Monday, March 9, 2009

The Death of Capitalism

It is often hard to precisely date a transition from one era to another. In a previous post, I argue that the current crisis stems from the LTCM crisis in 1998 and the moral hazard and low interest rate that followed, but that is certainly up for argument.

These days, one often hears the refrain that capitalism in the US is dying. But in fact, America left free market capitalism way back in 1913.

The year 1913 is best known in the US as the year Woodrow Wilson became President. Woodrow Wilson, of course, was the US's first "modern liberal" President. Two other events, which the Progressives from both parties had been working on for years, finally occurred in 1913 that marked the end of American capitalism: the income tax and the Federal Reserve.

The Sixteenth American, giving Congress the "power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration" was ratified by the required number of states in 1913. As promised, the income tax at first affected very few people. From 1913 to 1915, most people paid no income tax, and the top income tax rate was a low 7% on incomes above $500,000 (a huge sum in those days). But then came World War I and the top tax rate jumped tenfold to 73%. The top tax rate would eventually fall back to 24% under President Coolidge, but the government had proven that it can and will increase taxes significantly if it "needs" to. Under FDR, the top tax rate would hit a whopping 94% and even the lowest rate was at 23%, about as high as the top tax rate under Coolidge.

The second act, which Progressives had been working on for years, was the Federal Reserve System, which was enacted by the Federal Reserve Act of 1913. Like the income tax, this act appeared to have little significance at first. The purpose of a Federal Reserve was to provide an "elastic currency," which would in theory help prevent panics like that of 1907. The obvious initial problem with the Federal Reserve System is incompetence. With such a system, we rely on the Federal Reserve member to decide when and by how much to expand or contract the money supply. Herein lies the fatal conceit that government agents can know what market participants do not know. Market participants take their cues from price signals to determine supply and demand (in the case of money, they look to interest rates). In order to be more effective than the market system, government agents must have some other vast source of knowledge to replace price signals. History and logic prove that they do not.

While the Federal Reserve System is certainly a statist system, it was initially constricted by the gold standard. The Federal Reserve could expand and contract money supply in the short term, but the long term money supply was determined by the amount of gold in the system As long as we had the gold standard, the Fed was limited in its inflationary abilities. The gold standard stayed around much longer than low income taxes. While England and most other countries left the gold standard in World War I, the US managed to maintain it until 1933, when gold coins were confiscated and the conversion rate was changed from $20.67 per ounce of gold to $35 per ounce. This standard, more or less, was maintained until 1971 when the US left the gold standard once and for all.

Not surprisingly, if one looks at the long term trend of inflation in the US, one sees a big spike during WWI, when Britain left the gold standard and the world's gold came into the US, another increase in inflation starting in 1933 and through WWII, when the US changed the dollar to gold ratio and made gold coin ownership illegal, and after 1971 when the US permanently left the gold standard.

These two acts spelled the death of the United States' long history as a capitalist country. With the income tax, and more so with income tax withholding, a person's income no long belonged to himself. Yes, the government is kind enough to let us keep 70% of our income. If you believe your income belong to you and you give the government a share, try not paying your taxes. Furthermore, the government can raise taxes to extreme levels (94% under FDR) and even do so retroactively (under Clinton). When the government can take as much of your future or even past income with threat of garnished wages and imprisonment, obviously your income no longer belongs to you.

While the income tax takes away your income, Federal Reserve induced inflation takes away your wealth. Since the creation of the Fed, the value of a dollar has declined to 5 cents. Of course, we all expect inflation and it is built into bond rates and expected returns for stocks. In "normal" times, the constant 2-3% rate of inflation is discounted and does not affect the value of our assets. But not all times are normal. In the late 70s and early 80s, inflation shot up to double digit rates. The government can easily run the printing press, pushing inflation higher to devalue US government debt, either on purpose or through incompetence. Now, anybody who has US dollar denominated assets, such as Treasury bonds, US bank or money market accounts, or US equities, will see their net worth shrink dramatically.

Starting in 1913, the government has the power to take away your US dollar denominated wealth through inflation and to take away your income through income taxes. All of a sudden, the US government, not the American citizen, became the economic judge, jury, and executioner. As a result, 1913 goes down in history as the year capitalism died in the United States.

BTW, 1913 also marked the death of states rights with the ratification of the Seventeenth Amendment, transferring Senator selection from each state's legislature to popular election by the people of each state. Prior to 1913, the state legislatures chose Senators, giving the states a powerful check on the federal government. But after 1913, with direct election of Senators, the Senate became little different than the House of Representatives and Senators became more interested in "national" legislation and no longer had to follow the advice of the state legislature to get re-elected. As U.S. Senator Zell Miller of Georgia said: "Direct elections of Senators … allowed Washington’s special interests to call the shots, whether it is filling judicial vacancies, passing laws, or issuing regulations." In 1913, the states lost their last check on federal power and the federalist system officially died.