to extend our global economic hegemony unchecked forever. At some point, large numbers would catch up with us, wouldn’t they? China wouldn’t continue to languish forever, would it? That would be extremely un-Chinese of the Chinese.

After all, while we have slipped to only 24.5% of global GDP, we account for about 4% of the world’s population. In a word, that is awesome. Trust me, no one is feeling sorry for us. No one thinks we aren’t great economically. There isn’t a major country in the world who wouldn’t want our economic problems.

None of this is to say we shouldn’t expect our partners to trade fairly with us. Of course we should, and I don’t think anyone would argue otherwise. To that end, I/we haven’t agonized over the potential for a trading war with the rest of the world because I don’t believe that is what the Administration wants….let alone the rest of the world.

While crude and blunt, these announced tariffs are the start of negotiations. You can consider them the ante, if you will. They certainly seemed targeted at the Chinese. What also seems directed at the Chinese are some very pointed comments from the Office of the United States Trade Representative. Please click on the below web address to read the whole report. As you will be able to discern, the Chinese get 20 pages of findings…most of them pretty scathing when it comes to intellectual property rights, copyright and patent protection, etc.

https://ustr.gov/sites/default/files/files/reports/2017/NTE/2017%20NTE.pdf

Intellectual property rights matter to the US and manufacturing matters to the Chinese. If China isn’t going to enforce the accepted rules, I suppose President Trump is willing to roll the dice with Beijing when it comes to manufactures. That seems to be the heart of the matter, protecting US technology (etc.), and Trump is selling it to his core by talking up the steel industry.

When the smoke clears and the dust settles, American and Chinese officials will hash out some sort of compromise which allows both sides to ‘save face’ and maintain their ‘comparative advantages’ with one another. The end result will be a reduction in the counterfeiting of US brands, products, and technologies, and no major change in what we import from China.

So, in the end, are the Trump tariffs as bad as the Smoot-Hawley Tariff? Naw, they are an aggressive, unpolished negotiating tactic which will work better than Trump’s detractors but probably not as well as the President would like himself.

 

Have a great weekend.