Avoiding the Booby-traps

William Krehm
January 27, 1999
Toronto, Ontario

Meltdown is more than a book. It is a recorda record that could not have been compiled without a clear sense of where we were headed. The first issue of ER appeared in the spring of 1988. It was COMER's response to the proclamation of Zero Inflation as the sole goal of the Bank of Canada.

Twenty years earlier I had begun to be concerned by the widening gulf between conventional economic theory and the realities of the world. In the sixties the new society promised during WWII was actually being put in place. The financing of the war and the years of peace had proved it possible to run the economy without periods of devastating depressions. The theory for that had been worked out by Keynes and others in the thirties, but it needed a world war for that theory to be put to a bold practical test. The postwar depression that just about everybody expected, had been avoided.

Canada welcomed a huge penniless immigration. Newcomers and natives alike were housed to standards unknown before. By the sixties as the baby boom generation approached college age, post-secondary campuses sprouted like mushrooms across the land. Our health and social security systems were set up.

But the sixties were also a period when prices started inching upward. That was no accident, given the amount of public investment underway. But instead of analysis, the traditional wisdom of the thirties took over. Panic about inflation was whipped up, by those who had an interest in doing just that.

There was an altogether different explanation for that mild price rise. The new educational and social services, were not marketed. Instead they were paid for out of taxation. That could only swell the layer of taxation in price. The costs of the new social services entered the price index through that taxation. Their benefits, however, were not picked up by the price indexfor the same reason that you can't read the temperature on a barometer, or the air pressure on a clock. By definition, any unadjusted price index is blind to the benefits of unpriced services.

Let me make a key point here. If so unquestionable a relationship is ignored by policymakers for a decade or two or three, it does not lose importance. On the contrary, its importance goes on increasing until it attains crisis proportions.

The policy of pushing up interest rates to force prices to lie flat had to be self-defeating. For interest is a key cost in an economy that has been becoming more capital-intensive by the day. Prices can be brought down by high interest only by bringing down the economy itself.

What had been learned at a shattering cost during the Great Depression and the Second World War could not be completely buried overnight. So when I started writing on the subject it was still possible to get unorthodox ideas published. I made thirty copies of my paper and sent it cold to thirty economic journals throughout the world. It was published in May 1970 in the leading French journal in the field, La Revue Economique. No accident that it was published in France. France had a strong tradition not only of public enterprise, but there was a brilliant school of economists there who tried understanding the economy in social terms. After I had spent a couple of years proving that general equilibrium theory as taught in our universities had no relevance to the real world, I found the job had already been done in France as well or better than I had.

At the time there was a considerable national diversity in economic theory. Apart from the powerful French school, Scandinavian economists in some respects anticipated Keynes' ideas. The German historical school delved into history for its economic generalisations instead of deriving them from a bit of irrelevant mathematics. The self-balancing free market school that first neutered and then buried Keynes, was a distinctly American invention. American economicsthe so-called Washington Consensusthrough its control of the international organisations has gobbled up not only these diverse national schools but the very memory of them.

• • •

After my paper appeared in France I even received a proposal from a leading French publisher, Calmann-Levy, would I do a book on the subject? I spent a year enlarging my published paper into a book and sent them the manuscript. To this date I have not received an acknowledgement. During that year economic thinking had changed even in France. A militant free market orthodoxy was being imposed throughout the world. It singled out inflation as the one menace and high interest rates as the one cure.

The more experience disproved that dogma, the more sweeping the campaign grew to impose it. The phenomenon was explained by François Perroux, the leading figure of the French school of economics. He held that in every historic period the revenue of a particular group is taken to be the "dominant revenue." By its rate and volume, this is seen as the measure of society's health. Before the industrial revolution, the dominant revenue was the rent of the land-owners. Then it became the profit of industrialists. After the depression of the thirties the crucial investment was seen arising from the cooperation of the state and private industrial capital. Even the trade unions were regarded as junior partners in that alliance.

