World War II Cured the Great Depression? Unlikely

by Don Boudreaux on October 22, 2008

in History, Myths and Fallacies, War

Here’s a letter that I sent today to the Wall Street Journal:

To the Editor:

In his otherwise superb letter, Rolf Goehler repeats the dubious, if common, claim that World War II got America’s economy “going again” (Letters, October 22).

The official unemployment rate did fall (from 14.6 percent in 1940 to 1.2 percent in 1944), but it did so overwhelmingly because of military mobilization rather than because of improvement in the economy’s performance.  As economist Robert Higgs wrote about the war years, “Official unemployment was virtually nonexistent, but four-tenths of the total labor force was not being used to produce consumer goods or capital capable of yielding consumer goods in the future.”  So it’s not surprising that, according to Higgs’s estimates, personal consumption per capita in 1945 was only a paltry 2.5 percent higher than it was in the still-deeply-depressed year of 1940.

Regardless of WWII’s merits on other fronts, almost surely it was no great economic boon.

Sincerely,
Donald J. Boudreaux

See Robert Higgs’s indispensable book Depression, War, and Cold War (New York: Oxford University Press, 2006).  The quotation in the letter is found on pages 63-64; the data on consumption are found on page 71.

Also note that personal consumption per capita in 1944, the last full year of WWII, was about two percent less than it was in 1940.

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Paul Smith Jr October 22, 2008 at 6:34 pm

Of course World War II ended the Depression.

It distracted FDR from economics. Had WWII not occurred, we'd still in the Great Depression.

Sam Grove October 22, 2008 at 6:37 pm

War represents a large diversion of resources into "breaking windows", that is the destruction of created wealth, capital goods, and many lives.

That it could possibly be considered a "boon" to any economy is perversion.

Chris October 22, 2008 at 6:49 pm

(So, why do commentators names in some posts link to email addresses, and not in other posts? I prefer the links not to be clickable, mainly because I dislike spam harvesters.)

Sam Grove –

I have to believe that a small civil war taking out Robert Mugabe would probably be a net boon to the economy of Zimbabwe.

Sam Grove October 22, 2008 at 7:03 pm

I have to believe that a small civil war taking out Robert Mugabe would probably be a net boon to the economy of Zimbabwe.

No doubt, but a massive popular uprising would be cheaper.

I bet they have gun control in Zimbabwe.

Sam Grove October 22, 2008 at 7:04 pm

And it wouldn't be the war per se that would bring the boom. It would depend on what replaces him.

SteveO October 22, 2008 at 7:53 pm

Off topic:

James Kunstler will be coming to campus next week. I think he's a nut, but I'm trying to do some prep work.

If anyone knows of good austrian / libertarian sources that have critiqued or responded to his work, references or links would be appreciated.

HispanicPundit October 22, 2008 at 8:44 pm

If not WWII then what? FDR? I'm being sincere…what got us out then?

Alan Gunn October 22, 2008 at 8:52 pm

Can't vouch for this personally, but I've heard that FDR started letting up some on industry when he realized he'd need them to make planes and tanks, and that the unions lost some of their clout when wage-price controls made it harder to squeeze concessions out of employers and patriotism made striking look bad. At the very least, we didn't have a lot of the earlier attempts at government-induced cartelization that marked the early New Deal years.

Rudy October 22, 2008 at 9:14 pm

Good letter, Don. WWII didn't remove us from the Great Depression any more than earthquakes, tornados or hurricanes help economies (“Destruction Theory”).

Rudy October 22, 2008 at 9:40 pm

HispanicPundit –
Many history books solely focus on the rise in production and the lowering of the unemployment rate as two of the major factors as “helping our economy.” The unemployed during the Great Depression were simply diverted to armament factories or enlisted in the military – both of which does not create a thriving economy with a great standard of living.

If anything, the war made consumers worse off by moving capital, resources, and people away from civilian production – doing services and making things people want. If war, military, and armament production makes countries rich, the former USSR (who claimed to have a zero unemployment rate) would’ve been the best example of richness then. On the other hand, it was one of the poorest nations with resources being diverted to military build up – a economy doesn’t prosper with government direction.

Patricia October 22, 2008 at 9:59 pm

If Henry Hazlitt has taught us one thing it is that broking windows does not lead to economic growth. Keynes famously advised FDR to solve the depression in 1936 by building a lot of boats, taking them out to the middle of the ocean and sinking them. Then, building more boats. But again, broking windows doesn't create growth. Growth only comes when the market is allowed to function properly. Capitalism saved us from the great depression and capitalism will save us from the current financial crisis. And, Hayek would say capitalism is the only way to switch tracks and avoid the road to serfdom. Steve Forbes has a great new article on this very point. You should check it out: http://www.forbes.com/hcome/forbes/2008/1110/018.html. We can beat this crisis, if the regulators will get out of the way and let capitalism work its magic.

Methinks October 22, 2008 at 10:27 pm

the former USSR (who claimed to have a zero unemployment rate)

Of course we were all employed! We even had booklets we had to maintain called "the record of toil". I kid you not, they still exist.

Of course, we were all mostly employed in scavenging for food and other basic necessities, but that's employment, no?

An old Soviet joke: "Nobody works. But we get up early in the morning and we all do nothing together."

Rudy October 22, 2008 at 10:41 pm

I also like the old Soviet saying of, "The government pretends to pay us, and we pretend to work."

brotio October 22, 2008 at 11:18 pm

I'm surprised that Torquemuirduck hasn't warned all of you sinners that you'll be facing Inquisition if you don't cease and desist this sacrilege concerning St Franklin of Roosevelt.

Larry October 22, 2008 at 11:21 pm

I think you've oversimplified. The war may not have ended the GD, but it gave people an opportunity to save up their cash for the simple reason that there was nothing on which to spend it during the war years. But guess what happened right after the war? There was a huge pent up demand for housing and consumer goods…and once business retooled, plenty of cash to go after them. And we all know that a housing boom can really pump up an economy. Yup.

Peter Cresswell October 22, 2008 at 11:43 pm

SteveO, you asked "If not WWII then what? FDR? I'm being sincere…what got us out then?"

