The Bear’s Lair: Constraints are the foundations of civilized life

President Obama’s budget, global post-2008 monetary policy and Greece’s election of the leftist Syriza government all reflect the same impulse: the desire to remove constraints that had previously been thought mandatory. Just as in our social existence we are seeing the merits of some of the constraints the baby boomers so enthusiastically discarded in the 1960s and 1970s, so too in economic policy we will eventually see a reaction in favor of constraints. In economic policy as in social interaction, constraints are the fundament of a civilized life. As conditions change, we may well wish to adjust them, but they should never be abandoned, nor should their enforcement be relaxed.

In the eighteenth and nineteenth century, it was though necessary for governments to balance their budgets, except when war intervened. That’s why the United States was able to pay off its debt entirely in 1835 and to run large surpluses in the late 1880s. It’s also why Britain had a debt 20% lower going into the Great War than it had endured in 1815, even though the economy was many times larger.

Robert, Lord Liverpool, in struggling with Britain’s huge debt after 1815, was very clear that deficit financing and fiat currency were not an option. For Liverpool, Britain’s financial health depended on two things: balancing the budget (which Liverpool and his Chancellor of the Exchequer Nicholas Vansittart did remarkably quickly, achieving a surplus in the financial year 1818-19) and returning to the Gold Standard, which Liverpool steered into law in 1819, achieving full return to gold in May 1821.

For Britain, the fiscal constraint was still almost absolute during the early stages of the Great Depression. An expansionist Labour government, elected in May 1929, had indulged in its usual love of public spending and, together with the onset of recession, had badly unbalanced the budget. Since Britain was still on the Gold Standard a cross-party committee was organized to recommend public spending savings, including pay cuts for civil servants (a solution adopted by Latvia in 2008-09, which makes good sense when prices are deflating and unemployment is high.)

The Labour government refused to accept the full round of cuts, J.P. Morgan (junior) in New York refused to finance Britain without them and the government fell. It was replaced by a nominally all-party coalition, under which Chancellor of the Exchequer Neville Chamberlain maintained fiscal discipline, balancing the budget in the financial year 1933-34. The result was an astonishing boom, which gave Britain the highest five-year growth rate it was ever to achieve, before or since.

In the United States fiscal discipline was much less well maintained. For the first couple of years of the depression, the Treasury Secretary was the admirable Andrew Mellon, a holdover from the tax-cutting expansionist Coolidge administration. However, he steadily lost influence against the big-spending President Herbert Hoover, who threw money at depression problems, widening the deficit – much the same track as in Britain.

Since there was no danger of the U.S. running out of money (because unlike Gold Standard Britain, its exchange rate wasn’t overvalued) there was no attempt to cut spending; indeed various crony capitalist loan programs were vastly expanded. Instead, Hoover instituted a massive tax increase in 1932, raising the top income tax rate from 25% to 63%. This did little to cure the deficit, and sent the economy into a further downward lurch. Then FDR was elected, bringing an era of big spending and regulatory meddling. With World War II intervening, the U.S. budget was not balanced again until 1946-47, fully 17 years after the crash.

The Great Depression also saw the abandonment of the strictest constraints in monetary policy. Britain went off the Gold Standard of necessity in 1914; the regime had already been difficult to maintain in expansionary periods since the 1890s, as Britain operated with the self-inflicted disadvantage of unilateral free trade. Britain went back onto the Gold Standard in 1925 at the old parity, which was at least 10% overvalued, having in 1923 rejected electorally the possibility of abandoning unilateral free trade and thereby balancing the books.

When things got tough in 1931 the National Government went off the Gold Standard. As Sidney Webb, Lord Passfield, a Cabinet minister in the previous Labour government, said “They never told us we could do that.” To which I would respond, given Passfield’s proclivities (he and his wife were to produce an admiring book “Soviet Communism – a New Civilization” a few years later) that hiding this possibility from Passfield and his colleagues was a fine example of Bank of England Governor Montagu Norman’s admirable long-term monetary management. The 1931 monetary easing, eliminating the overvaluation of sterling, certainly played a role in Britain’s rapid 1930s growth.

In the United States the Great Depression also saw the abolition of monetary constraints, with FDR setting the gold price in his bathrobe each morning for most of the second half of 1933. However, with fiscal policy so bad, real recovery never occurred.,

The catalyst for the abandonment of both fiscal and monetary constraints was Maynard Keynes. In Britain, he was highly influential in the 1929-31 Labour government, but was cut out of further influence by Chamberlain before oozing his way back in when World War II began (while he was cut off from insider information in the 1930s, his investments took a huge bath.) In the U.S. he was already influential on Hoover, who liked to appear “modern,” but his influence on the New Dealers remained fairly modest until he and Harry Dexter White cooked up the infamous 1944 Bretton Woods Agreement.

