OPEC Cries Uncle; Failed In Its Bid To Eliminate U.S. Shale Following a Flawed Economic Theory

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12 MIN READ - From the Cautious Optimism Correspondent For Economic Affairs and other Egghead Stuff

Throughout late 2017 and early 2018 OPEC has enacted enormous production cuts in a Saudi-led bid to raise oil prices from the 2016-nadir of $26 per barrel. The production cuts are a reversal of OPEC’s multi-year price war where the cartel pumped at near-full capacity despite plunging oil prices.

               

But the reversal towards production cuts marks an abandonment of their previous strategy to put the newly conceived U.S. shale oil industry out of business and return the global market to OPEC dominance. Since U.S. shale is producing at record levels today even as OPEC tries to raise prices, the strategy has clearly failed and OPEC has effectively cried uncle. Why did OPEC think they could knock out their new competitor and why didn’t the plot succeed?

LEADING UP TO THE PRICE WAR

Early this decade U.S. shale oil producers were for the first time able to pump oil profitably at market prices that hovered between $80 and $100 per barrel. Spurred on by new hydraulic fracturing technologies and production techniques, oil and natural gas production boomed in areas like the North Dakota Bakken and South Texas Eagle Ford formations. After decades of steady declines, American oil production began to rise rapidly early in the 2011-2014 period.

OPEC, whose cartel of nationalized oil companies has enjoyed control of a large share of world oil production capacity, saw U.S. shale oil production as a new threat to not only their dominance, but the ability to partially control world prices through coordinated production increases and cuts among its members. True, some OPEC members “cheated” from time to time and continued to secretly pump oil despite agreements not to, and the result was OPEC was often not able to place world oil prices exactly where it wanted, but the appearance of a new and very large non-OPEC producing nation would greatly undermine OPEC’s long-standing leverage. Cartel leaders, particularly Saudi Arabia, correctly identified U.S. shale as a threat and plotted to eliminate it through a price war.

As shale oil poured out of the USA, the ballooning supplies pushed oil prices below the long-standing $80 floor in late 2014. Once oil prices fell below shale breakeven points, U.S. shale producers predictably cut back on now unprofitable projects. But OPEC continued to pump at full capacity since, after all, its conventional oil production costs were lower. However the real objective this time was to drive prices so low that the entire U.S. shale industry was bankrupted and wiped off the map.

A little-reported complication for OPEC is that despite lower production costs on conventional Middle Eastern oil, OPEC member governments are heavily reliant on revenues from their national oil companies to finance their fiscal budgets and operations. Saudi Arabia for example is estimated to have a breakeven production price of only $12, but it spends more than $50 of each barrel’s revenue to fund government programs (the exact numbers are a secret but experts believe these estimates are close). So as OPEC’s refusal to cut production drove oil prices down further and further, many member countries actually began to lose money as their government expenditures outstripped per-barrel revenues.

Over the 2005-2014 decade as oil prices usually hovered well over $80 Saudi Arabia and other OPEC members were able to produce profitably, fund their government operations, and still enjoy profits that were diverted into burgeoning reserve funds. But in 2015-2017, even as oil prices fell to $50, then $40, and even $30 they planned to tap into those reserves and wait out the price war until competition from U.S. shale was bankrupt—driven out of business by losses. Then, according to the plan, OPEC would recapture its traditionally dominant market share, cut production, raise prices back to $80-$100 or higher, and enjoy enormous profits that replenished their diminished reserve funds.

This is the classic strategy of so-called “predatory pricing” which dominates mainstream economic thinking in the monopoly and antitrust field. Drive prices down to the point of losses, outlast your competition with your war chest of reserves that allows you to better withstand those losses, and then when no competitors remain establish a monopoly that allows you to jack up prices, replenish your war chest, and go on to enjoy bonanza profits that gouge the consumer forever.

Yet the strategy failed and after three years Saudi Arabia and OPEC threw in the towel. Why?

THE PREDATORY PRICING FALLACY

The theory of predatory pricing has been with us since the late 19th century when Ida Tarbell wrote her fallacious muckraking newspaper series accusing John D Rockefeller’s Standard Oil of the practice. In the century-plus since the idea has been propagated among academics and the media, and it easily caught on with a (mostly uninformed) general public since it appeals to a victimization mentality that proposes consumers are helpless in the face of a market leading firm with enough power to drive all competition out of business through lowering prices and then enjoy an abusive 100% monopoly market share. 

