An Ode to Intervention

Fred E. Foldvary

[Comment on The Stiglitz Report: Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis by Joseph E. Stiglitz et al, 2010, written in preparation for a Roundtable at the annual Council of Georgist Organizations conference, held in Minneapolis, Minnesota, Friday, 5 August, 2011]

The question of whether the Crash of 2008 was caused by deregulation can be illustrated by the following analogy. Suppose in an economy, the government prohibited gambling. That would be a restrictive regulation. The rationale for the regulation could be that gambling can for some families reduce the income available for basic needs. Then the government changes the law, legalizing gambling. That would constitute deregulation. But suppose that to deal with the possible damage to family members who might be deprived of basic needs, the government restored to needy families the funds gambled away. That would constitute a subsidy to gambling.

The result of the combination of deregulation and subsidy to gambling would be a vast increase in gambling, greater government spending, and either higher taxes or greater deficits. What would be the essential cause of the negative economic effect? Interventionists would argue that the deregulation was the problem, since if gambling were illegal, there would be much less, and there would be no subsidy to an illegal activity. Free-marketeers would argue that it was the subsidy that was the problem, since if the gamblers had to bear their own losses, there would be less gambling compared to subsidized gambling, and the government would avoid the expense of the subsidy.

This basic analogy describes the situation with the real estate and financial industries. There was a small amount of deregulation combined with a vast increase in subsidies, chiefly to real estate, which inflated the land values upon with the structure of mortgages, mortgage-based securities, and mortgage-based derivatives were erected.

Subsidies to real estate relative to other assets include tax deductions for property taxes and mortgage interest, large tax-exemptions for capital gains, tax-free real estate swaps, and legal-fiction depreciation deductions. Cheap credit, made so by expansionary monetary policy, is another large subsidy. The greatest subsidy to land rent and land values is implicit: it is the generation of greater site rent and site value by government's public goods, paid for mostly by taxes other than on land. With relatively low taxes on land values, the public works and civic services of government become capitalized into higher land value. If these public goods were instead paid for by the landowners, that would reduce the rent kept by the owners and capitalize land values back down, eliminating the subsidy.

Subsidies to the landed interests and their financial symbionts are analogous to waving red meat in front of a wolf. When the wolf snaps at the meat, one could conclude that the animal is greedy. But the more fundamental cause is tempting the wolf with the meat, since it is in the nature of the wolf to grab meat where he can. Financiers of course seek speculative gains, but when government waves subsidies and bail outs, to merely blame wolfish greed is misleading.

Besides the subsidies to land values, there are of course tax interventions in the form of property taxes that fall on buildings, real estate transfer taxes, and generally taxes on incomes and sales, all of which are well known to distort prices and output, and reduce investment. There are also substantial restrictive financial regulations beyond the prohibition of force and fraud, by many state and federal agencies including the Federal Reserve, the SEC, and the FDIC. Regulations also include mandates, orders to act, such as the requirements imposed by the Community Reinvestment Act of 1977 and its subsequent legislative and regulatory changes.

Thus the real estate and financial markets are far from free, and to claim that a non-existent "free market" caused the crash and crisis is analogous to claiming that unicorns are the cause of climate change.

The preface (ix) begins with the proposition that "policies of deregulation and financial and capital market liberalization ... led to the crisis." Per the gambling example, this ignores the role of subsidies, let alone taxation, mandates, and restrictions. Stiglitz (ix) goes on to say, "The crisis exposed deep flaws in notions of market fundamentalism, the theory that unfettered markets would lead to efficient and stable outcomes," as though there actually existed a pure free market that failed. Since the market was far from free, a non-existing entity can cause nothing, and the crisis could not possibly affect the concept and theory of a pure free market.

Since Stiglitz is well aware of the financial bailouts prior to 2008, that he nevertheless labels the system an "unfettered" free market (57) reveals deep flaws in the conventional economic way of thinking to which Stiglitz, for all his excellent work such as on the Henry George theorem, falls victim, along with other Nobel-level economists and policy makers.

The Commission of Experts on Reform of the International Financial and Monetary System, headed by Joseph Stiglitz, was established by the President of the General Assembly in October 2008, during the depth of the financial crisis. The members were diverse in coming from various geographic regions, and having served in various positions in government, commerce, and academia, but judging by the consensus report, any variation in economic thought was about the structures of the status quo, rather than truly going outside that box.

