Wednesday, May 1, 2013

A Year of Constitutional Political Economic Centennials: The Income Tax and the Fed

It can be argued that 1913 was both the last year of the extended 19th century as well as being the most important for determining the nature of the 20th century, even if "Man of the Century" Albert Einstein had already had his "Annus Mirabilus" in 1905.  Most historians see the 19th century Pax Brittanica with its more or less functioning gold standard lasting from the Congress of Vienna in 1815 to the outbreak of World War I in 1914, when the Guns of August destroyed that Proud Tower, to quote Barbara Tuchman.  As it was, aside from the two major political economic changes in the US, Stravinsky revolutionized classical music with the premiere of his Sacre du Printemps in Paris on May 29, 1913, and the Armory exhibition in New York brought the developing modern art of Europe (particularly from Paris) to the US as well.

The first of these changes, which solid libertarians view as the awful end of the pure laissez-faire US economy, was in fact one to the Constitution itself, the 16th Amendment, which allowed Congress to raise a federal income tax.  Lincoln had done so initially in the Civil War, but the income tax was declared unconstitutional by the Supreme Court in the 1895, after Cleveland introduced another (Lincoln's had been allowed to expire in 1873).  While many associate it with Woodrow Wilson, whose presidency began in 1913, in fact it had been long in the making, and its ratification was completed on Feb. 5 of that year, just shy of a month prior to Wilson's presidential inauguration.

As it was, Wilson played a larger role in the passage of the Federal Reserve Act in December, 1913, which also had been long in the making, drawn largely from the Aldrich Plan of 1910 (revised in 1912), which in turn had been instigated by leading bankers after the "Rich Mans' Panic" of 1907.  In order to obtain support from populist-minded Democrats in Congress, Wilson added the Federal Reserve Board, which he promptly stacked with hack politicians knowing little of banking or economics, something that continued for some period afterwards, in order to offset the power of bankers over the somewhat autonomous regional Federal Reserve banks that were clearly under the control of bankers and could then set their own disbount rates, and which were the centerpiece of the Aldrich Plan.

Yesterday there was a mini-conference in Washington on the centennial of the Federal Reserve Act with four speakers: Liaquat Ahamed, author of _Lords of Finance_; former Fed Vice Chair and current long list candidate to succeed Bernanke as Chair next January, Donald Kohn; former Vice Chair, Alice Rivlin, and former Acting IMF Director, John Lipsky.  Ahamed spoke on the Fed's actions in the Great Depression, noting that the crucial mistake of raising interest rates in Fall 1931 was overwhelmingly driven by the then strong adherence to the gold standard.  He also noted the conflicts between the board and the regional banks as well as even between regional banks, such as how in early 1933 the Chicago Fed refused to lend money to the New York Fed when the latter was experiencing substantial gold outflows as hampering Fed policy in that crisis.  Persky noted that the Fed is no longer as powerful within the US in terms of regulating the financial sector as is the Bank of England in the UK or the ECB in the eurozone or the Bank of Japan in that country, and that dollars now only constitute 60% of global foreign currency reserves.

In my view the most interesting remarks were made by the former Vice Chairs, both in terms of what happened in the 2008 crisis and what one can do about such things, if anything.  As longtime right-hand man of Greenspan and Vice Chair during the crisis, Kohn defended the Fed's actions throughout, although with the caveat of "based on the information that we had at the time."  Thus, on the crucial matter of the housing bubble, he recounted three hearings they had on the issue: one declaring that housing was overpriced in 2005, another by someone from the NY Fed saying that the housing market was not a bubble and not overpriced, and another that said it was overpriced by 20%, but that a decline from the bubble peak would lead to no significant harm to the economy.  He did admit that by Fall 2006, then NY Fed President Timothy Geithner was "banging the gong" about systemic problems due to global interconnectedness and lack of transparency in financial markets particularly related to derivatives based on housing mortgages, then beginning to go sour after the bubble's peak passed in mid-2006.  But Kohn declared that, "By then it was too late to do anything about the structural problems," and argued that the Fed behaved "aggressively" to support the financial system starting with the clearer outbreak of problems in August, 2007.

Rivlin more specifically addressed the problem of bubbles.  As Vice Chair in the late 1990s she declared that, "Of course we knew there was a speculative bubble in the stock market," but then went on to say that the policymakers at the Fed did not know what to do about it.  She accurately noted that a policy of raising interest rates in order to squash such a bubble would "bring down the whole economy," along with the bubble.  Indeed, although she did not say so, such an effort in 1929 was a major contributor to the stock market crash turning into the Great Depression, even though Ahamed argued that the Fed was fairly responsive in the immediate aftermath of the crash.  More generally, Rivlin argued that indeed the Fed should try to do something about bubbles, or somebody should, but admitted that even now she is not sure what that should be, important as it is.

Indeed, the issue has reappeared.  Kohn admitted that some blame the Fed's relatively easy monetary policy stance in 2003-04 for stimulating the housing bubble, although according to the Case-Shiller index, the rise of the price/rent ratio in housing above historical norms dated back to 1998 when nobobdy noticed it because all eyes were on the ongoing bubble.  But now housing prices in at least some parts of the US are rising again, most dramatically in Phoenix, San Francisco, and Las Vegas.  It is unclear if these are moving up more rapidly than rents, which are reportedly also rising, which would be the clearer sign of a renewed bubble, but reports are out that "flippers" have appeared in some of these markets, who can, of course, make money simply on rising prices, irrespective of if those prices are being matched by rent increases or not.  In any case, it is quite likely that some of the caution being reported out of the current Fed about any extensions of the QE program and even of slowing it down somewhat soon probably partly reflects internal worries about this possibility of a housing bubble reemerging.  We do indeed need tools other than a contractionary monetary policy to deal with such phenomena, even if what we are currently seeing is not a renewed housing bubble. 

(For discussion of the need for alternative ways of dealing with bubbles, see Rosser, Rosser, and Gallegati, "A Minsky-Kindleberger Perspective on the Financial Crisis," Journal of Economic Issues, June 2012, 45(2). pp. 449-458, available near bottom at .)

Barkley Rosser

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