Such was the idea OPEC had of regaining their dominant market share, encouraged undoubtedly by their own economic advisers who they’ve sent to study at American Ivy League universities to study mainstream economics for decades.

However in practice no one has ever been able to produce an example of a firm that successfully achieved and then held a monopoly market share with this strategy. A few firms that achieved close to 100% market share such as Standard Oil and ALCOA did so not through predatory pricing, but rather through relentless innovation and cost-cutting that continuously benefited consumers. 

Companies like Standard Oil and Alcoa consistently grew their market shares profitably, never by incurring years of losses to destroy competitors followed by giant price hikes. OPEC’s failed attempt to drive out its competition is another example that fails to prove the theory.

Furthermore any examples of coercive monopolies that have abused consumers with impunity have all been monopolies established and protected by government legislation—not free market practices. AT&T famously gouged consumers on long-distance telephone rates from the end of World War I to its breakup in the early 1980’s, but what’s less well known is that AT&T was formed by an act of Congress that forced all of Bell Telephone’s competitors to merge into a single entity (at the urging of Bell incidentally, which was losing market share to new competitors) and then granted the new national telephone company a monopoly on all long-distance service. Most cable television operators are granted local monopoly licenses by municipalities in exchange for broadcasting certain content “in the public interest.”

In fact, not only is empirical evidence lacking that predatory pricing has ever worked, the theory itself is full of holes. University of Chicago’s John S. McGee famously wrote in his late 1950’s paper on Standard Oil that predatory pricing was a flawed theory and irrational strategy for several reasons. Loyola University economics professor Thomas DiLorenzo sums them up as follows:

1. “As an investment strategy, predatory pricing is all cost and risk and no potential reward. The would-be 'predator' stands to lose the most from pricing below its average cost, since, presumably, it already does the most business. If the company is the market leader with the highest sales and is losing money on each sale, then that company will be the biggest loser in the industry.”

2. “There is also great uncertainty about how long such a tactic could take: ten years? twenty years? No business would intentionally lose money on every sale for years on end with the pie-in-the-sky hope of someday becoming a monopoly.”

3. Even if a firm was able to withstand years of losses and finally establish a monopoly, “nothing would stop new competitors from all over the world from entering the industry and driving the price back down, thereby eliminating any benefits of the predatory pricing strategy.”

Thomas Sowell adds yet another contradiction in the theory, one that is particularly relevant to the OPEC story:

4. “Even the demise of a competitor does not leave the survivor home free. Bankruptcy does not by itself destroy the fallen competitor's physical plant or the people whose skills made it a viable business. Both may be available-perhaps at distress prices-to others who can spring up to take the defunct firm's place.”

In the case of U.S. shale, OPEC wasn’t even a market firm but rather a cartel of coercive government-sponsored national oil company monopolies. And yet even with all its governmental powers OPEC could only succeed in bankrupting some operators, but hardly all.

And even some of the bankrupt producers reorganized and resumed operations with a cleaner balance sheet. Those that ceased operations altogether simply capped their wells and sold the assets off at firesale prices to other firms. The buyers, who obtained the already drilled wells at very low cost, could now operate without the burden of heavy debts that plagued the original producer. 

So now if OPEC were to cut production and raise oil prices back to $80-$100, they would face the same competing wells again but run by producers who enjoy lower costs due to lightened debt loads and smaller interest payments. 

So according to theory skeptics, in the end the market share picture would not change all that much only that Saudi Arabia and other OPEC members would have burned through decades of reserve funds that were lost in the trade war.

ENDGAME

As the price war dragged on through 2015, 2016, and most of 2017, the Kabuki theater performance played out exactly as predatory pricing skeptics would have predicted—with two additional twists, both of which worked against the Saudis (more on that in a moment). OPEC continued pumping and oil bottomed out at a shocking low of  $26.

Several smaller, higher cost shale players did go bankrupt. Some reorganized and stayed in business. Others sold off assets in bankruptcy auctions (assets that continued to operate under new production companies) and some ceased operations and capped wells—assets that lie dormant and wait for oil prices to rise again before producing.