At the time Wall St. and the banks were in the doghouse because of their major responsibility in bringing on the Great Depression. As the price for their bailout, Roosevelt had put ceilings on the interest banks could charge or pay, and on what they could do with other people's money. On this spartan regime they recovered, and came to lust after the old flesh-pots. By 1951 the Fed-Treasury Accord in the US weakened the ceilings on interest rates, and launched the banks of the world on the comeback trail.

In Canada, by the sixties our banks had been allowed to enter non-banking fields and mortgages. The removal of ceilings on interest rates had opened the door to their taking equity positions and accepting risky junk bonds as security. Until 1955 the banks had been required to hold reservesprimary and secondary equivalent up to 15% of their deposits. The primary reserves were in cash and earned them no interest, the secondary reserves were in interest bearing securities. In 1980 the secondary reserves were wholly abolished and the primary reserves brought down to 4%, then to 3% and in Canada phased out altogether by 1994.

That deregulation was getting the banks into ever deeper trouble. Time after time they had to be bailed outalmost invariably this happened with still more deregulation. It was like allowing the patients in an anti-addiction clinic to prescribe the therapy. Every alternative to high interest rate for dealing with real inflation was suppressed. Previously it had been possible to deal with an overheated by raising the reserve requirement. That forced the banks to lend less but at rates no higher than 6%. To defend the currency, exchange controls had been resorted to from time to time. Today for that purpose we push up our interest rates to attract hot foreign money.

If you consider economic theory as a quest after truth, there is no way of understanding what happened to the body of economic knowledge from the latter sixties on. But Perroux's theory of the "dominant" revenue provides the key. Interest rates are the revenue of an economic group not devoid of appetites. That raises an obvious conflict of interest that was never addressed. If you rule out all other ways of handling monetary problems and proclaim interest rates the one blunt tool in your kit, what you are setting up is not a free market, but the monopoly of a single revenue.

The people who ran this show were not out to win academic brownie points. The more disastrous the policies, the more they tightened their grip on what was taught or published. If you plot side by side the major disasters of the "zero inflation" policy and the stepping up of the dosages of that policy a clear correlation emerges.

By the late seventies interest rates, feeding into costs and prices, rose ever more quickly. So the remedy chosen was to push up rates still higher. But to hide what it was up to, the US Fed announced that it was no longer concerned with interest rates. It would rein in the money supply and let the interest chips fall where they may.

But here comes the joker in the pack. Because of the deregulation already pushed through, no one could say what the money supply might be. The money supply was defined as money held for transactions. This consisted of cash and non-interest bearing chequing account deposits. But the Fed had recently introduced chequing accounts that did earn interest. Naturally, with high interest rates spreading uncertainty, a lot of money was parked in these new hybrid accounts. The Fed chairman, Paul Volcker, suddenly noticed that the deposits in them had jumped sensationally. At a loss what to do about it, he panicked. And when a banker panics his knee-jerk reaction is a to raise interest rates. So interest rates were pushed up to well over 20%. Those rates ransacked government treasuries throughout the world, and bankrupted businesses. This brought on the S&L crisis in the US that eventually cost the taxpayers a half trillion dollars. In Canada we had bankruptcy of several trust companies and a couple of Western banks. And once again the cure was more deregulation and hidden subsidies to the banks.

• • •

The new Governor of the Bank of Canada, John Crow, chose this very time to announce zero inflation as the one purpose of the central bank. He claimed that anything less, whether the economy was booming or in the gutter, would lead to a replay of the German superinflation of 1923. At that time it took a wheelbarrow of marks to buy a mug of beer. Of course, Crow was aware that was nonsense. The German hyperinflation had very specific causes. Germany had lost a war; the Allies had tried extracting unrealistic reparations in foreign currency. When Germany fell into arrears, the French occupied the key Ruhr industrial basin. The Germans, left and right, responded with a general strike. Virtual civil war broke out. Raising the German hyperinflation of 1923 as an argument in the Canadian debate, implied that if interest rates had been pushed up high enough, there would have been no lost war, no reparations, no occupation, no civil war.

