The Gold-Standard and the Perfect Economic Storm

Interview with former Jersey City Mayor Bret Schundler

Former Jersey City Mayor Bret Schundler, now a professor of public policy at The King's College-New York City, sat down with me recently to talk about the financial crisis, what policymakers should be doing about it, and how it is affecting local municipalities.

When Schundler became mayor of Jersey City in 1992, he inherited a $40 million deficit, a highly corrupt council, rising crime, and a dying business community. Instead of firing off city workers or raising taxes to meet the deficit, Mayor Schundler set to work promoting efficient government and pro-business policy solutions.

Through sweeping reforms he reduced property taxes, brought investment back to the city by divesting assets, and innovated new financing means for affordable housing. By the time he left office, in 2001, he had privatized the city bus system, reduced crime 40 percent, and rooted out the corrupt leadership structure within the city.

Before becoming mayor, Schundler was an executive at the Wall Street economics research powerhouse C.J. Lawrence, where he advised investment managers at firms nationwide on economic trends.

Anthony Randazzo, Reason Foundation: Before getting into politics you worked on Wall Street at Salomon Brothers and C.J. Lawrence. What did you do for them?

Bret Schundler: At the time, C.J. Lawrence was the top-ranked economics research firm on Wall Street. My job was to meet with portfolio managers at banks, insurance companies, and other institutions and communicate what our economists believed to be happening in the country. At Salomon Brothers, I was involved with what might be called total portfolio sales. When a client, beyond buying an individual security, wanted the PhDs at Salomon to review its overall portfolio, I was the intermediary.

Randazzo: Given your background in basically selling economics research, what were the policy errors that led us to today's economic crisis?

Schundler: That's an interesting question. A case can be made that what I think were policy errors were not errors at the time, just like a pharmaceutical may be the right prescription for an ailment, but then lead to problems when other pharmaceuticals, with which it doesn't mix well, are prescribed later.

In the wake of the post-9/11 global recession, central bankers throughout the world cut interest rates. Gold and commodity prices turned up almost immediately, but Western economies remained anemic for over a year, and overall producer and consumer inflation remained low. Central bankers faced a conundrum. Should they raise short-term interest rates, presuming rising commodity prices to be a harbinger of future inflation, or should they keep short-term rates low to spur economic growth?

They chose the latter course, and gold-standard Libertarians would say that this was a major error - that excessively-low interest rates since 2003 have caused an excessive expansion of credit throughout the world, and that this led directly to today's problems. Had central bankers not ignored the soaring price of gold for so long, had they hiked interest rates early enough and high enough to stabilize gold prices, we would not have had a housing bubble, we would not have had an over-capacity problem in other credit-sensitive sectors such as the auto industry, and we would not have had financial institutions everywhere going bankrupt today. They argue that we would have had slower growth since 2003, but that it would have been sustainable growth.

To avoid making such errors, gold-standard libertarians say central bankers should peg their currencies to a fixed-measure of value, such as gold.

Randazzo: Do you agree that today's problems are the result of these bad monetary policies, or is there a counterargument to what you just laid out?

Schundler: The counterargument is that raising interest rates in 2003 to stabilize gold prices would have caused outright deflation, and that this would have put the economy through the same kind of wringer we are going through now-only several years earlier. This counterargument defends the central bankers' decision to keep rates low, and states that today's problems are the result of an unpredictable confluence of factors ultimately mixing together to create what might be called a "perfect storm," economically speaking.

These perfect storm economists would remind you that prices are a function of supply and demand, and that the tidal wave of inexpensive products that has been flooding the globe since China and India began freeing up and opening up their economies has been inherently deflationary. Keeping interest rates low, they argue, was the right response to this "supply boom." Expanding global credit allowed the increase in the global supply of goods to be matched by an increase in the global demand for goods, with rapid, non-inflationary, economic growth the direct result. Credit-sensitive demand for housing and automobiles naturally ticked up given this extended period of low interest rates, but given that general inflation remained under control, what makes low interest rates and people being able to afford a new house or a new car a bad thing? What makes non-inflationary prosperity a bad thing?

These perfect storm economists believe that if central bankers had tightened in 2003, they would have simply added the deflationary impact of rising interest rates to the deflationary impact of the Asian supply boom. Just as the West was starting to climb out of recession, falling prices would have signaled to economic players that they should cut production. Why would central bankers have wanted to do that, they ask? Why would they have wanted to treat non-inflationary economic growth as a bad thing that needed to be snuffed out, just because gold prices were rising?

Randazzo: What are the answers to this position by gold standard enthusiasts?

Schundler: They'd say that monetary policies operate with a lag, and that you can't use current Consumer Price Index (CPI) readings to gage where your monetary policies will take you six months or a year down the road. You shouldn't look out your car's rear window while driving forwards. You should watch for what's ahead of you. And like it or not, they'd say, the world uses gold as its universal, fixed-measure of value; so if gold prices are rising, it is a signal that inflationary pressures and expectations are building, and that you should take immediate corrective action even if your CPI readings do not yet show a problem, and even if your economy still seems fragile.