But most shale players and virtually all of the major U.S. oil and natural gas players weathered the storm and survived, even as profits fell sharply or they incurred losses.

Meanwhile OPEC member states burned through their reserves at an alarming rate. By some estimates Saudi Arabia’s reserves were down over 40% in just 2-1/2 years and were still falling rapidly in early 2017.

https://srsroccoreport.com/low-oil-prices-continue-to-decimate-saudi-arabias-currency-reserves/

Reserve funds that had taken decades to build up were being decimated in just a few short years. In a recent 60 Minutes interview with Crown Prince Mohammed bin Salman, one of Saudi Arabia’s top economic advisers confessed to CBS that the kingdom was heading toward a major sovereign financial crisis in a few years if it did not change course.

Hence in late 2017, seeing most U.S. shale and conventional energy E&P players still in business and watching their own reserves dwindle, the Saudis threw in the towel and called for the first of what would become a series of production cuts to raise prices. 

Now in early 2018 oil prices are off their $26 lows hovering near $70, but U.S. shale is still here and producing more than ever. If OPEC’s goals were to incur losses in exchange for eliminating the U.S. shale oil industry, they succeeded only in the first and failed miserably in the second.

In the end the OPEC predatory pricing scheme has been a giant flop that has cost them hundreds of billions of dollars.

To add insult to injury, two unexpected twists added to OPEC’s failures. 

First, during the 2014-2017 price war, shale oil technologies continued to make revolutionary progress and production costs plummeted even further. Even if breakeven prices for shale had remained $60 or $70, OPEC’s plot would have flopped anyway, but lower production costs only accelerated its demise. New and improved 3-D geological surveying, horizontal drilling, drill bit, fracturing fluid and computerized drilling technologies reduced well completion times, increased oil and natural gas well recovery rates, and cut production costs nearly in half again. 

The decline varied from shale formation to formation, but as you can see here typical breakeven costs have fallen by around half in most areas. For example falling from about $68 to $30 in the North Dakota Bakken, $82 to $40 in the Eagle Ford, and $81 to $32 in the Permian Delaware formation.

http://fingfx.thomsonreuters.com/gfx/rngs/OPEC-MEETING/010030SC1P5/USA-SHALE-OPEC-B.jpg

And this data is already old—from 2016. Production costs in early 2018 have surely fallen further. U.S. shale turned out to be a lot more resilient than OPEC had hoped.

The other twist is that oil and natural gas production has opened or expanded in several new formations across the country since the price war began. In 2014 production came predominantly from the North Dakota Bakken and South Texas Eagle Ford. But in the years since oil and natural gas have poured out from the Utica and Marcellus formations in the north Appalachians, the Niobrara of Colorado and Wyoming, and the North Texas Barnett to name just a few.

But most of all, a herculean production boom has restarted in the West Texas Permian.

The Permian was a major conventional oilfield in early 20th century—part of the historical Texas boom seen in old Hollywood films. However starting in the 1970’s production of conventional oil dwindled as easy-to-reach oil was exhausted and the Permian was mostly abandoned—thought no longer profitably recoverable. 

However underneath the conventional fields were vast additional supplies of oil and natural gas trapped in shale formations, and the shale fracturing revolution has reopened the Permian for business. Recovery of its tens of billions of barrels of shale oil and nearly 100 trillion cubic feet of shale natural gas has ramped up quickly, and in early 2018 the Permian alone already accounted for approximately one-quarter of all U.S. oil production; approximately 2.5 million barrels a day.

As OPEC continues to cut production and oil prices creep up slowly, the cartel’s leaders have been forced to watch helplessly as U.S. shale producers move in to fill most of the gap. In the past OPEC’s cuts may have produced prices topping well over $100 by now. Instead they are in the high $60’s. Their only hope now is that worldwide oil demand will grow rapidly enough that even U.S. shale will not be enough to prevent triple-digit oil prices. But even if that day eventually comes, the USA will also share in the spoils with its own domestic windfall profits and high-paying American jobs. 

The U.S. is already forecast to be the world’s largest oil producer in 2018 and a net energy exporter by 2023. Its burgeoning energy exports will also make a sizable dent in the highly-publicized trade deficit, and a lot less money will go to parts of the world that many argue “hate us.”