Before coming to the Bank of Canada, Governor Crow had spent his entire career with the International Monetary Fund, mostly in Latin America. He brought to the BoC an imperial manner up to then reserved for wretched Third World countries. The fact is that when statutory reserves were done away with in Canada, only the UK and Switzerland among major countries had also done so. That is if we except the offshore shelter havens like the Cayman Islands which more than countries are financial brothels where anything goes. Since then of course any Third World country thrown on the mercies of the IMF has had such independence of its central bank from the government and the end of bank reserves imposed on it. But there was not the remotest reason for Canada to have ended reserves except John Crow's ambitions as superachiever. And of course it had become urgent once again to bail out our banks.

That rescue came from two different directions. In the late 1980s the Bank for International Settlements (a sort of central bankers' club) published its guidelines for Risk-Based Capital Requirements. These declared the debt of developed countries risk-free. It could therefore be accumulated by banks without tying up any of their capital. Business loans on the other hand required 8% of their own capital. That enthroned money-lending as the dominant revenue. In Canada that was accompanied by the phasing out of the non-interest-earning reserves that banks had to put up with the central bank as a proportion of the deposits they held. Between the two measures banks were able load up with another $60 billion of government debt without coming up with a penny of cash of their own. To make room for that, the Bank of Canada obligingly reduced its own holdings of government bonds even in absolute terms.

This amounted to an annual entitlement for the banks of at least $5 billion. That was how the banks were bailed out from their huge losses in financing Robert Campeau's shopping spree for department store chains in the US, and the Reichmanns' folding real estate empire in New York, London, Mexico, and dozens of other hare-brained speculative schemes.

The gimmick behind the bailout was a simple one. When the central bank holds government the interest paid on it finds its way back to the government as the sole shareholder of the bank in the form of dividends. When the chartered banks hold the same debt that interest stays with them. Neat trick, so neat you've got to keep it secret from the public.

By 1992 the zero inflation policy had clearly become one huge disaster. But did the government and the Bank of Canada soften its position? On the contrary. In defence of the "dominant revenue," they behaved exactly like the garrison of a besieged fortress. They manned the battlements and prepared the molten lead to pour on the besiegers. They moved to put zero inflation into the constitution and the Bank of Canada Act, as well as the independence of the central bank from the government, to make that practically irreversible. All three caucuses of the Banking subcommittee of the Commons turned down the proposal, but that was not even reported by the media.

Deregulation and the two measures I have just described, have changed even the food chain of our banks. They were allowed to take over brokerage houses, underwriting firms, derivatives boutiques. From being interest-driven, our banks have become stock-market dependent. Imperceptibly, the dominant revenue has shifted from interest to speculative profits. If you don't make use of the dominant revenue concept, it would be hard indeed, to pick up that crucial shift. For several years COMER sang a lonely solo on the theme.

There is a vast difference between the interest rates and speculative profits as dominant revenues. High interest rates are poison to stock markets. And with deregulation on all fronts the American stock market has been behaving like an air ship without landing gear. The private institutions that have taken over money creation are not just in control of the gambling joints but are their own biggest customers. They have acquired command of the public treasury very much in the way in which they financed the Leveraged Buyouts of private corporations. First they loaded it with high interest debt, and then downsized government services. When the deficit has been pushed high enough it took over from inflation as the driving bugbear.

That set the stage for the privatisation of government assets at fire sale prices. Indeed the bizarre accountancy of our government makes it impossible to say what a public asset is worth. When a physical capital asset is acquired by Ottawa it is written off in a single year and entered on the balance sheet at a token $1. Because of that the government could sell the St. Lawrence Seaway or the Parliament Buildings for one thousand dollars, and book a profit of $999. Then in front of the TV cameras that could patriotically be applied to reducing the debt. And then the buyers can lease the asset back to the government at a fair market rate and list it on the stock exchange to make a further killing.

• • •

You will find in our book a statistic that we compile from data in the Bank of Canada Reviewthe proportion of the chartered banks' assets to the cash held by them. That basically continues the credit-creation multiplier from the period when reserves still existed. With a difference. Until two or three decades ago there were strict limitations on what the banks could do with the credit they created. Today they can invest it in just about anything they set their heart ongamble on the stock market, in derivatives, in foreign junk bonds, buy up chunks of foreign banks and other concerns. That ratio has increased from 11 in 1946 to 363 today. But even that doesn't tell the whole story. The assets for the most part are evaluated at their historic costi.e. what they paid for them, not their present market value. The denominator of the proportion on the other hand is not a reserve against their deposits, but strictly what they need to operate their business, to meet their daily net cheque clearance with other banks, and meet their customers' cash needs. Take that away and the banks would be out of business.