Randazzo: That sounds pretty credible.

Schundler: It is credible. But again, the perfect stormers have a credible counterargument, as well. They acknowledge that rising commodity prices are usually a signal that money is being allowed to grow too fast, and usually serve as a harbinger of budding inflation in the general economy. But they say this wasn't the case in 2002 and 2003. They argue that as Western companies set up production facilities in China and India to save on product labor costs, their labor savings allowed these companies to cut finished goods prices. This increased consumer demand not only for these finished goods, but also for the commodity inputs that go into making these finished goods. This pushed up commodity prices, but the impact of these increases upon finished goods costs was more than offset by the labor cost savings. Thus, even with commodity prices rising, you had these manufactured goods falling in price. Had central bankers not kept interest rates low enough to create offsetting inflation in other economic sectors, the overall economy would have suffered from deflation, which the perfect stormers believe has very negative economic consequences, and is very hard to turn around.

Randazzo: So these perfect stormers are saying that the world's central bankers made appropriate decisions, and that their keeping interest rates low did not in any way contribute to today's problems?

Schundler: No, they acknowledge that keeping interest rates low was a major contributing factor to the housing bubble. But they assert that their decisions were right at the time, and that it was only a confluence of later, additional factors that caused things to go wrong.

Factor two was that investment bankers throughout the world found innovative ways to package mortgages, home equity loans, car loans, and other forms of debt that enabled these novel securities to gain AAA credit-agency ratings - ratings that these securities did not, in retrospect, deserve. This led investors to have false confidence in the credit quality of these investments, and that, combined with the easy money policies of central banks, produced an excessive increase in financial leverage all throughout the global economy.

Next you had factor three: the Clinton administration decided that with interest rates low, and with home prices rising, a great way to help low-income people build savings would be to encourage easier mortgage underwriting standards so low-income people could buy a home with almost no money down. American home prices sky-rocketed upward, propelled not just by the first two, global factors, but also by this specifically domestic, specifically mortgage market-related jet engine.

Factor four had to do with unscrupulous mortgage-brokering and outright fraud in the mortgage application process. You had unethical mortgage brokers helping people get loans they obviously couldn't afford on the assumption that if clients couldn't service the debt, they could just flip the home in a few months for a profit. You had borrowers lying about their income, and outright fraud as to the collateral value of properties being purchased. Bubbles create manic behavior. So you can argue that this fraud factor was a by-product of the bubble, not a cause. But it certainly worsened the problem.

The fifth factor is a prime example of the law of unintended consequences. In the late-1990s, senior officers at Enron committed fraud by grossly misrepresenting, on the company's financial statements, the value of certain assets. This was against the law and these Enron officials went to jail for it. But rather than leave well-enough alone, Congress and the Financial Standards Accounting Board decided that accounting standards should be rewritten so as to wholly eliminate subjective judgment when valuing a company's assets. Under the new rules they promulgated, company officials became legally bound to value corporate assets on the basis of currently prevailing market prices for those assets, ignoring the fact that the smooth functioning of market can sometimes become disrupted, and ignoring the fact that a company which invested in such assets may have no intention of selling them - especially not when a market is temporarily disrupted.

Randazzo: You're talking about mark-to-market rules.

Schundler: Yes. It sounds reasonable to say that assets should be valued at their prevailing market price. But when the inevitable housing correction came, many mortgage-backed bonds suddenly became worthless. The investment firms holding these bonds took charge-offs against their capital, and many regulated financial institutions, which are required by law to maintain minimum capital to asset ratios, were forced to sell various financial assets. The knowledge that some investors were going to become forced sellers of diverse financial assets caused many other investors in these markets to head to the sidelines, temporarily, in the expectation of lower future prices. This forced selling, combined with a sudden lack of buyers, disrupted some thinly-traded markets to the point that they momentarily stopped functioning altogether. Market disruptions like this has historically been temporary, but the new mark-to-market accounting rules required that securities for which there is no current market be valued at zero, even if a security's issuer is rich in cashflow and profits and shows no sign that it will miss any interest or principal payments. This accounting rule change is forcing many investment companies to value even creditworthy assets as worthless and to take additional charge offs. And this, in turn, is creating a vicious cycle that is driving the markets ever lower.

In this way, these mark-to-market rules have caused what was principally a mortgage market problem to transmute into a much more general financial crisis - one that is destroying investor confidence, driving down securities markets, wiping out trillions of dollars of financial wealth, slashing consumer demand, and destroying operating companies all throughout the world.

Randazzo: Okay, so ultimately would you say that central bankers made a mistake in keeping interest rates low for so long?