I find Mark Skousen's answer the most compelling. See: 'Saving the Depression: A New Look at World War II' – Mark Skousen

PS: Good to see 'Saint FDR' getting a well-deserved kicking. Good stuff. :-)

SteveO October 23, 2008 at 12:19 am

Peter:

You missattributed that question.
A common occurance due to the poor formatting of the comment thread.

(which has been mentioned to the creators many times)

Ironman October 23, 2008 at 12:31 am

If it helps, it was ending World War II that ended the Great Depression. First and foremost, the end of the war removed extreme inflationary pressures stemming from wartime production and excessive government consumption of resources. Second, the most highly skilled members of the U.S. workforce returned from military service, allowing a boom in labor productivity. Third, over the years of the New Deal and WWII, businesses learned to operate lean enough to earn small profits, which became big profits once production controls, quotas and other constrictive government regulations set down over the period were lifted.

Martin Brock October 23, 2008 at 1:36 am

The "Reality Based?" thread seems to be broken now too. I can't post to it either.

Martin Brock October 23, 2008 at 1:40 am

Martin, I don't know what the baby boomers have to do with this (why specifically baby boomers?), …

The people between 45 and 65 today are unlike any previous generation for several reasons. Their birthrate was lower, their life expectancy is greater, their productivity is higher, and they expect rents comparable to the unprecedented rents experienced by the generation preceding them.

The expectation of rents is the problem now. We're searching for these rents, and we're not finding them, so we're demanding that states create them for us, because creating rents is what states do.

Fannie and Freddie could not have sold mortgage backed securities as it did if we hadn't been willing to buy them, and these institutions didn't sell the most dubious "securities" anyway.

We all want to retire like our parents who retired, but we can't. Even many of us apparently with lots of "savings" can't retire as we expect, because the "savings" are promissory notes of dubious value. All of the criticism of statecraft here is justified, but it doesn't address the present question.

Why this particular statecraft at this particular time? Would other statecraft have avoided this problem under the circumstances? I doubt it.

… but I don't see the functional difference between this war and that.

The war against the present corporatism is not so different from the war against past socialism, and it's not so different from the earlier, classically liberal struggle against feudalism, but the historical context is very different. Rent seeking is nothing new. Promissory notes of dubious value are nothing new. States protecting "investors" is nothing new.

What is new is the unprecedented birthrates, the unprecedented life expectancy, the unprecedented productivity and the unprecedented expectation of retirement based on the experience of a single generation without the same characteristics. We can read Mises and Hayek to understand these problems only so much.

I also think banks are "systemically critical" because government has mad it so, not for any natural reason.

I agree. I don't really believe any bank is "systemically critical" at all. We aren't bailing out these institutions as much as we're bailing out the holders of their notes, and I don't at all believe that the problem is limited to mortgage backed securities.

The holders of these notes are the "capitalists" by definition, so we are in fact bailing out "capitalism" here. "Capitalism" is not synonymous with "freedom" or even "free enterprise" or "free markets". Capitalists hate free markets.

There are restrictions on who can offer what services and even who can and can't own a bank.

These restrictions may be counterproductive, but with or without them, we'd still have an unprecedented lot of people seeking rents now, and effective rents don't just magically appear because so many people want them.

Even if they banks were naturally interlinked by lending to one another to maintain adequate reserves and if institutions were also linked because they issued insurance to one another (CDS is a form of that), I doubt that there would have been as much risk floating around in the system if there were not promises from the government to backstop the industry via the Fed and Fan & Fred.

And Federal Deposit Insurance, Pension Insurance, loan guarantees for college students and GM and all the rest. Now, we have an Office of Financial Stability empowered to "secure" any note of any description, and demand for its "services" can only rise.

If there is no backstop (i.e. the were not able to socialize losses), it's doubtful many banks would have made such imprudent loans because they would have adjusted their risk assessment to not include government backstops.

No. The demand for promissory notes of dubious value determines the supply of these notes. The supply is perfectly elastic. You want a promissory note of dubious value? I have one for you. Want two? I have two. What seven hundred billion? Just let me find a pen. Once I have your money, I'll do something with it. Trust me. Has a bank ever refused your deposit on the grounds that it couldn't find a borrower?

You can be as angry as you want at corporations for seeking rents.

I'm not angry at them. I might as well be angry at the sun rise. I'm only describing them.

But it's like being angry about earmarks – as long as the federal government gives states money, it is the job of every state representative to get as much of it as they can for their own state.

Right. But it's about the capitalists in this scenario, not the state governments, although state governments do have pension funds, college tuition trusts and the like.

Likewise, as long as the government has the ability to create rents, corporations and special interest groups will seek them.

Certainly. Government always has the ability to create rents. It does little else.

Theoretically, in a socialist society the means of production are owned collectively.

Well, they're owned more centrally.

In practice, it is impossible for a collective to run anything.

Collectives never run anything. Central planners run things inefficiently, in the market sense of "efficiency", i.e. they run things without the information in market prices.

But market efficiency also concentrates wealth and presumably makes yield distributions fat tailed, so market capitalism can't provide "securities" for most people, even with well meaning financiers diversifying investments.

Don't misunderstand me here. I don't want the security. I'm a skydiver. We do have a choice to make between freedom and security. I want the freedom.

Capitalism can only provide promissory notes of questionable value, and when a fat lot of "investors" buy these notes without actually producing sufficient, real means of production, the value of the notes can only be dubious.

Children are the real means of production we didn't produce. All the other "investments" we made are insufficient for the retirement we expect, based on our parents' experience, because we didn't produce enough children. Our children didn't produce enough children either, not if we want the retirements our parents enjoyed.

Human Action is The Ultimate Resource, according to Ludwig von Mises and Julian Simon. We've invested heavily in extending our lives but not so heavily in the means of producing what we expect to consume, aside from the longer lives. That's why our promissory notes have dubious value.

At some level, people all over the world understand this problem, even if we aren't discussing it so much now. They're now buying our Treasury notes hoping to exchange them for food later, but we're inflating the value out of the notes while we transform our economy to produce moonshine from much of our corn. That's the central planning part.

Individual groups emerge, asserting the need for more subsidy. So, in practice, socialism and corporatism are very much alike. It's really the same war.

