Central Banks: The Neurosurgeons of the Global Economy

By Cheryl Grey, on August 5th, 2008

Every few years, some anti-governmental organization pushes the bright idea to abolish the U.S. Federal Reserve System or make its officers answerable to the voting citizenry at large. The idea seems to be that such “quasi-bureaucratic” agencies are unacceptable under our Constitutional, democratic system, even though it’s no secret that similar central banks perform essentially the same functions in every other civilized nation around the globe.

<p><b>What is the Fed?</b>

<p>The Federal Reserve System was founded in 1913 by Congress to stabilize the burgeoning nation’s financial system and provide a basis for its future economic growth. At the same time, the U.S. monetary system was nationalized (prior to that time, even the most local of banks could print their own money).

<p>The Federal Reserve’s mandate from Congress is to regulate and support the banking industry and to maintain price stability through the control of inflation and economic growth, a process called monetary policy. It also provides financial services to the U.S. government and to depository and investment banks around the nation as well as to some foreign institutions.

<p>The Federal Reserve sets monetary policy via the wholesale or between-banks lending rate, which influences the supply of money in the U.S. A low interest rate, also called loose or dovish monetary policy, pumps a lot of money into the system. This “cheap money” encourages people and businesses to purchase on credit, from buying a house to expanding a factory, which in turn stimulates the economy and helps create jobs.

<p>However, if the economy is growing too fast and inflation rears its ugly head, the Fed can raise rates, creating tight or hawkish monetary policy and removing money from the system. This makes credit purchases more expensive and slows the economy until higher prices and the resulting low dollar purchasing power are squeezed out of it.

<p>This is a delicate and difficult process, what Charles Wheelan in his primer <i>Naked Economics</i> calls “the economic equivalent of brain surgery.” To accomplish this task, the Federal Reserve must operate independently and be answerable to no one but the judgment of history. (Collectively, the world’s central banks consider their worst performance to be their insistence on maintaining the gold standard through the Great Depression.) Just think, if the chairman and governors of the Fed could be influenced by voters or bureaucrats, then the economy would be at the mercy of special interest groups.

<p><b>Emergency Economic Neurosurgery</b>

<p>In January 2008, on Martin Luther King, Jr. Day, with recessionary fears whipsawing the emotions of traders from terror to avarice and back again, stock markets around the world began to crumble, led by a sell-off by the French investment bank Société Générale that began in Tokyo. Thanks to the Internet’s instant communication across international borders, the crash swept across Asia and Europe as each successive market opened in the neighboring time zone. Investors went into a selling frenzy, hoping to cut their losses and exit the markets with whatever they could salvage.

<p>Because of the Monday market holiday, that first around-the-globe rush skipped over the United States. As opening hour crossed the Pacific and the International Date Line, the crash again assaulted Tokyo, marched across Asia, then Europe, punched the United Kingdom in passing—and came to a screeching halt at Wall Street.

<p>Before the New York market opening on Tuesday, January 22, the Federal Reserve announced an emergency three-quarter percentage point slash to the U.S. interbank rate. This dramatic move, the first emergency cut in seven years and the largest cut in a quarter century, stunned the U.S. stock market into pausing for a deep breath in what a Wachovia Bank analyst described as a “who’s your daddy” moment. Then the bell rang, the market opened and normal trading began.

<p>The Dow Jones lost around 4% for the week. The Hang Seng in Hong Kong, the German DAX, and the EuroStoxx 50 all lost over three times that amount. The Fed’s move prevented a bloodbath on Wall Street.

<p>No single depository bank, and arguably no other central bank in the world, could have stopped a global stock market crash with one surgical interest rate stroke. It’s a testament to the creativity of the Bernanke Fed and the irrefutable argument to those misguided souls who consider the Federal Reserve to be unnecessary.