If the assetsthat may include Indonesian bonds, chunks of Thai, Mexican and Venezuelan bankswere to shrink across the board by 5%, our banks would have lost all their capital. That is exactly the position of several of the largest Japanese banks that our banks have been so determined to emulate.

And then they will be back for the next bailout. What form can that bailout take now that the reserves have been done away with?

Trial balloons have already been launched that may provide the answer to this question. In Mexico legislation has actually been passed providing for the restoration of reserves up to a certain amount, but on these reserves the central bank will pay the banks the going rate of interest. Something of the sort has been broached by certain of the central banks of the constituent countries of the Euro union.

If that is allowed to happen the following cycle will have been completed. The non-interest bearing reserves put up by the banks with their central bank were whittled down and eventually even abolished. And with little room for reinflating the banks' capital by moving further along this line, the path will be retraced, but with the central bank now paying interest to the banks for reserves put up with them. Negative seigniorage will flow to the banks from the government for having assigned to them its powers of money creation.

Of course, this would increase government deficits and usher in a new period of slashing public services and imposing user taxes.

When the banks come to the government for the next bailout, we propose a quite contrary course. Non-interest-bearing reserve requirements must be restored. High interest rates must be abandoned as a means of controlling inflation even where it really exists. Instead the restored reserve requirement can be raised to cool the economy and or lowered to make more credit available in the event of a recession. Currency crises can be defused with temporary exchange controls. Barriers must be set up to brake the flow of hot money across frontiers.

The funds for bailing out what banks merit being bailed out must take the form of loans by the central bank, repayable with interest. All this must be perfectly visible to the public. Banks who get themselves into trouble after the next bailout should be required to put up a higher than the current reserve requirement for a number of years. This would enforce more responsible use of the credit-creating powers assigned to them.

But enough of this heavy technical stuff. Let's sample some of the lighter fare in the book. A good bet would be to look up Gordon Thiessen in the index.

First entry, September, 1989. "The Globe & Mail carries the following pearl. Mr. Gordon Thiessen, the Bank of Canada's second-in-command points to car sales which slumped earlier in the year, but rebounded in April. He said cheap financing offered by auto dealers had exacerbated inflation. Now anybody who has bought a car will realize that the financing charges are part of its cost. At least one manufacturer is giving its buyers the choice between loss-leader financing and a price rebate. Such below-cost financing would thus rank as an anti-inflationary measure, especially since auto plants are being shut down because of excess inventories. But anyone who dares reduce any interest rate is desecrating the most hallowed of the BoC's altars.'"

This gaffe of Mr. Thiessen's earned rather than deprived him of merit points. For in May 1995 we were reporting on Mr. Thiessen's Toronto debut in his new role as John Crow's successor as governor.

"The advent of a new BoC governor is always the occasion for edgy speculationparticularly because the pronouncements of the new dignitary urbi et orbi are couched in the Bank's own church Latin without translations into the vernacular. We thus depend in part on intuitive appraisal. As with vintage wines, we roll the performance on our tongues. Then, rather than swallow, we spit out, and consult our mouths for the after-taste."
"Canadian scholars might ponder why one third of the BoC's governors to date have come from Saskatchewanof all our provinces one of the most remote from high finance. But then Mr. Thiessen's predecessor was a Brit who for pomp and circumstance might have been presiding from elephant-back over the durbar of a long-vanished empire. To restore the balance it was almost mandatory that his successor be from Saskatchewan."

• • •

But by June 1996, Mr. Thiessen, however, seems to have clean forgotten his native Saskatchewan, a province that had more than its fill of deflation during the thirties. Not only had the price of wheat gone through the floor but much of its parched topsoil had blown away. Gordon Thiessen earned himself a front-page spread in the G&M. He announced his worry about deflation developing within the next two years.'