Socialism and corporatism aren't so different, but neither is fundamentally new. Neither was fundamentally new in the twenties either. That's the whole point of The Road to Serfdom. The present war is very different from past wars, because the demography and other factors are fundamentally new.

Sam Grove October 23, 2008 at 2:33 am

We do have a choice to make between freedom and security.

That's an illusory choice. There is no security to be found by giving up freedom, because it places our faith in the promises of others who can't possibly value our security as much as their own.

Are you all following Martin?

The pool of producers is shrinking relative to the pool of consumers.

An entitlement to future production is only worth what it will actually buy when the future is now. What it will actually buy depends upon the productivity factor times the number of producers.

Many promises are made, few will be able to be kept.

Peter Cresswell October 23, 2008 at 6:11 am

Oops. Sorry, Steve. :-)

Martin Brock October 23, 2008 at 6:29 am

There is no security to be found by giving up freedom …

Unfortunately, there is. It ain't necessarily your security though. Others will happily surrender your freedom for their security. If you don't already have substantial nominal "security", you'll find the search for it more difficult in the near term. You can buy U.S. shares at this point and gamble on timing. Shares are probably oversold now, but I don't expect much higher highs for a while. We aren't repeating 1987.

… it places our faith in the promises of others who can't possibly value our security as much as their own.

You won't starve. They'll throw you a bone. Don't worry about that. They don't want you revolting.

Many promises are made, few will be able to be kept.

Fewer are kept than can be made. Statesmen will keep their taxpayer sponsored pensions with cost of living adjustments, I'll wager. They'll bail out plenty of wealthy bondholders (including institutional investors like pension funds and insurance companies), though they'll inflate much of the value out of the bonds in the process. They'll keep the price of assets like real estate from falling too much.

I'm not sure about the price of corporate shares, because we'll convert corporate equity into income, and we'll probably do it by leveraging rather than by declaring dividends, i.e. corporations will sell (or give away) notes effectively promising their revenue to noteholders, especially their own established interests like corporate officers and some current shareholders and employees, but the leverage won't buy the later earnings that entrenched interests promise future shareholders.

They've already done it in fact. That's why share prices are falling now. No one knows how much shares are really worth, because we don't know how leveraged the companies are or how much competition such leverage can survive or how much competition statesmen will permit. The real danger now is that highly leveraged companies will survive, because we won't allow younger, less leveraged companies to compete with them.

Speedmaster October 23, 2008 at 7:45 am

The 'WWII ended the Depression' myth is widespread. I was taught that in high school in the mid 1980s.

Eric Hanneken October 23, 2008 at 9:14 am

Wartime, by Paul Fussell, provides some good details on how poorly American and (especially) British civilians lived during World War II, notwithstanding the paper increases in GDP.

Eric Hanneken October 23, 2008 at 9:16 am

Wartime, by Paul Fussell, provides details on how poorly American and (especially) British civilians lived during World War II, notwithstanding the paper increases in GDP.

roystgnr October 23, 2008 at 10:15 am

"Personal consumption per capita" is about as meaningful a statistic as "testicles per capita" (1.0). Some averages don't matter.

In the economic case, the average doesn't matter because the marginal utility of money depends strongly on how much of it you already have. Would you rather take a 13.4% pay cut, or a 13.4% chance of becoming unemployed for the same length of time?

Also, is there anyone who actually supports the strawman "World War II ended the depression by giving lots of people tank construction jobs"? No? Then you might want to construct an argument against "World War II ended the depression by convincing governments that they had a bigger threat to deal with than inflation and globalization, leading some to lay off on the deflationary and trade restrictive policies that turned the depression Great to begin with." Your first commenter got it exactly right.

Eric Hanneken October 23, 2008 at 11:02 am

Also, is there anyone who actually supports the strawman "World War II ended the depression by giving lots of people tank construction jobs"? No?

Heck yes. I just did a Google search on "World War II" and "Great Depression." From the results, there's this example:

Mobilizing the economy for world war finally cured the depression. Millions of men and women joined the armed forces, and even larger numbers went to work in well-paying defense jobs.

Also this:

As European nations went to war American factories began to make war goods to sell to nations like Britain. After Japan attacked Pearl Harbor over ten million American men went into the service in one way or another. This opened up a huge demand for workers to supply them and the Depression was over.

The "war production" explanation for the end of the Great Depression was also taught to me in high school. It's popular.

David Peterson October 23, 2008 at 11:40 am

I'm sure many who accept this narrative of the end of the great depression ironically also (rightly) criticize the war in Iraq for harming our own economy. Was WWII a special case of the broken window working? Maybe libertarians should exploit this inconsistency in an attempt at forcing people to question some of the narratives of the great depression.

Methinks October 23, 2008 at 11:46 am

Martin, you're answering me from the previous thread, eh? Maddening how the comments are swallowed on those threads. I'll come back when I have more time to respond to you. Apologies for taking the thread off track, though.

Martin Brock October 23, 2008 at 12:37 pm

Methinks, no one ever accused me of obsessive topicality anyway.

Bill K. October 23, 2008 at 12:37 pm

Was the great fall in unemployment in WWII in part due to personal motivation? How much did being drafted if you were not in a critical job increase mens' motivation to try harder to find work? Or has our culture changed so much that the song, "Hey Mr. Custer, I don't wanna go" didn't apply then?

Sam Grove October 23, 2008 at 1:27 pm

There is no security to be found by giving up freedom …

Unfortunately, there is. It ain't necessarily your security though. Others will happily surrender your freedom for their security.

_________________________________

Thanks for elucidating that for me Martin, that's pretty much what I meant, though I thought it was implied in my reference to "others".

When you give up your freedom to OTHERS, you place your security under THEIR auspices. Of course they will use their authority in behalf of their own security.

Sam Grove October 23, 2008 at 1:29 pm

I think it likely that entry into the war required the ending of many New Deal constraints on economic behavior.

No doubt the dairy farmers stopped dumping excess milk production, etc.

Hans Luftner October 23, 2008 at 2:00 pm

Maddening how the comments are swallowed on those threads.

Some older threads have lost literally days worth of comments, including, tragically, some of my own witty & insightful remarks.

Methinks October 23, 2008 at 4:31 pm

That is tragic, Hans. I'm not being sarcastic.

