The Importance of Economic Discipline

There was an interesting article inside the Wall Street Journal Thursday morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises”) In the article, a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”

During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.

Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times.)

The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.

Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.

Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.

Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff.)

Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See this article for more.) (Also see this op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy.”) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.

The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.

Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.

Second, size becomes all important. Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail.”

Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.

In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.

But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Superfreakonomics”) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.

In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.

Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately.

Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!

Comments

[Michael Clark:]

Wonderful article. We have treated the word and concept 'discipline' with disdain for decades in America. It is as though saying 'no' to oneself was a sign of backward thinking, that pleasure and self-indulgence was the true meaning of life in the 'modern' world. Also, discipline was associated with religion and militarism, I think. So self-indulgence became and assumed 'virtue' since religion and militarism were 'evil'. Saying 'yes' to yourself was supposed to bring happiness and joy and satisfaction.

Look where we are now, one of the most self-indulgent cultures since...France in the nineteenth century. (A bit of a joke.)

It's time to say 'no' to ourself. It's time to view discipline as a strengthening of our inner nature. The debt culture never said 'no' to itself. It followed the Madison Avenue logic: 'Why, because you deserve it!" So go out and buy anything you want, no matter what, no matter if it costs too much, not matter if you can't afford it. Have that big piece of chocolate cake. Why, because you deserve it. Also: Why, because we are making a killing selling your overpriced chocolate cakes.

Americans need to respond to the current crisis by helping to deflate prices: stop borrowing money; stop buying things you don't need. Say no to the government-inspired self-indulgence, to the government-inspired inflation of the undisciplined consumer (and consumptive) mania.

Nov 12 11:35 AM

[Leftfield:]

The undisciplined approach has spawned such influence in the US that we presently appear incapable of making sound policy decisions. Political influence and payoffs trump everything. Constitutional principle is an antiquated joke to most. Argentina appears to be our future. That country was once economically on a par with the Europe and the US, before WWII but could never free itself from bad, shortsighted, politically expedient, lowest-common-denominator decisionmaking.
Inflation is dishonest. This lying and deceit takes on greater and greater influence by enabling the lies of government promises and influence-peddling to drive out value-added sustainable production and jobs. This is like an addiction, and the US is now taking one more, huge, destructive fix.

Nov 12 12:04 PM

[user396040:]

Hyperinflation creates all sorts of problems - I was in Brazil in the 1980's and stayed at a hotel where the rates rose every day; incidentally, the hyperinflation was occuring under a military dictatorship that imposed "discipline" in some very brutal ways but did not seem to have a handle on monetary policy. Obviously, hyperinflation is a disaster which leads to all kinds of inefficiencies. A more difficult issue is the debate between the implicit policy of low and controlled inflation we have had since 1940 and a policy of no net inflation long term which we seemed to have under the gold standard. Between 1800 and 1940, it appears that prices remained stable on a net long term basis although there were wild swings between inflation and deflation over the 140 year period and the deflationary times were characterized by enormous economic hardship. Since 1940, we have tried to avoid deflation at all costs and the result is net long term inflation so that prices now are roughly 10 times higher than they were in 1940. We have avoided hyperinflation, although we got close in the late 1970s and early 1980s - the Fed was able to bring inflation under control by raising interest rates. So it appears that with some use of intelligent monetary policy we can have low inflation without hyperinflation but the price may be periodic recessions brought about by higher interest rates. Anyhow, I am not convinced that the pre-1940 world was better nor that the current policy leads inevitably to hyperinflation. This is a complex issue that cannot be resolved by generalizations like "inflation is bad", "discipline is good," "we must have a strong dollar," etc.

Nov 12 01:51 PM

[Dave Wrixon:]

All a bit academic really. There is not even a fundamental acknowledgment that there is a problem.

Nov 12 02:28 PM

[Marcus Aure...:]

Very interesting article.

Most discussions of inflation center on the destruction of stored wealth and its effects on those trying to save. Most such articles proceed to discuss activity centered on protecting one's existing wealth against the ravages of inflation. Not too long ago I saw someone discussing one of the major stock indices how it was doing real good in absolute terms -- but vs. against another measure (IIRC gold price in any event I took it as a measure of real value instead of dollar value) that index did not look so hot anymore.

A buddy of mine frequently rages against speculative financiers. I keep hearing him talk about a fellow who performed a massive shorting operation and won big time. My buddy then complains about how the money was "non-productive" and should be taxed at a higher rate. I don't view such exercises as completely without merit -- there is a very important message others need to heed in such transactions. More importantly as John points out, inflationary policies serve to motivate such operations.

I've never really understood the reason why governments absolutely hate deflation of any sort. The reason is becoming more and more clear.

Nov 12 04:53 PM

[Bill S. Friend:]

In Brazils case, huge fertile lands that have never seen a plow along with a moderate climate lends itself well to prosperity. Brazil is also rich in natural resources, a boon in this current commodity favored atomosphere. Perhaps the people wresting control away from years of corrupt governmental regimes, should provide an example for Americans who suffer at the hands of a pretentious, ignorant congress who has long since lost sight of the framework formed by our founding fathers known as The Constitution of the United States of America.

Nov 12 11:00 PM

[Joe Siegel:]

Right out of the Austrian School of Economics. Simple and ever so prescient.
check out libertythruknowledge.com

Nov 13 12:10 AM

[surfgeezer:]

Both countries are huge exporters of commodities, and that by default creates large influx's of cash and thus inflation.


Quote:" Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading.

What Brazil finally did and Argentina hasn't is control the oligarchy that was receiving that cash and begin building their countries infrastructure. By investing in the building blocks of manufacturing and "value added" jobs they now have a diversified economy and a growing middle class. As you state a strong depoliticalized central bank willing to painfully raise rates and, as they recently showed, a willingness to discourage/tax "hot money" for the greater good. We unfortunately are stuck in oligarch funded media debates over the "constitutionality" of "income redistribution" or even a central bank legality.

Nov 13 12:56 AM

[olddoc74:]

An excellent article, John, as always. Some of us would like to see you in office, guiding this wayward nation. Unfortunately, most of the legislature would have to be replaced before an honest man could effect the nevessary restorative measures.

Nov 13 10:08 AM

[auto44:]

Well said.

Nov 14 12:39 AM