St. Januarius' blood

[CrackSmokeRepublican]

St. Januarius' blood

    * by Martin Hutchinson
    * January 04, 2010

It being January, I am drawn irresistibly to the British Prime Minister Benjamin Disraeli's only significant contribution to monetary policy thought, his comparison of a particular step to the supposed Naples miracle of the liquefaction of St. Januarius' blood. His comparison, far-fetched though it seems, was instructive and it's well worth considering whether there are any equivalent steps that could be taken today.

In a House of Commons speech on August 30, 1848, Disraeli said: "Just at the moment when unutterable gloom overspreads the population, when nothing but despair and consternation prevail, the Chancellor of the Exchequer – I beg pardon, the Archbishop of Tarento – announces the liquefaction of the blood of St. Januarius, as the Chancellor of the Exchequer announced that a wholesome state of the currency had returned: the people resume their gaiety and cheerfulness; the panic and the pressure disappear; everybody returns to music and macaroni as in London everybody returned to business, and in both cases the remedy is equally efficacious, and equally a hoax."

The policy that spurred this rhetorical flourish was that splendid 19th century trick by which the authorities staved off liquidity crises: suspension of the 1844 Bank Charter Act. That Act had modified the rigors of a pure Gold Standard by allowing the Bank of England to issue bank notes, but had limited the issue to a maximum of 14 million pounds. Suspension of the Act allowed the Bank to issue more notes; however, on the occasion concerned, the Bank had not needed to do so as its ability to issue more notes had itself been sufficient to quiet the markets and relieve the crisis. Thus a policy that had no tangible economic effect – that indeed led to no tangible economic action – had nevertheless resolved the crisis and produced beneficial results. Hence Disraeli's comparison to the supposed miracle by which St. Januarius' blood was liquefied.

The profile of a policy that resembles the famous liquefaction is thus established. It must be a policy of minimal direct economic effect, which yet changes market expectations to such a degree that a substantial objective is achieved. The 1844 Bank Charter Act was in this respect a clever mechanism; it provided a cap on note issuance in normal times, thus preventing the money supply from indefinitely expanding and causing inflation, while at the same time allowing a safety valve to be opened in times of genuine crisis (to use a steam-age analogy that its drafters would have understood). Whether the existence of the safety valve had pernicious long term effects can be argued – certainly the British banking system became more prone to bailouts over the century, as was to be demonstrated in 1890 – but the policy lasted 70 years from 1844 before World War I destroyed it, in itself not bad going.

The Christmas Eve decision by the U.S. Treasury to extend unlimited support to Fannie Mae and Freddie Mac was such a policy, albeit one pointed in a pernicious direction. In reality, it makes very little difference; Fannie and Freddie have such massive political support that no kind of devastation in their home mortgage operations would cause the Obama administration to abandon them. However, the unlimited support line from the Treasury allows them to extend their pernicious operations aggressively, thus diverting yet more U.S. capital into the wasteful housing sector, and increasing the contingent liability on taxpayers still further.

Come the November midterm elections, the Democrats will be able to claim that house prices have recovered substantially on their watch. However, a market that is propped up artificially in this way has a tendency to extract its revenge by requiring still larger and larger subsidies in order to avoid collapsing to its true equilibrium level, perhaps still 15% below current levels. Thus the cost to taxpayers, homeowners who buy houses in 2010 and the U.S. economy in general from this particular "miracle" of Treasury sleight of hand will be substantial.

Turning in the opposite direction, to an action of no direct economic consequence that could cause a genuinely useful miracle, we can consider the effect of a modest increase in the federal funds target rate, perhaps to a trading range of 0.25% to 0.50% from its current 0% to 0.25%.

This would have no immediate economic effect. With inflation already running at 2% to 3% and heading higher, short-term rates would remain heavily negative, so monetary policy would remain hugely "stimulative" as Ben Bernanke and the political class wants it.

However, such a move would have a considerable effect on commodity and energy markets. Currently, the main near-term threat to continuing economic recovery arises from these markets, in which prices are continuing to rise and may at some point get to levels that threaten recovery, by draining purchasing power out of commodity-using Western economies and/or produce a confidence-sapping acceleration of inflation.

With interest rates near zero, speculation by hedge funds and other money pools on commodity price rises appears a risk-free proposition, as such speculation can be financed at negative real interest rates.  Only when it seems likely that interest rates will rise to positive real levels will speculators back off the commodity markets. A ¼% rise in the Fed's target range would create doubt in the mind of commodity investors, thereby slowing the inexorable rise in commodity prices and delaying the moment at which policymakers have to get serious about incipient inflation.

Such a rise is a perfect "St Januarius' blood" move therefore. It has no significant direct economic effect, but is nevertheless highly efficacious in achieving policymakers' goals. But even with this incentive, I doubt that Bernanke will do it.

Another way in which policymakers can have a "St. Januarius' blood" effect is by ostentatiously choosing an economically sensible policy that blocks the possibility of economically foolish ones. France is doing this currently with its carbon tax. While the version of the tax that is currently being debated has too many loopholes, a carbon tax at a moderate rate has two beneficial effects: it helps to reduce the budget deficit, which in France as in many other countries has grown dangerously large, and it staves off the possibility of the bureaucracy-creating economy-destroying monstrosity of a cap and trade system of emission controls such as proposed by the U.S. Waxman-Markey bill. Any time the private sector can be left to make its own adjustments, with the addition of a moderate tax that steers it in the politically preferred direction, a huge bullet has been dodged in the economy-sapping additional costs that are normally imposed by state control.

The United States could have a similar benign effect by agreeing to raise the eligibility age for Social Security and Medicare entitlement by one month each year from 2026, the year in which the Social Security retirement age reaches 67. Such a change would have no direct economic effect at all for the next 16 years but it would at a stroke eliminate the long-term deficit in the Social Security system and greatly reduce that in the Medicare system.

Further reductions in the Medicare system's deficit certainly require a year or two to allow the whole health-care question to be depoliticized after 2009's battles. Then, some cost-saving measures such as limiting damage awards for medical malpractice are themselves highly political.

However, there is one counterintuitive measure that could be taken which would hugely reduce costs in the system overall even though at first sight it would increase federal funding for health care. That would be for the federal government to fund properly the mandate it imposed on hospitals in 1986 to treat indigent patients in emergency rooms, without regard to their ability to pay. If the federal government reimbursed the costs of this mandate, hospitals would no longer have to load the losses onto the charges for insurance-covered patients or the even higher charges on individuals, nor would they have to employ a large staff chasing deadbeats. Since the unfunded cost of emergency room treatment is estimated at $80 billion annually, transferring that burden to government would save two or three times that amount from the costs to insurance companies and individuals of medical treatment, probably saving 1% of GDP from health-care costs by that reform alone.

Few are aware of this unfunded mandate imposed on hospitals, which appears to be of no political salience. Moreover, its correction would be close to budget-neutral if costed properly, because the federal government already pays medical costs for such a high proportion of the populace. However, its economic effect would be large and benign. It thus qualifies as a "St. Januarius' blood" policy. It is also ethically correct; the government should not be imposing quasi-charitable mandates on businesses without paying for them.

Policies that are "equally efficacious, and equally a hoax" are the ones policymakers should be looking for. They are easy to impose, because they appear to have few wider implications, economic or political. Yet their real-world effect is substantial. Of course as in the case of housing finance, it helps if politicians don't pick the worst such policies, which lead in an economically damaging direction. But nevertheless they remain very useful tools when you can find them.

The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com

Views are as of January 4, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

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