Methinks October 23, 2008 at 5:37 pm

their productivity is higher, and they expect rents comparable to the unprecedented rents experienced by the generation preceding them.

What does their productivity have to do with rents? What rents did the generation before them experience that the boomers now expect? I honestly just don't know what you mean. Let's hope this thread doesn't swallow your answer. If it does, see you on a different thread.

Fannie and Freddie could not have sold mortgage backed securities as it did if we hadn't been willing to buy them, and these institutions didn't sell the most dubious "securities" anyway.

Fan & Fred guaranteed the cash flows of of the MBS they sold. Fan & Fred also were themselves guaranteed by the government (nobody bought the fiction that they weren't). Those two sold plenty of junky MBSs and plenty of institutions bought them and that this became a major source of losses in their portfolios. Without the guarantee, only fools would have bought the MBSs. There are plenty of fools, but not this many.

We all want to retire like our parents who retired, but we can't. Even many of us apparently with lots of "savings" can't retire as we expect, because the "savings" are promissory notes of dubious value. All of the criticism of statecraft here is justified, but it doesn't address the present question.

Our parents saved. The boomers did not. Our parents retired to a relatively modest life (well, somebody's parents – mine will die at work), boomers expect to retire to an expensive life of adventure. The definition of a wonderful life has changed and that life is more expensive. I don't know what you mean by "savings are promissory notes of dubious value." Typically this is where you start to get all upset about treasuries again and I remind you that treasuries are not the only investment vehicles. If treasuries disappeared, there would be plenty of other much higher yielding investment vehicle.

The holders of these notes are the "capitalists" by definition, so we are in fact bailing out "capitalism" here. "Capitalism" is not synonymous with "freedom" or even "free enterprise" or "free markets". Capitalists hate free markets.

Ahem…some of us capitalists are willing to bear the consequences of the risk that we took, thank you very much. I know what you meant, though. Buffet is the focus of my anger at the moment because of this. But, we're not bailing out capitalism. We're getting incumbents re-elected by an ignorant populace.

And Federal Deposit Insurance, Pension Insurance, loan guarantees for college students and GM and all the rest. Now, we have an Office of Financial Stability empowered to "secure" any note of any description, and demand for its "services" can only rise.

"Office of Financial Stability". The name alone makes my skin crawl. Are we getting a Ministry of Virtue and Vice? In the Soviet Union there was a government office for everything. The effect of these offices was obviously the opposite of the intended and, predictably, they became a source of many jokes. I see this in our future.

The FDIC is funded by premiums collected from banks. The other stuff is just all pure socialism.

Has a bank ever refused your deposit on the grounds that it couldn't find a borrower?

No. But it used to refuse to lend to people who could not pay it back before it could sell these bad loans to a GSE. They were also competing with Fan & Fred, whose borrowing costs were lower than banks'. There's more to it than that, but you shouldn't underestimate the distortions caused by Fan & Fred.

But it's about the capitalists in this scenario, not the state governments

It's analogous. My regulating body has created rents for me. I have to collect them on behalf of my investors. I can't turn to my investors and say "sorry, guys. Our return is going to be lower because I'm morally opposed to government rent creation." I'd lose all my investors to competitors and then the only companies left would be those that collect those rents. If government didn't create them, I couldn't collect them. I don't need them because I think I'm good enough at what I do without regulators protecting me from competition. But, the voters want the regulator to create those rents because they don't understand how much it costs them. If I try to explain it to them, they assume I'm lying because the benevolent government told them something different. I wrote a whole second post about that was swallowed up.

But market efficiency also concentrates wealth and presumably makes yield distributions fat tailed,

Not nearly as much as command economies. The temptation of the anointed few in government collecting and redistributing the meager production of the country to steal vast amounts for themselves is too great. My books are packed right now, but the wealth concentration in the Soviet Union compared to the United States was astonishing. The difference between the rich Nomenklatura and the average citizen was greater and that wealth was concentrated in a smaller percentage of the population. Also, it depends on how we calculate wealth. Is power wealth? I believe either Don or Russ wrote an excellent post about that recently. Bill Gates doesn't have the power to confiscate your house. He can only offer you an amount of money for which you will agree to sell him your house. The state has the power to remove you on its terms. I'll take Bill Gates over the State.

so market capitalism can't provide "securities" for most people, even with well meaning financiers diversifying investments.

Anyone wanting absolute certainty (which is what security is) should kill themselves. Once dead, you will no longer be exposed to any uncertainty at all. Nothing else will provide you security, thus faulting capitalism with the lack of it is ridiculous.

I don't have children and I think I'm too old at this point. But, I will probably die working. I have produced more than I will probably consume in my lifetime already. I am entitled to my production. That's not an "entitlement". Even if I had children, I wouldn't want to suck off of them when I get old. That's just me. And, anyway, I will probably work until I die. What I resent is strangers feeling entitled to the product of my labour and I have a posse of lawyers and accountants to prevent them from getting at it.

They've already done it in fact. That's why share prices are falling now. No one knows how much shares are really worth, because we don't know how leveraged the companies are or how much competition such leverage can survive or how much competition statesmen will permit. The real danger now is that highly leveraged companies will survive, because we won't allow younger, less leveraged companies to compete with them.

This wasn't in response to me, but I don't think you know what you're talking about. You're overfocused on leverage. Leverage is fine. Plenty of companies can be highly levered and it's not a problem – even now. The reason stock prices are falling now is because of supply and demand, a falling expected future free cash flow and a higher expected WACC. Since since FCF/WACC is the standard valuation stock valuation model, a decrease in the numerator and an increase in the denominator mean a smaller number (stock price). The volatility in the market results from uncertainty and wild disparities in predicted FCF and WACC. Earnings expectations are FCF issues and financing costs are WACC issues. Also, Hedge Funds are being delevered and selling out their portfolios to either meet redemptions or to meet margin – or both. That puts downward pressure on stocks. To the extent that this surge of supply drives the stock to below whatever some trader's estimated FCF/WACC model spits out, he's a buyer.

Martin Brock October 24, 2008 at 7:49 am

What does their productivity have to do with rents?

Nothing. That boomers have high productivity is significant, because they lower output more when they leave the workforce. For output to remain the same, an equally productive worker must replace each boomer leaving. Older workers typically earn higher wages. Do the higher wages really signal higher productivity?