It is notable that the Commission was not established during the boom that preceded the crash. The cause of every recession is distortions in the previous boom, and so it shows the intellectual poverty of both policy makers and economists that no Commission was established during the time the boom was headed towards the real estate crash and financial waterfall.

The Introduction reveals that the Commission members fundamentally Misunderstand the roots of the crisis. Stiglitz et al write that the downturn "began as a crisis in the financial sector" (2), that it "originated in the financial sector" (57). A deeper analysis would realize that the crisis began in the real estate sector, specifically in the rapid and unsustainable speculation in rising land values. Only when land values ceased to rise, and then fell, was the financial sector negatively affected. The cause of the financial downfall was its loans, speculations, and derivatives on land value.

On page 10 the Report does acknowledge "that subsidies can be just as Disturbing to a free and fair trading system as tariffs." But the context of that statement is international trade, and thus the Report fails to recognize the pernicious general role of fiscal and monetary subsidies.

The Commission members also misunderstand the effects of monetary subsidies. They write (21) "Financial markets mismanaged risk and misallocated capital.

Had markets done what they should have, the availability of capital at low cost could have led to large increases in productivity, rather than further impoverishing lower income Americans."

Stiglitz et al evidently do not understand the time-structure of capital goods. Goods with a long period of production, i.e. from the start of investment until the full return is obtained, are more responsive to interest rates than rapidly circulating capital goods such as inventory. The most important capital goods with a long period of production, hence low rate of turnover, is real estate construction and purchase. Hence, financial capital at artificially low cost, due to monetary expansion, gets loaned to real estate, whereas at market-based interest rates, they would have financed "large increases in productivity." The fault is not "financial markets" as such, but the manipulation of interest rates by the central bank.

The philosopher Hegel wrote that governments do not learn from history. Governments do react to history, but they make incorrect conclusions. Thus is the case as Stiglitz (21) writes "One of the most important lessons of the Great Depression was that markets are not self-correcting." This does not distinguish pure markets from markets hampered by intervention. Since the latter was the case throughout American history, it could well be the interventions that cause the boom-bust cycle, and which hamper recovery, as many economists have concluded. Indeed during the recession of the early 1920s, government did nothing about it, and the economy recovered quickly, whereas the strong interventions of the 1930s did not prevent the depression from dragging on.

The Report notes the increasing inequality of income, but does not do a factor analysis of returns to wages versus land rent. Classical theory, especially that of Henry George, explains that much of the gains from economic progress and expansion become captured by land rent. The public collection of rent would therefore equalize incomes without hampering the economy.

While advocating greater regulation, Stiglitz recognizes regulatory capture: "Regulators may be 'captured' by those that they are supposed to regulate" (64). Regulatory capture results in subsidies. A strict avoidance of subsidy would reduce the rationale for regulations and go a long way to reduce regulatory capture, just as the absence of bailouts to gamblers reduces gambling and reduces the rationale to restrict gambling.

On tax reform, the report recommends (187) taxes on carbon emissions and on financial transactions. A tax on transactions treats the effects of the problem rather than the cause, and would be costly to monitor. There would be massive evasion, just as today, transactions for illegal drugs are not reported to the authorities. An emissions charge would indeed provide environmental benefits more efficiently than regulations, and also would be a positive source of government revenues. But the authors do not propose the tax that would prevent the massive fiscal subsidy to real estate: a tax on land values.

The existence of a real estate cycle in the USA and other countries for the past 200 years (Foldvary 1997, Harrison 2005) is unrecognized by the Stiglitz report. Stiglitz is, however, well aware that land value taxation would not only provide an efficient source of revenue to government, but also prevent the fiscal subsidy to land values that is the origin of the land value boom that underlies financial bubbles. By not recognizing this essential theory and historical fact, the Stiglitz Report has lost a historic opportunity to truly resolve the current crisis and permanently eliminate the boom-bust cycle.

References

• Foldvary, Fred. 1997. "The Business Cycle: A Georgist-Austrian Synthesis." American Journal of Economics and Sociology 56(4): 521-41.
• Harrison, Fred. 2005. Boom Bust: House Prices, Banking and the Depression of 2010. London: Shepheard-Walwyn.