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Three Proposals to Solve the Present Financial Crisis

By Evelyn Black, on August 5th, 2008

If you aren’t feeling seasick yet from watching financial markets shoot up and then plunge over and over again over the course of the past year, you must be one of those sane people who ignores the market unless a line is spotted extending down the block from your own personal bank and brokers are raining down from rooftops like cats and dogs. If you are one those lucky few, good for you!

The rest of us are a little queasy at this point.

Since November of last year we have witnessed the kind of drama on Wall Street that belongs in a horror movie, not in a field of finance that impacts our 401(k)s. We’ve watched the Fed, Congress, and the President react with this, that, and the other emergency measure, and with each magic trick, we held our collective breath and watched and waited to see what came next.

While it’s great that the Fed and our branches of government are able to think creatively and act nimbly in the face of possible financial systemic meltdown, it would be even more wonderful if it seemed that anyone actually had a handle on how to smooth the waters with consistent policy that is forward-thinking rather than reactive. It strikes me that each emergency fix (the last one being the Fannie/Freddie rescue package) leaves us less confident than before. Lack of confidence in a financial system is, in general, a bad thing. So while we are in a lull here (knock on wood), I’d like to raise the question, “What, if anything, is the hard choice that will get us back on track over the long run?”

On Sunday, the New York Times ran an editorial about ailing banks and a request by private equity firms for the Fed to drop regulations preventing them from running banks into which they invest large sums of money. Currently, federal law prohibits this to prevent conflict of interest and a too-great concentration of economic power into elite hands. With so many banks hurting for capital and in need of cash infusions, it must be tempting for the Fed to take this proposal seriously and quietly allow something that nine out of ten ordinary people won’t notice anyway let alone understand.

The Times makes the point that this is a terrible idea, not the least of the arguments against it being that it is private equity firms and financiers who operate outside the scope of bank regulation who got us into this mess in the first place. By creating and promoting highly-speculative, mortgage-backed investment securities, they nearly crashed the entire system. To back off on regulation right at at time when what we need badly is more, not less, oversight is tantamount to giving the fox the key to the hen house and hoping that it will all just work itself out, somehow.

The real problem of course is, where is the money banks need going to come from?

Congress can pass all the bail-out bills it wants, but the fact remains, the U.S. is not exactly rolling in it. Cash, that is. If regulations are not relaxed so that private equity firms can bail out banks and then run them however they see fit, what will happen to the banks?

The banks will fail, that is what will happen to them. The one possibility that we rarely hear put forward as a serious solution is that maybe that is exactly what needs to happen. Why are we trying to prop up a banking system that made one disastrous greedy decision after another without regard to the consequences of those actions? If the free-market is self-regulating (and that’s another discussion entirely, the question of whether or not it really is), then why don’t we let it regulate itself by weeding out the weak?*

To take an even longer view, at some point the U.S. will have to set actual policy and stop jumping in with wads of emergency-measure chewing gum to plug the financial dikes. Why do we have a private organization (the Fed) calling the shots on regulation and deregulation that directly hits the pocket books of ordinary people? We are all paying for this: all of us except the CEOs and high rollers who jumped with golden parachutes or escaped with cash before the train started to derail. Those people, those few at the very top, are mostly coming out unscathed. That’s wrong. Everyone knows it is wrong. No one is speaking to that injustice much less taking any aggressive action to change it.

Instead, we have vultures hovering and foxes circling, holding out wads of cash and asking for special favors. And Congress, after having very self-righteously accomplished exactly nothing in regards to energy policy (Democrats wanted to slap the hands of oil speculators who aren’t responsible for high gas prices, and Republicans wanted to drill offshore even though it won’t help either), is now adjourned and the country is talking about whether or not Barack Obama has anything in common with Paris Hilton and Brittany Spears.

That is insanity on a plate.

The hard, longterm fix is to find a way to tie money to actual value again. I know this will sound dusty and lame to fast-track types who are energized by leverage, but somebody has to say it, and since I’m already old I don’t mind throwing it out there. You can make money by moving money around, scrambling numbers, and gambling on outcomes for awhile, but eventually the smoke clears, the mirrors crack, and what do you have? You have what we are looking at right now.