What rents did the generation before them experience that the boomers now expect?

The simplest answer is "Social Security", but that's only the simplest answer. We all understand the demographic imbalances in the Social Security system, right?

Fan & Fred guaranteed the cash flows of the MBS they sold.

Apparently not. Maybe they said they would.

Fan & Fred also were themselves guaranteed by the government (nobody bought the fiction that they weren't).

Right. So Fan & Fred didn't guarantee anything. The real guarantor was the government.

I suppose most people expected the government guarantee, but this guarantee wasn't a fact in the past. It was a risk; otherwise, mortgage backed securities wouldn't have yielded more than Treasuries.

Without the guarantee, only fools would have bought the MBSs. There are plenty of fools, but not this many.

There are as many bonds as there are fools. That's the point. The supply of bonds grows to meet every demand. The supply is perfectly elastic. If the supply of oil were similarly elastic, we'd never run out of oil, but the supply of oil is not similarly elastic. Neither is the supply of labor.

Our parents saved. The boomers did not.

The boomers are their parents' savings. The boomers didn't really save as much, because they had fewer children. Real saving is the purchase of a real means of production.

1) Raising a child does purchase a real means of production, even if the parent is not entitled to any of the child's produce.

2) Purchasing a Treasury note does not create a real means of production, even if the purchaser is entitled to some taxpayers' produce.

We routinely call 2) "saving", but 2) is not investment. We do not call 1) "saving", but 1) is investment.

Our parents retired to a relatively modest life (well, somebody's parents – mine will die at work), boomers expect to retire to an expensive life of adventure. The definition of a wonderful life has changed and that life is more expensive.

No. Social Security provides no expensive life of adventure, and even the Social Security system doesn't add up for the boomers without additional rents. The additional rents are income taxes "repaying the trust fund".

I don't know what you mean by "savings are promissory notes of dubious value." Typically this is where you start to get all upset about treasuries again and I remind you that treasuries are not the only investment vehicles.

Real estate prices are falling. Corporate share prices are falling. The price of oil and gold are falling. All of these values rose in the past, of course, but I'm not buying in the past. I'm buying now.

Treasury notes are not the only rents. They're the purest, least disputable rents. Other entitlements called "rent" may involve some real means of production. A parcel of land has its own marginal productivity, distinct from a man laboring on the land. Valuable food may grow wild on land even if no man ever plants or harvests it.

In the Ricardian, marginalist theory of market capitalism, I may charge for the use land. The price I may charge is the value of the land's intrinsic productivity, its productivity apart from any labor. This real value is not the "rent" in "rent seeking".

I may also threaten to shoot you if you use any land whatsoever without my consent. If my threat is credible, I may then charge for the land whatever you'll to pay to avoid starvation. This price is not the value of the land. It's the value of my gun. That's the "rent" in "rent seeking".

If treasuries disappeared, there would be plenty of other much higher yielding investment vehicle.

Really? Then why are ten year Treasuries yielding less than four percent now? Who is paying so much for these notes? Why aren't they paying less for the higher yielding vehicles?

Don't say "risk", because that's not an answer. I'm discussing yields discounted for risk. If I expect half of my investments to yield nothing, that the other half yield twice as much as a Treasury doesn't make my yield higher.

Ten year Treasuries haven't been so dear in fifty years. Why are they so costly now? Why not twenty years ago? If you don't address this question, you aren't facing the facts.

Someone will find a much higher yielding investment vehicle, but that's beside the point. The point is that an investor can't expect it.

It's like Peak Oil in the U.S. Someone will find a profitable oil well this year, but we're well over the peak of the Hubbert curve, beyond a rational expectation of profit from searching for wells. Someone will also hit the jackpot in a Vegas slot machine today, but no one can rationally expect to hit it.

Ahem…some of us capitalists are willing to bear the consequences of the risk that we took, thank you very much.

Right. I'll believe you when you're insolvent and refuse to stand in line at the Office of Financial Stability. If you tell me that you don't need a bailout, you aren't really telling me anything.

Buffet is the focus of my anger at the moment …

Steve Forbes celebrated the bailout on NPR yesterday morning. He's still pushing his flat tax too.

But, we're not bailing out capitalism.

We're bailing out capitalists. Isms don't need bailing out, because they're imaginary.

The effect of these offices was obviously the opposite of the intended …

The Office of Financial Stability is obviously Orwellian, but after eight years of the Bushniks, Orwell seems more prescient than ever.

No. But it used to refuse to lend to people who could not pay it back before it could sell these bad loans to a GSE.

Banks preceded the GSEs. Banks made bad loans before the GSEs, but selling loans to the GSEs is not the interesting phenomenon. Buying CDOs from the GSEs is the interesting phenomenon.

The question is: why didn't investors buy something else? You say that higher yielding investments are just waiting out there. Why didn't investors choose those instead? Why do I not hear this dog barking?

I was an avid Sherlockian in my misspent youth, by the way.

They were also competing with Fan & Fred, whose borrowing costs were lower than banks'.

Fan & Fred had lower borrowing costs only because people overpaid for the risk of the securities, sans bailout. In other words, Fan/Fred investors weren't really investing in my children's mortgage payments. They were investing in my children's tax revenue, because my children will pay the taxes first.

There's more to it than that, but you shouldn't underestimate the distortions caused by Fan & Fred.

I don't underestimate the distortions, but FNMA has been around as a "private" corporation since the sixties. Their business is not new.

The GSEs basically replaced the S&Ls when the S&Ls imploded, so the demand existed before the GSEs. The GSEs never bought more than 15% of subprime mortgages, and when the GSEs stopped buying subprime mortgages in 2004, they lost market share, so the demand existed after the GSEs. The demand still exists now.

… the wealth concentration in the Soviet Union compared to the United States was astonishing.

Right. People typically don't get this. "Forcible equality" is a myth. Statesmen always force inequality, regardless of what they say they're doing, even regardless of they think they're doing.

Also, it depends on how we calculate wealth. Is power wealth?

Wealth is power. It's a variety of power.

Bill Gates doesn't have the power to confiscate your house.

He has the power to take it from me. His power isn't precisely the same as Bush's power, but it's still power.