Schundler: I think they did. Here in the United States, not only did [Alan] Greenspan not raise the Fed Funds rate in 2003, he continued cutting it. He took the rate all the way down to 1%, and kept it there until mid-2004. By that point, gold and commodity prices had been rising rapidly for over two-and-a-half years.

Now it is true that gold and commodity prices, from an exceptionally low level in late-2001, simply climbed back in mid-2004 to their average price level of the previous 20 years. Moreover, real GDP growth, which had soared in 2003 following Bush's supply-side tax cuts, was again slowing in 2004. So there was some justification for the Fed's actions.

But if the Fed had worried more about how rapidly gold and commodity prices were rising in 2003, and had begun gradually increasing the Fed Funds rate instead of continuing to cut it, you would have seen inflationary expectations begin moderating in 2004, you would have seen gold and commodity price increases slow as these commodities approached their 20-year average levels (instead of sky-rocketing past them), and you would have seen housing inflation slow too - which would have been a very good thing.

Randazzo: If the Fed had done this, would we have suffered the CPI deflation and economic recession that it feared?

Schundler: Yes, but only if the Fed tried to get gold and commodity price increases to come to a screeching halt. Even gold-standard libertarians acknowledge that pegging the dollar to gold will produce deflation (and often recession) during a supply boom. But they believe that allowing prices to fall at such times is necessary for the longer-term health of an economy: it lets markets clear and sends the appropriate signal to goods producers that it is time to cut production. Other economists think that deflation is so destructive, and so hard to reverse, that it cannot be tolerated even briefly. But I think this is a question worth more study.

I'm not a gold-standard libertarian myself. I don't recommend mechanically pegging the dollar to gold. I think central bankers should be concerned with maintaining general price stability, not the price stability of an individual commodity. That said, for all the reasons cited earlier, gold prices provide an extremely good gage of investors' general inflation expectations. With gold prices soaring in 2003, I think the Fed should have begun gradually raising the Federal Funds rate. If it had, I think it could have moderated inflationary expectations and taken some air out of the housing bubble while still keeping CPI inflation and economic growth from going negative.

By being too slow to act, the bubble got way out of control and inflationary pressures did start to build. To rein them back in, the Fed ended up having to jack up the Fed Funds dramatically between 2004 and 2007. This burst a bubble that should never have been allowed to grow large in the first place.

But it's possible that I am wrong about all this and that the perfect stormers are correct. It's possible that Greenspan did precisely the right thing at the time and that it was only the confluence of those other factors that made everything go awry. I think my analysis is correct, but when you are talking about complex questions, such as these, not even hindsight is 20/20.

Randazzo: Well, let's talk about financial innovation and regulations. Was the real problem insufficient government regulation of the financial markets? Do we blame financial innovations, like securitized mortgages, or the rating agencies for not properly evaluating the risks to investors of many complex new securities?

Schundler: I don't think financial innovation should be faulted. Regarding the question of regulation, there is an important role for government regulation in the financial markets. But politicians frequently promulgate rules to serve some organized special interest, not the common good. And even when politicians try to do the right thing with a regulation, you often get unintended consequences, as was the case with the mark-to-market requirements following the Enron scandal. In fact, you can argue that is was a bad regulation which is also to blame for bond rating agencies not properly evaluating credit risk during the bubble.

Randazzo: Sure. Could you expound on that point?

Schundler: Current regulations require that a security be positively rated by, quote, "one of the three national bond rating agencies" before certain investors may purchase it. This gives the big three national bond rating agencies oligopolistic control of that bond rating business and puts the government's imprimatur upon their work, even when it is sloppy. It might be better to open up that market to any bond rating entity, which demonstrates to the government that it is competent. If you had had a lot more bond rating entities looking at different kinds of securities, you would have had a higher probability of some entities identifying their true risks.

Bond rating agencies are currently hired and paid by a security's issuer. That is a problem too. The hired agency is incentivized to go easy on today's issuers so tomorrow's issuers will also want to hire it. Issuers should instead be required to deposit a credit review fee with the SEC, or some other government instrumentality, which this instrumentality would use to hire a randomly-assigned bond rating entity out of the larger pool of "competent" bond rating entities that we spoke about creating a moment ago.

If you had had more competent credit analysis taking place in the last ten years, you wouldn't have had so many investors throwing money at inherently risky securities, and you wouldn't have had so many financial institutions getting themselves dangerously over-leveraged.

Randazzo: Have the past two presidential administrations made a mistake in encouraging lending institutions to give low-income people mortgages with practically no money down?

Schundler: Yes. Investing in any asset entails some risk. And people shouldn't be encouraged to take on risks they cannot afford. But that is exactly what the Clinton Administration did. It encouraged what might be described as "predatory lending" - that is, the marketing of mortgages to people who couldn't afford them.