But within the week Mr. Thiessen ate crow before the Finance Committee. "I will probably regret forever that I mentioned it." "It" referred to the D-Word deflation that had been unmentionable for two decades.

Why should the head of the BoC regret forever' mentioning his worry about deflation when it is on the minds of most Canadians? The BoC was founded in 1935 to lift the country out of a deep deflationary ditch. Since then despite the hyperinflation of the stock market, the deflation of the real economy has proceeded to the point where it has pushed out Monica Lewinsky in media coverage. Where does that leave Mr. Thiessen? Nobody in government asks that question. And where a disagreement exists, article 14 of the Bank of Canada Act gives the Governor of the BoC thirty days to comply with the Finance Minister's written instructions.

Since this article has been left to gather moss, the miracles under Governor Thiessen continue rolling in. In December 1996, the ratio of the banks to their cash was nudging 300 to one as a result of the ending of the statutory reserves. That was the moment that Governor Thiessen chose to declare that that ratio no longer existed. And yet that ratio had for decades been described as "the multiplier" in the textbooks including one published by the Canadian Bankers Association itself.

For some decades now the economies of the world have been run by isolated statistics picked out of their context like the cherries off a birthday cakethe consumer price index, and the government deficit. The price index was misleading for a variety of reasons but the main ones were ignoredthe layer of taxation in prices paid for essential unpriced public services whose benefits the index ignored. It also ignored the damage inflicted on society and the environment during the production of marketed goodsthe so-called externalities, for example, degradation of the environment, the lack of adequate care to children whose mothers go out to work. Our government, moreover, treat their investments in human and physical infrastructures as a current expense and write them off in a single year. This strange accountancy exaggerated the amount of real inflation. And the use of high interest rates as the sole means of dealing with it played havoc with the government's finances.

So in time the panic button of runaway inflation was taken over by the panic button of the runaway deficit. The remedy, however, remained the samehigh interest rates. This made it possible to push through the agenda of slashing all social programs and bringing the world back towards the twenties.

And yet there was a whole menu of alternative courses to deal with both rising prices and government deficits. But to recognise these you would have bring the other sectors of our economy into your policy-design : the public sector, the household economy, the ecology.

But for that, economists must learn what high school students are taught in their first year physics coursesthe difference between scalar and vector quantities.

A scalar is an absolute quantity with no sense of direction. A vector is a quantity with a sense of direction, from the Latin for carrier or traveller.

The mass of a potato is a scalar, but when you drop a potato it falls to the ground because of the vector gravity.

Economists have been trained to think only in scalar terms. They must be taught to ask what the effects of policies will be when they cross the boundaries of the market and move on to the ecology, the household economy, and other non-market subsystems of our mixed economy. When that happens, you are in for some surprises. What can be a saving for the private firm when it pollutes the environment, suddenly appears as a threat to human survival when viewed from the ecology. Debt may be a dangerous thing in personal finances, but if you extend that maxim to government, paying off the debt does not make sense if there are still idle workers and resources around. Pay off the government debt? You must ask what are you going to use for money if you indeed paid off the public debt. Sea shells? Our base money today is government debt. There is no other.

Let me give you an example, of the unsuspected policy options that would open up if we retrained economists to think in vector terms. For a quarter of a century, inflation and budgetary deficits have been the very pivot of policy-making. Perceived inflation, however was fuelled by a growing tax-burden that denatured our price signals. And high interest rates, imposed to suppress inflation, were responsible for much of the government's deficits and debt. If you really are concerned about inflation and deficits, balancing one of these against the other in a downward direction should be the point of departure of policy design. A quarter of a century ago in this sense I proposed the idea of special tax-bonds with an interest rate well below market. To compensate for the lower interest rate, any earnings invested in such bonds and the interest paid on such bonds would be tax-free.

• • •

There would be a powerful hedging feature in the arrangement. Even by the initial trade of government revenue for a lesser interest burden the structural price climb would be lessened. Structural price rise is price increase due not to excessive market demand but to the fact that the market makes up a shrinking part of our mixed economy. By trading lower taxes for lower interest rates such structural price rise would be lessened. To the extent that tax bonds disappointed expectations in this respect, the state would profit by a greater capital gain when the principal fell due. The real value of that principal would have been eroded. On the other hand, to the degree to which such structural price climb was decreased, the state's capital gain would be less but the price climb would have been reined in without wrecking the economy.