I'll take Bill Gates over the State.

The distinction isn't meaningful. Bill Gates can't offer me anything without the State enforcing his own entitlements. The State enforces my title to my house, and the State enforces Gates' title to assets worth far more, so Gates can have my house and a million more like it if he wants.

I'll take Gates' statutory powers over Bush's statutory powers, with a few provisos, but don't tell me I'm escaping the State. I'm not believing it.

Anyone wanting absolute certainty (which is what security is) should kill themselves.

The real quantity of rent available to us, per capita, and our ability to gain entitlement to the rent, is lower than the quantity available to our parents. We differ from our parents in this regard.

We don't get as much rent as we can buy. We get as much rent as our children will pay, and fewer children, per rent seeker, will pay less rent.

If you and I were the last two people on Earth, we could sell one another reams of promissory notes in our prime, and we'd still starve in our elderly infirmity. And we would sell one another the notes. We woouulld (in Yoda's ominous voice).

In fact, some of the boomers' parents are still alive, still competing with their children for the rents.

Nothing else will provide you security, thus faulting capitalism with the lack of it is ridiculous.

I'm not faulting anything. I'm only saying that free market capitalism can't provide retirement security to people generally as a matter of fact, particularly this generation of people.

Even if I had children, I wouldn't want to suck off of them when I get old.

We like to think so. We also like to pretend that we "earn" our Social Security benefits by paying FICA taxes, but in reality, we support our parents by paying FICA taxes.

We also like to believe that our public education was a gift, but in reality, we pay for it when we pay school taxes. My school taxes are the yield of my education, not the yield of my children's education. My children's education hasn't generated a yield yet. To be a rational investment, this education must pay for itself.

Most of the problem with statutory entitlement is largely a matter of irrational accounting. Identifying my Social Security benefits with my FICA taxes is irrational. Identifying my public education with my parents' school taxes is also irrational.

The word "rational" here involves meaningful ratios, not logical consistency in some ideological system.

You're overfocused on leverage. Leverage is fine.

"Leverage" today isn't the same as leverage two decades ago, because the outlook for growth is different.

Companies aren't borrowing to grow so much now. They're selling secure income streams.

Present borrowing is more like declaring a dividend. Declaring a dividend is the opposite of a growth policy.

Corporate factors pay dividends to shareholders, but they can sell an income stream to anyone, and they can pocket much of the revenue from the sale. What would you do?

The reason stock prices are falling now is because of supply and demand, …

That's always true.

… a falling expected future free cash flow …

The expected cash flow to shareholders is falling. That's right. Genuine leverage should increase expected cash flow to shareholders by enabling more growth than reinvested earnings alone, but recent borrowing has a different purpose and a different effect. That's why I write "leverage" with quotation marks.

Since since FCF/WACC is the standard valuation stock valuation model, a decrease in the numerator and an increase in the denominator mean a smaller number (stock price).

You've lost me here, but I'm not believing that the current fall in share prices is like the '87 fall. The next twenty years are very unlike the last twenty years, and lots of people understand the difference.

In the 80s and 90s, the labor force grew rapidly, and the ratio of retirees to workers was stable. In the next two decades, the labor force grows much more slowly, and the ratio of retirees to workers doubles. Don't tell me this difference is not significant.

That we aren't much discussing the difference only persuades me more strongly that the difference is highly relevant. I see signs of denial, not irrelevance. New highs in share indices, much higher highs, followed soon after the '87 correction. I don't expect the same pattern now.

It's about supply and demand, but investors demanded growth over income in the eighties. Investors now increasingly demand income, and they don't expect it from corporate dividends. There's a reason for that. Bondholders are paid first. So are preferred shareholders. Then there's the tax man. He's paid before everyone.

Should you buy shares now? I suppose so. Will the S&P 500 reach 2000 in the next decade? I doubt it.

Martin Brock October 24, 2008 at 9:16 am

If people between 20 and 64 are "workers" and people over 64 are "retirees", the U.S. population of workers between 1970 and 2000 grew 56% while the population of retirees grew 74%.

Between 2000 and 2030, the Census Bureau projects the U.S. population of workers to grow 18% while the population of retirees grows 104%.

The growth rate of the working age population in the future is a third of the rate in that past, so if we retire at 65, productivity growth must triple just to maintain past economic growth.

If the growing population of retirees continues consuming like the current population, productivity growth must more than triple to maintain the current consumption of workers.

Will productivity growth triple? I doubt it. Does China solve this problem? No. After decades of a one child policy, China's population now ages even faster, although China still has a decade or more with a much higher ratio of workers to retirees.

These numbers are cast in stone now. We can't go back in time and have more children.

Here's the thesis, again.

We can't grow in coming decades as we grew in previous decades, because we haven't invested in the real means of production required for this growth, i.e. we haven't raised enough children.

Since we can't grow so much in the future, we aren't leveraging corporate earnings to finance this grow, but we're selling corporate paper regardless.

We're selling entitlement to corporate revenue instead of declaring dividends, because capitalists prefer bonds to shares and because corporate factors can pocket revenue from the sale of bonds.

Common shareholders lose, but they're irrelevant, because they're neither officers of the corporations nor board members.

Officers game the bond sale revenue to create short-term profits and reward themselves with bonuses and options. Board members authorize the bond sales, so they're first in line to buy the bonds. Later, they're first in line to sell the shares.

It's a win-win proposition, if you're a corporate officer or a board member; otherwise, you don't matter.

Tell me that's not happening. Hell, I'd do it. Wouldn't you?

More to the point, I've personally seen it happening.

Sam Grove October 24, 2008 at 12:42 pm

Well, we can't know what the future will actually bring, so all we can do is project trends.

Muirgeo's support for universal health care is one approach…when people get too old to produce, you ration the care available to them. Perhaps severely.

Methinks, are you following Martin here?

If I may simplify.

Projecting from current trends, the expected returns from investment in retirement will not be there because there won't be enough people producing them.

All this trading of paper boils down to this elemental: production precedes consumption.

Papers of entitlement, like dollars, aren't absolute, they are proportional.

The question for the future is: How many will be producing and how much will they produce?

People often stop producing when they reach retirement, they don't stop consuming till they are dead.

