Confession is good for the soul, or so I am told. While Doug Noland takes a well deserved Friday off (he'll be back next week), I thought I would take this opportunity to take you on a mildly self-indulgent journey to explain how reading Doug's work has affected the economic the thinking of a one-time hardcore Supply-side believer.
Graduating from college in 1980 in the shadow of 21% interest rates and a gold price higher than the DJIA, I was looking for some economic philosophy that could solve the enormous problems of the time. I knew instinctively that the liberal wisdom taught to me at the University of Wisconsin was not the answer. After graduation while serving a sentence as an auditor in the summer of 1981, I pulled a copy George Gilder's Wealth and Poverty off the shelf of a downtown Chicago bookstore. The most important chapter was entitled, "Laffer and Liberal Economics".
The crisply written 20 pages poked fun at the old liberal economists like Galbraith and Heilbroner who thought more taxes and regulation were the answer to our economic problems. Instead the chapter clearly explained that lower tax rates were the answer. This chapter led to the inhaling of required Supply-side authors like Waniski, Roberts, and others. I remember the feeling of hope as the Kemp-Roth tax cuts were finally signed into law after a bitter battle.
The next step to the forging of a "true-believer" was listening to the Wall Street economists make dire predictions about the disasters about to befall the economy as the recovery accelerated in 1984-5. Runaway inflation and deep recession were the only possible end for the loose fiscal policy advocated by the Supply-siders of early Reagan administration, according to Wall Street. But these predictions of doom never came true. The experts were wrong, the Supply-side stuff seemed to work. There is nothing more powerful than holding a philosophy that is in the distinct minority, then seeing that philosophy solve real problems much to the amazement of the "experts" of the day.
The final step in the process of creating a Supply-side believer was surviving the crash of 1987 with hardly a dent. Not only had lower taxes and deregulation solved the problems of 1982, it had withstood the crisis of 1987 with flying colors. Nothing could stop us now, not even the election of Clinton who had the Democrats sounding like Republicans of the early 1980s. Democrats were actually talking about incentives and free trade. It was Supply-side Nirvana
But a funny thing happened on the way to the Revolution. While few were watching, under the general guise of financial deregulation, very unusual things were happening in the financial markets. Momentum investors, hedge funds, derivatives, CDO's, syndicated loans, gain on sale accounting, and many other factors became an ever increasing part of the financial landscape. Most of these things had been around in some form for many years, so on the surface they did not seem to be a source of concern. Supply-siders ignored this stuff, it was financial deregulation so it must be all right.
When I first read Doug Noland's work in 1997 I found it very interesting, but in all honesty I was unsure how important it was. At no time during the Revolution were we worried about debt structures, credit spreads, and other such seemingly esoteric items. We were certainly in the middle of a bubble in equity prices, but it was unclear to a now aging Supply-sider that any real economic damage was being done.
The first part of the puzzle that Doug sold me on was what was going on in mortgage finance. I knew that Fannie Mae looked like an overvalued stock, but I had no idea what they had really been up to. I had always viewed Fannie as a quasi-insurance entity, not as the primary risk-taker they had actually become. Right under the noses of millions of conservatives, Fannie, Freddie and friends have socialized the residential mortgage process. Ironically Gilder blasted the GSE's in his 1981 book for channeling $30 billion of investment into homes. Decrying the drain on investment capital that this seeming large amount of credit took on more productive capital spending, Gilder wrote, "New or marginal corporations that lacked guarantees, exemptions, and subsidies simply could not compete with the hydra-head mortgage machine". These days $30 billion is a slow month for the mortgage machine. Why didn't Supply-siders stop the enormous flow of capital into residential homes?
Next I made the mistake of playing devil's advocate one day and saying the most derivatives were used for harmless hedging transactions. Flying off Doug's formidable bookshelf came the book F.I.A.S.C.O. by Frank Portnoy a former Morgan Stanley derivatives trader. Stories about "ripping customers heads off' were enough to convince me that derivatives were not benign hedging vehicles, but products invented to enrich their creators. The next piece of required reading was Lowenstiens's When Genius Failed. If this book is not enough to induce intense feeling of nausea, then you don't understand how close a group of supposedly smart, Ph.D. economists came to blowing up the global financial system. I was beginning to think maybe I had missed something in my undying confidence in Supply-side economics.
Then I had the misfortune of listening to a young banker from Chase Capital Partners explain all the deals he was doing. I had no idea of the size and scope of what was now being done in the name of banking. In a speech to an alumni group he indirectly admitted that there was an enormous amount of lending going on in order to eventually get the equity underwriting business. He also talked about the large loans to so called private equity firms, and about the risks inherent in that business. Now I understood how Ranger owner Tom Hicks could afford $150 million for A-Rod. After the speech, for the first time in many years I actually looked at the footnotes to a large bank's financial statements. This was no longer "your father's Oldsmobile." Banks had become supercharged Ferraris that more closely resembled global hedge funds. The fear level was rising.
The final blow to my confidence came in the simple reading of a money market fund's semi-annual report. I have an MBA in Finance, published articles in financial journals, taught thousands the CFA curriculum, and have studied the equity markets for 20 years, but then Doug asked a simple yet troubling question, "What are these things that your money market fund owns?" I was embarrassed to say that I had no idea. Genesis Funding, Tulip Funding, and my personal favorite, Atlantis Funding (wasn't Atlantis underwater?), I had no idea what these things were. Do you? This was first real venture into the shady world of structured finance. Apparently these monsters have no publicly available financial statements. They have no location, and you can't in any way find out what they actually own. The material that explains them is a flow chart that would give a Nobel Laureate an immediate headache. What these things really are is an unholy combination of less than AAA loans combined with derivatives in a Byzantine structure that can only be analyzed by saying "I hope the rating agencies are right." Having seen rating agencies in action over the years I immediately switched all my brokerage firm money market accounts to treasury-only funds. I'll lose a few basis points in yield, and sleep much better.
It will be up to economic historians to decide how much of the growth and prosperity since 1980 was a result of the Supply-side Revolution, and how much falsely created by an out-of-control credit system that allowed growth at the cost of a debt structure we cannot afford. Five years ago I would have confidently said that 100% of the accolades would have gone to the Supply-siders. Now I am much less sure I know the answer, but a least I understand the problems.
Twenty years ago Gilder chided the liberal economists of the 1970's for trying to apply old solutions to a new problem. Today it is time for those in both parties to realize we have a new set of problems. It is time to bludgeon the Laffer/Kudlow wing of pro-growth economists with the stark reality that yesterday's solutions will once again not solve today's problems. Removing the double taxation of dividends, or any other fiscal scheme, will not solve the problem. The new solutions for today's problems can only be started by taking the harsh medicine needed to fix a credit system that is enormously unhealthy.
I beg and plead with anyone who has supported the pro-growth agenda of the past 20 years to take a few simple steps.
1. Read Doug's speech on the pervasive effects of the GSEs on our credit system
2. Read F.I.A.S.C.O and When Genius Failed
3. Read the financial statements and footnotes of JP Morgan Chase
4. Review the balance sheet of any high-yielding money market fund
The first step to solving a problem, is admitting a problems exists. Far too many pro-growth economic thinkers are in denial. Perhaps someday all us ex-Supplysiders can have a meeting. It might start:
Hello, my name is Gregg and I am a recovering Supply-Sideaholic.
Gregg Jahnke