I have three modest proposals, none of which will be taken seriously even in my dreams, but here they are:

1) Create a comprehensive and aggressive national energy policy which includes subsidies for development of alternative energy, generous tax rebates for homeowners who invest in it or in energy conservation, aggressive development of alternatively-fueled vehicles, and redesign and rebuilding of infrastructure. This alone will create new jobs and reduce our dependence on foreign oil. It should be our top priority. Right now it isn’t even on the edge of the map. Energy policy? What energy policy?

2) Require lending institutions to reduce the principal on their property-backed loans to a number that is more in line with the actual value of the property, and then take the loss on the difference. This will cause some financial institutions to go under. Oh well.

3) Re-examine and re-work banking regulations so that banks cannot skirt their fiduciary responsibilities by running around Depression Era safeguards using investment houses and third party financiers. The American people should be involved in this, meaning that it should go through Congress and be discussed publicly at length, not hammered out in private at the Federal Reserve.

If we have to foot the bill for misconduct, we should get a say in what the rules are and how they are enforced. It strikes me that this should be the very least we could do in the interest of fairness and longterm success. It distresses and angers me that to date so little has been done.

The next wave of defaults is just around the corner. How about getting a comprehensive plan together before it hits instead of after?

I don’t know how much more nausea I can personally take.

*Editor’s note: For the Austrian economics point-of-view on allowing Fannie Mae and Freddie Mac to fail on their own, see J.D. Seagraves’ article “Fannie Mae and Freddie Mac: It’s Time for the U.S. to Let Go.”



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Why Doctors Are Not Good Businessmen

By J.C., on August 5th, 2008

It seems almost every other day I hear about some young college kids starting up a new business. Perhaps it is a dot com or social networking business or something unique. What everyone always wants to know is this – what is the business model?

This has got me thinking about the business model of medicine and in particular the business model of a private practice. I’ve come to the conclusion that being a doctor in private practice is not a good business model. Here’s why:

In this great country of America, the cost of running a business is very expensive. The main cost is labor and payroll. Here in America we are over-educated and over-paid. We expect great benefits and time off. We want the good life, no matter what rung of the economic ladder we sit on. This cultural phenomenon of entitlement is evident in the fact that payroll benefit costs run about one-third of actual salary costs. Thus it costs about $30 in benefits for every $100 you pay an employee. (No wonder why everyone wants to outsource to India or China these days.)

For most small business owners, the productivity of each employee increases revenue. Whether the product is a widget or a hot-dog or computer software, the general concept of employee productivity is that employees increase revenue and the more revenue per employee the better. Thus as sales escalate to the point of needing another employee, the revenue from that person’s productivity more than covers his cost. Thus scaleable businesses typically have desirable business models.

In private practice medicine, revenue is dependent on the productivity of one person – the doctor. Hiring more employees does not increase his productivity. The only thing that can increase revenue is for the doctor to work harder and faster to see more patients or do more procedures. He is the rate-limiting step in the business model. This is the reason why your trips to the doctor’s office get shorter and shorter.

Most businesses are based on a scaleable model of sales. However the product of a doctors office can only be created by the doctor and delivered by the doctor. In essence, it is a one employee enterprise and everyone else in the office is ancillary staff. In fact, it could be argued that the doctor actually works for the employees and not the other way around. He has to see patients and do surgeries to pay his staff’s salaries. Thus the incentive of the doctor is to actually hire underqualified staff to pay lower salaries and cut costs.

If you were an investor looking for small businesses to invest in, you definitely would not want to invest in a doctor’s office. If that doctor got sick or tired (or old) then he would not make money. Since he is not an employee, he actually loses money when he takes vacation. Not only does he not earn income, he still has to pay his staff.

Given the above thoughts, it is not a suprise that doctors are not typically great entrepreneurs. To boot, they are often considered some of the dumbest investors around!



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