Martin Brock October 24, 2008 at 2:04 pm

That's basically what I'm saying. I'm not a Cassandra. I don't think we're all about to starve. I just don't think we're all about to retire as soon as we think we are. That's not really a bad thing.

On the other hand, I do worry about the pressure of rents on people still working. We do want to retire, and we do expect more retirement than we can have without more confiscatory rents.

Medicare in its current form is unsustainable and will blow up soon without reform. The solution to this problem isn't difficult. Old people don't get so many pacemakers, bypass operations and the like. Maybe they die earlier … maybe. I'm not sure they do. I'm very skeptical of the efficacy of much modern medicine. If people die a bit earlier, how much of a loss is that really? We already live much longer than the most regal nobility a couple of centuries ago.

Social Security pensions (the Old Age and Survivors Insurance program) probably is sustainable without substantial reform, although I want it reformed anyway because it's terribly regressive and inequitable. It does demand more tax revenue though, and we'll likely draw this revenue from the supply side. A progressive consumption tax for this purpose makes more sense.

The less obvious rents are more worrisome, because I just don't know how burdensome they are. The Social Security Administration publishes these reports every year, so I have some idea of what this system promises, but I little idea what corporatists have promised themselves otherwise.

Methinks October 24, 2008 at 2:20 pm

Methinks, are you following Martin here?

Sort of. I take issue with some of these assertions.

Projecting from current trends, the expected returns from investment in retirement will not be there because there won't be enough people producing them.

This assumes no increase in productivity. It assumes that workers can't be replaced by machines and it assumes that only Americans are needed to produce, doesn't it? We can import labour and the world's population is not declining. Expected return from which investments. Certainly neither the stock market nor the fixed income markets are focused on a lack of people. And the entire distinction on growth vs. dividends is false. Dividends are paid from free cash flow. Free cash flow is what is discounted to determine stock price.

All this trading of paper boils down to this elemental: production precedes consumption.

What trading of paper specifically? Martin doesn't have a very good grasp of finance and he is often singularly focused on treasuries. So, I'm wary of talking about trading "paper" until I know what that means. Do you know what he's talking about?

Papers of entitlement, like dollars, aren't absolute, they are proportional.

What papers of entitlement? Corporate bonds pay bondholders out of corporate revenue (it's a pretax item). Shareholders have a residual claim on the company and its earnings. Investors and creditors are entitled to these cash flows because they lent money or bought stock.

The question for the future is: How many will be producing and how much will they produce?

That's the question for social security, no? It certainly isn't the question for private business.

People often stop producing when they reach retirement, they don't stop consuming till they are dead.

If we aren't having as many children (and I see no practical remedy for this), then we'd better save more of those consumption credits for future consumption.

Do I understand your arguments correctly? I'm still not sure I do.

Sam Grove October 24, 2008 at 3:14 pm

This assumes no increase in productivity. It assumes that workers can't be replaced by machines and it assumes that only Americans are needed to produce, doesn't it?

Yes, no assumptions other than projections from trends. It also makes no assumption about the impact of increasing political meddling in the market on future gains.

I don't even mention the Kurtzweil singularity.

We can import labour and the world's population is not declining.

We have been importing labor. This explains why illegal immigration has been more or less tolerated. Who will make the argument for more legal immigration?
And will people want to come here if they face high levels of taxation and a high cost of living?

What papers of entitlement?

Any and all recorded agreements regarding claims on returns from future production.

"The question for the future is: How many will be producing and how much will they produce?"

That's the question for social security, no? It certainly isn't the question for private business.

It's a question for everyone.

The non-productive can only be supported by the productive via production in excess of their own cost of living.

In that a business is an endeavor of the productive, then it is a question for private business.

If we aren't having as many children (and I see no practical remedy for this), then we'd better save more of those consumption credits for future consumption.

Credits against future production.

There are a number of trends here, including:

Economic regulation
Government spending
Diversion of would-be producers into non-productive activities (ie, the war on drugs, bureaucracy, etc.)
productivity gains
demographic trends
educational product
etc.

Part of the reason this so-called "crisis" is worrisome is that the chosen ones in D.C., and their supporters, seem to think there is no limit to their ability to effect desired outcomes with guns and printing presses. Rather than look in the mirror, they have decided to blame "the market".

You should be more than mad, you should be worried. The value of credits on future consumption depends entirely on future production.

Production precedes consumption.

maximus October 24, 2008 at 3:37 pm

"I suppose most people expected the government guarantee, but this guarantee wasn't a fact in the past. It was a risk; otherwise, mortgage backed securities wouldn't have yielded more than Treasuries"

Martin-

This isn't quite correct. It's a technical point but the spread between agencies and treasuries was mostly due to the partial tax exemption of treasuries and the short call provision on the agencies, (vs. non-callable treasuries). The agencies usually were callable within a year and they rarely weren't called away. I stopped using them in portfolios for this reason, even though they looked like a great buy. Furthermore,it was implied that the Government wouldn't let the agencies debt fail and most traders new this. Therefore there was very little risk premium in the price of the agencies.

Martin Brock October 24, 2008 at 3:45 pm

This assumes no increase in productivity.

No. It only assumes that the rate of productivity growth in the first three decades of this century will be less than triple what it was in the last three decades of the last century, because we already know that the working age population will grow one third as fast.

I don't assume no productivity growth. I assume less than a three-fold increase in the rate of productivity growth. If we have the same rate of productivity growth, GDP growth will be a third of what it was, because working population growth will be a third. That's already in the cards, and we can't do a thing about it.

It assumes that workers can't be replaced by machines …

We already know that machines don't simply replace workers. No IT/automation professional will tell you so. Machines increase the productivity of workers but don't replace them.

Boomers are already more productive than any workers in human history, and they'll soon leave the workforce in droves. As they leave, they'll take even more output with them than they would have taken without the productivity enhancement.

… and it assumes that only Americans are needed to produce, doesn't it?

No. China's population ages even more rapidly than ours.

Europe's population has already aged more than ours will age in the next decade. The U.K. is now where we'll be in ten years.

Russia's population reportedly shrank recently.

So did Japan's. Japan has already been down the demographic road we're approaching, and it's already had a decade-long period of slow or no growth. This theory has already been tested, although Japan has other resource constraints that we don't have.