Bretton Woods, which lasted until 1971, imposed extreme and damaging monetary stringency on Britain, which while fiscally very sloppy maintained an overvalued exchange rate throughout the Bretton Woods period, suffering debilitating foreign exchange crises at frequent intervals. A 1952 attempt to escape its trammels, the ROBOT scheme led by Treasury officials who were still pre-Keynesian together with Chancellor of the Exchequer Rab Butler, was stymied by the economic illiteracy trio of Prime Minister Winston Churchill and his colleagues Antony Eden and Harold Macmillan. Since fiscal policy was pretty unconstrained, both debt and inflation rose ad infinitum and the economy stuttered until, after the Bretton Woods collapse freed up monetary policy, fiscal policy and monetary policy were both brought under tight Thatcherite control in the 1980s.

The United States was an immense net beneficiary of Bretton Woods, because for a quarter-century the system kept trading partner currencies overvalued. Collapse of both monetary and fiscal constraints led to a period of inflation and malaise in the 1970s; then renewed monetary discipline in the 1980s and fiscal discipline in the 1990s produced something of a Golden Age. After 1995 however, monetary discipline was relaxed, and after 2000 fiscal discipline fell apart, leading to the collapse of 2008.

Since 2009, monetary constraints have been abandoned altogether throughout the world. Conversely, after periods of incredible profligacy producing unprecedented peacetime deficits, both Britain and the U.S. have restored a modicum of fiscal discipline, with the 2013-14 recoveries in both countries being notable for having been utterly unpredicted by Keynesians.

The abandonment of constraints has so far appeared almost cost-free. There has been no inflation and governments, helped by central bankers have easily been able to finance their deficits. The voices of fiscal and monetary laxity, like those of moral laxity among the 1960s hippies, have been overwhelmingly powerful. In the United States, following Mitt Romney’s loss in 2012, even many formerly sober center-right monetary and fiscal hawks embraced the new religion of infinite “stimulus.”

Even in the short term, there are large hidden costs to this. Savers have been persistently ripped off by negative real interest rates, so the capital base is being eroded. Public debt has soared and continues rising, as deficits remain far above historical levels. Unemployment remains far above the officially admitted figures while small business formation remains far below the levels of previous years. Productivity growth in both Britain and the U.S. has slowed to exceptionally low levels, with a 1.8% fall in U.S. productivity in the fourth quarter of 2014. Asset prices have soared to unsustainable levels, while the regulations introduced in an attempt to control the asset bubble or to combat global warming have imposed huge costs on the economy, most of them invisible, in terms of lost productivity.

As in the moral sphere, it is in the long term that the costs of abandoning constraints will become truly apparent. When the asset bubble bursts, the systemic capital shortage will become only too obvious, while bankruptcies will abound as bad investments are liquidated. Deficits, already too large, will become truly unmanageable in the next downturn. The minor declines in the U.S. and British credit ratings will become major drags, as the countries approach debt levels from which recovery has historically proved impossible. Needless to say, living standards will decline; it is to be hoped that British and U.S. electorates will not choose the same economically suicidal way out as the Greek one recently did.

Globally, constraints need to be reintroduced. A nominal GDP growth target is probably the best way to run monetary policy, but the target needs to be 2% not 5% — there is no problem in a little mild deflation if real GDP growth is running at 3-4%. A Gold Standard would be an ideal way of achieving this, provided global population growth can be kept down to manageable levels so the supply of gold is adequate. Without a Gold Standard, the constraint needs to be embedded as far as possible, subject to two thirds majorities and the like, so that it cannot be abandoned every time the electorate is feeling foolish.

Budgets need to be balanced, and entitlement programs need to be actuarially sound over the long term. In this respect, the innovations over the last two decades in public sector accounting, showing massive long-term deficits in social security and Medicare/Medicaid programs, need to be taken more seriously. An $80 trillion deficit over the next 75 years is just too mind-boggling to worry about, but the programs need to be re-balanced in such a way that those deficits descend to more manageable levels, even if their calculation requires heroic assumptions about longevity and medical cost increases. Finally, the dead hand of regulation needs to be removed, making way for faster productivity growth and making the solution of monetary and fiscal problems possible, even within tight constraints.

As in moral areas, the economic constraints we wish to live by may be different from those of our ancestors. But they should not be unduly lax, they must be the same for all governments, left or right, and they must be enforced.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)