And it wasn't just these low-income borrowers who got hurt; it was the credit market more broadly. When the government encourages lenders to make non-recourse, 100% loan-to-value mortgages, and subsidizes the interest rate certain borrowers pay, you have to expect that borrowers will over-pay for homes, that this will push the price of many homes above their economic value, that it will facilitate a housing bubble, and that a dramatic increase in mortgage defaults will be the ultimate result. And that's precisely what happened.

Randazzo: You obviously also think the mark-to-market regulations were a mistake.

Schundler: Yes, and the government still hasn't fully reversed them - which it should do immediately. It would break the downward spiraling of the financial markets.

Randazzo: Assuming the government can correct the regulatory errors still in the system, what should the federal government be doing now to spur on economic growth?

Schundler: We need a more pro-growth tax system. We need to increase our savings rate. We need to lift the burden of what should be society-born costs from the back of American business. And we need to improve the effectiveness and efficiency of government spending, so our public investments and social commitments don't bankrupt us.

Randazzo: What kind of pro-growth tax changes would you recommend?

Schundler: In general, we should decrease individual taxes on work and investment, and tax consumption instead. There are a lot of different ways you can move in this direction and still maintain the progressivity of our current tax code (that is, still have rich, big-spenders pay a higher effective tax rate than poor, low-spenders). Reducing high marginal tax rates, and substituting an Armey or Forbes-type of flat income tax system with a high standard deduction would move us forward. A FAIR-type of consumption tax would move us even further. And you needn't worry that taxing consumption would mean no one would consume anything. People don't work for the hell of it. But it would be great to have people consuming more on the basis of increased income, not just increased debt.

Eliminating the capital gains tax would be a particularly pro-growth tax reform. Capital investment is the quickest way to increase a worker's earning potential. When a farm worker goes from harvesting wheat with a sickle to harvesting it with a tractor, his labor becomes much more productive and valuable, and his earning-power rises. Want to increase the earning-power of American workers? Then stop taxing the capital investment necessary to replace, metaphorically speaking, their sickles with tractors. Let our workers compete with those whose hourly wages are one-tenth of ours by having the capital equipment necessary to produce, in an hour, more than ten-times as much. Don't let capital gains taxes decrease the pool of capital that is available for high-return investments, or discourage more marginal capital investments altogether. Don't let the government tax away capital which could have helped American workers produce and earn more, just so it can misspend that money in ways that are often wasteful.

A third pro-growth tax reform would be to reduce taxes on American business. America's corporate tax rates are practically the highest in the world these days. They are higher even than in the semi-socialist welfare states of Western Europe. This is driving business investment away from America and to countries where the corporate tax rate is lower. Investors don't care; it doesn't matter to them where a business locates. But American workers are being hurt as these jobs go elsewhere. If we want to help American workers, we should reduce corporate taxes for the same reason we should reduce or eliminate individual taxes on work and investment. Not taxing money which is left productively invested in job and income generating businesses would help generate more jobs and higher incomes. That would be a very good thing. One justification for taxing corporations is that it discourages business owners and executives who want to skirt taxes on their personal consumption from just mislabeling it a business expense. Yet at a minimum, corporate tax rates should be lowered, paid dividends should be made deductible, and corporate capital investments should be more quickly depreciated. Each of these actions would increase the funds that American corporations have to make themselves more competitive.

Randazzo: This is all really fascinating, particularly grappling with the past to learn for the future. However, the intellectual debate doesn't mean much for local governments who can impact federal policy. What has the financial crisis meant for municipal governments and their citizens?

Schundler: I think the impact here in Jersey City is going to be a lot of increased unemployment and decreased income, because there is a lot of the financial industry here and in the regional area. I think we will see some tax appeals by property owners because as values come down on property that reduces the ratable value of their property. But then you have to increase taxes to increase income or simply have less income as a city.

So initial impacts are increased joblessness and you'll have decreased property values and decreased tax revenue. Then you have a decrease in state aid, because the state is taking a hit on those income taxes and sales taxes. So of those three factors, one of them is hitting our families directly-they're also losing wealth, their homes and so forth-but then the city itself is losing property tax revenue and state aid.

I think the thing to do is to get your spending under control. To some degree, services are so inefficiently provided by government that no one will necessary notice a cut. They don't notice any improvements when spending goes up, they don't notice deterioration when spending goes down. There are a lot of complaints by government unions, but the average citizen won't sense it much. If you're a city, you should try on one hand to cut spending, and on the other hand work hard to expand the productivity of your government spending. So rather than have any reduction in services you try to improve services while spending less.

The question then arises, why don't governments do this all the time? Why would this be something they should do when a financial crisis hits? I would argue it is something they should do all the time. It becomes especially important in times of crisis. When you can't afford to fool around anymore, you should stop fooling around.

Anthony Randazzo is Director of Economic Research





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