We can import labour and the world's population is not declining.

The U.S. population is not declining either. It's aging. The problem is the aging, not an absolute decline; however, serious demographers even predict a peak in world population by mid-century. That's only forty years away. I'm older than that myself, and with luck, I'll still be alive then.

Certainly neither the stock market nor the fixed income markets are focused on a lack of people.

Yes, they are. Many people are aware of this issue, whether we're discussing it or not.

And the entire distinction on growth vs. dividends is false.

No, it isn't. A corporation declares a dividend when it can't effectively reinvest its own earnings.

Dividends are paid from free cash flow. Free cash flow is what is discounted to determine stock price.

When a company sells a bond, it pledges its revenue to bondholders. The principal and interest payments are costs and lower expected earnings unless capital investment financed from the bond sale grows earnings enough to replace the bond payments and then some.

If the company grows sufficiently, we can meaningfully call the debt "leverage"; otherwise, "leverage" is more like a political slogan, only cover for selling entitlement to corporate revenue.

So what do companies buy with the proceeds of a bond sale when the rate of workforce growth falls seventy percent? Machines that operate themselves?

No. Machines don't operate themselves. Technology can increase productivity, sometimes, but the higher productivity often requires more highly skilled labor along with the machinery. The complexity of modern technology is not simply in the machinery. It's in the heads of the operators. You know this from your own experience. I certainly do. I learn new technology for a living, every single day.

What trading of paper specifically? Martin doesn't have a very good grasp of finance and he is often singularly focused on treasuries.

No. Again, Treasuries are only a standard example. They're the purest rents, because they're pure entitlement to tax revenue, and they're standard measures of risk aversion, because they don't default. I focus on them for these reasons.

So, I'm wary of talking about trading "paper" until I know what that means.

Again, I worked for a company only a few years ago that sold a billion dollar bond to finance its own purchase by an investment bank.

The company was privately held. Essentially, the owner (another company) agreed with the investment bank that the company was worth a billion dollars.

Then the owner instructed the company to sell a billion dollar bond to the investment bank.

Then the company gave the billion dollars to the owner, essentially as a dividend, whereupon the company was worthless, i.e. it's net worth went from a billion dollars to zero.

Then the owner essentially gave the company to the investment bank as a gift. The company owes what would have been its earnings without the bond sale to the investment bank.

That's not a hypothetical. It happened. I witnessed it myself.

So what sort of paper am I discussing? Precisely that sort of paper. Is this example clear enough?

Corporate bonds pay bondholders out of corporate revenue (it's a pretax item).

More to the point, it's a pre-earnings item.

That's the question for social security, no? It certainly isn't the question for private business.

Of course, it is. The Social Security problem is demographic. The same demographic imbalance has profound consequences for private business as well. How do businesses grow output as rapidly when the workforce grows only a third as rapidly?

Investors and creditors are entitled to these cash flows because they lent money or bought stock.

Bondholders are paid first in bankruptcy, and companies can't elect to cut principal and interest payments as they can elect to cut dividends, so if I want income, I'd rather be a bondholder than a shareholder.

If we aren't having as many children (and I see no practical remedy for this), then we'd better save more of those consumption credits for future consumption.

Simply saving consumption credits doesn't produce anything for us to consume. That's what children do. Money has no hands.

Martin Brock October 24, 2008 at 3:52 pm

… the spread between agencies and treasuries was mostly due to the partial tax exemption of treasuries and the short call provision on the agencies …

I'll buy that. I don't know the fine points of these securities. I suppose the spread included some risk premium, however small, but I don't know how large it was.

Sam Grove October 24, 2008 at 4:17 pm

Methinks,

You might try viewing the situation without all your financial knowledge.

The physical reality is that all consumers, everyone, can only consume the product of producers.

Finance is about how consumers gain the right to consume what is produced by producers.

Practical knowledge informs us that you can't consume what has not been produced.

An entitlement to a piece of the pie is not a guarantee of how big a piece you get.

The pie may get bigger, but if the number of non-producing consumers increases more than the growth of the pie, then your claims to pie will be competing with other claims thereby raising the price of the pie.

Unfortunately, political entitlements have given a lot of people impression that consumption is a right rather than something that is earned.

The AARP is one of the most powerful political interests in the country. Consider how retired people will react to calls to shrink their portion of pie.

Martin Brock October 24, 2008 at 5:07 pm

Finance is about how consumers gain the right to consume what is produced by producers.

Right. Well put.

Consider how retired people will react to calls to shrink their portion of pie.

Retirees have always been disproportionately influential in elections. They're heavily dependent on rents, and they have lots of free time on their hands. Today, they're around 17% of the voting population. In twenty years, they'll be around 27%.

Also, more retirees will have no children, so they won't care so much about the pressure their rents place on the generation behind them. Parents will have accumulated less entitlement to rent, so they'll be correspondingly less influential and even more dependent on the rents they do have. That'll piss off some childless people, but it's just a biological reality.

Methinks October 24, 2008 at 6:52 pm

Sam (Martin, I'm not ignoring you, but I don't have time to unravel all you're trying to say),

What you (and Martin) are basically doing is predicting economic contraction based on the fact that this country and other developed countries have low birth rates. No?

I don't think it's that simple because other countries have very high birth rates and those countries' populations are very young as a result. You don't actually have to physically import the labour to this country to take advantage of their production. You can invest your saved up consumption credits in them. There are no laws preventing you from investing in foreign companies and plenty of American companies have exposure to international labour markets and international consumer markets – as long as trade is not further constrained.

Since only American labour is taxed for the purposes of Social Security, this won't add to the social security "pie". Either those benefits will have to be cut or taxes will be raised, further disincentivizing work for younger generations.

I think we know how old people will react to a cut in their entitlements to the production of their children and grandchildren and the results of this reaction will be a drag on the U.S. economy.

So, I don't think you can lump social security entitlements with investment income. Investment is more flexible.

Martin Brock October 24, 2008 at 6:53 pm

Clarification: Retirees are around 17% of the voting age population and will become 27% in the next twenty years. They also vote disproportionately, so they'll likely become even more than 27% of the electorate, and they'll be heavily dependent on rents.

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