Moreover, insurance features could be incorporated. The tax-free feature would apply only to the original bondholder, so that if the bonds were sold before maturity it would be at a discount because of the lower-than-market interest rate. However, in the event of the death of a breadwinner, extended illness in the family, or lengthy involuntary unemployment they could be made redeemable at pari.e. at an effective bonus, equal to the discount the state would forgo. It would thus incorporate an insurance feature that would be very timely today.

In the ER of September 1995, I wrote: "Recently somebody sent me a copy of a paper originating in or close to our government, with the title Options for Eliminating Deficits and Reducing Debt.' In it was the statement: "The government could reduce the interest rate it pays on outstanding debt by making such interest tax-free. But what it gains in lower interest rates it would lose in lower revenues." In other words the government would give up a scalar and receive a scalar in return, and the result would be a wash. What is missing is a vector sense that would look into possible advantages of the lower interest rate and lower taxation when the effects crossed the boundaries separating the public sector from other areas of the economy.

Still more amazing it ignores what turning down those two key parameters would do for the market economy itself. Clearly lower taxes and lower interest rates combined would be an immense stimulus to the private sector. And with both of the parameters turned downward there would be plenty of room that without fuelling price increases. There is a reason for something so obvious having been overlooked: Lowering interest rates does not pass the dominant revenue testif interest is your dominant revenue.

You could turn out no end useful schemes once economists were taught to think in vector terms.

There is an important first step towards making economic policy-making people-friendly once more. The central bank must be brought back to its original purpose which is still to be found intact in the Bank of Canada Act. A revision of the Bank Act, on the other hand, is necessary to restore the reserve requirement. Internationally, our central bank must press for the repeal of the Risk-Free Capital Requirements introduced by the Bank for International Settlements which requires no additional capital for private banks to hold debt of our government. Until our banks are gotten off the dole and led back to banking in this way, we shall continue to suffer from the Mother Hubbard syndrome: the cupboard will always be stripped bare for speculative high jinx. And there will always be too many children to know what to do. Under the name of "the non-accelerating inflation rate of unemployment," or NAIRU, the Mother Hubbard fairy tale, passes as pure science amongst economists today.

To pull society off this disaster course, economic theory must be rethought from the bottom up. For its most basic level the job has been begun by John McMurtry of COMER with his "Life-Value Metric" which appraises policy by the criterion of whether it enhances or diminishes the range of human potential. That must be reflected by bringing back the concept of value as distinct from pricesomething that existed in economics until the development of marginal value theory a century and more ago. That recognises no other value than the market price that clears the market. Obviously that leaves all non-market areasthe ecology, the household, out in the cold. That model is the genetic code that produced the free market thought-monopoly that is undermining society today.

There is a simple way of adjusting the price index to pick up the benefits instead of just the costs of such non-marketed items. I will be happy to describe it in popular terms if any one wishes me to during the question and answer period.

Society has been run over globally by the most meticulously planned ideological campaign of modern times. Over a half-century, a well-oiled machine has systematically captured just about every lever of power. It was a catastrophic illusion to believe that this could be countered with a few time-proven policy gimmicks and the sort of catchy slogans readily accessible to the broad public. That might serve to win an election. But electoral successes with such skimpy preparation invariably turn out Pyrrhic victories.

Well-intentioned governments find the treasury syphoned to emptiness, and key statistics and the very language twisted like the girders of a bombed building. We must begin by understanding what hit us, and study the vulnerabilities of our formidable foe. That calls for a rethinking of economic theory to make sure that what are presented as the constraints of reality are not in fact booby-traps planted by our opponents. Once that is done, then the popularisation and street-smart politicking will be in place. But the two are not to be confused.

We do not have a chance unless we match our opponents in the thoroughness of our response. That is what COMER and the book Meltdown are about.

Copyright © 1999 COMER Publications