And of course OPEC’s dream of destroying U.S. shale and capturing its old dominant market share is a distant memory. The grand plot failed and the cartel’s members burned through a fortune of losses—losses that were effectively wealth transfers to the world’s energy consumers in the form of a windfall plus, unfortunately, national and state governments that viewed lower prices as an opportunity to stealthily impose energy tax increases. OPEC has learned the hard way that mainstream antitrust and monopoly economic theory usually doesn’t work.

Perhaps they shouldn’t have sent those advisers to Ivy League schools and considered alternative free-market-friendly universities instead. Studying at University of Chicago, George Mason, or San Jose State instead of Harvard, Yale, and Princeton would have saved them tens of thousands of dollars in tuition costs—and a few hundred billion in oil losses.

Lessons from the Great Depression: Trade, Protectionism, and The Smoot-Hawley Tariff (Part 1 of 3)

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11 MIN READ - In Chapters 1-3 of this Great Depression series, we’ve discussed the intensifying effects of higher taxation, swelling government spending, and federal price and wage floors on what began as the Recession of 1929 but tragically grew into the Great Depression. However no policy conversation is complete without discussing international trade and the notorious Smoot-Hawley Tariff. “Smoot-Hawley” has at times been blamed as the main driving force behind the Great Depression and in more recent times reassessed as a nearly insignificant factor. As we shall see later the truth lies somewhere in between with the tariff still playing a major role in worsening the slump.



I. THE TARIFF'S ORIGINS

A little known story about Smoot-Hawley is that the tariff legislation was already being deliberated and drafted throughout 1929 even before the October stock market crash. 

American farmers had not participated in the prosperity of the “Roaring Twenties.” Global demand for U.S. crops peaked during World War I, spurring farmers to borrow and overexpand production only to be caught in a global postwar tapering of demand for U.S. agriculture that retreated to normal levels. The Republican Party, at the time longtime proponents of protectionism going back to the early 19th century Whigs and Alexander Hamilton’s Federalists, had already passed generally protective measures in the 1909 Payne-Aldrich Tariff which in turn was reduced by the Woodrow Wilson Democratic majority’s 1913 Underwood-Simmons Tariff Act. 

With Warren Harding’s Republican victory in 1920 duties were reintroduced in the 1922 Fordney-McCumber Tariff, but as farmers continued to languish throughout the decade the GOP promised to deliver additional federal assistance during the 1928 election campaign. Upon Herbert Hoover’s 1929 inauguration Congress quickly began drafting the new legislation.

But proposing tariffs on imported food was an odd way to help farmers in 1929. The USA already imported very little food. For example, just 1/50th of one-percent of U.S. corn consumption came from imports in 1929. Although not every imported crop represented so small a share of the domestic market, the overall competitive impact of agricultural imports was still very small. Also the USA was running a considerable trade surplus at the time which made tariffs an ineffective way to help farmers who were reeling instead from high debt and low prices due to worldwide oversupply. And the unemployment rate was just 3%. 

Once word spread that Congress was drafting a new tariff with Herbert Hoover’s blessing, manufacturers quickly descended on Washington to lay their own claims. The legislative conferences quickly descended into a morass of lobbying and special interests. The process slowed as every industry and its Congressional sponsor had their say. Senators and Congressmen engaged in extensive “logrolling” or trading of votes. That is, if a Senator from Virginia promised to support tariffs on imports that protected Colorado interests, Colorado’s Senator would promise to support tariffs on imports that protected Virginia’s interests (a true exchange between Senator Charles Waterman, R-CO and Carter Glass, D-VA).

Senate sponsor Reed Smoot (R-UT) was a seasoned and capable legislative administrator, himself having helped draft the 1909 and 1922 Republican tariffs, and upon completion of the combined House-Senate version he named the bill the “Smoot-Hawley Act,” departing from the tradition of placing the House sponsor’s name first (ie. “Hawley-Smoot” for Rep. Willis Hawley, R-OR). 

By mid-1930, after a series of marathon deliberations poring tediously over countless imported items one-by-one, the bill’s combined version was finally passed and sent to President Hoover’s desk with strong Republican support and Democratic opposition. In the end Smoot-Hawley was touted as an aid effort for the ailing American farmer, but the majority of its duties were levied on imported manufactured goods and raw materials with only a small minority imposed on agricultural imports.

II. WARNINGS FOR HOOVER

Hoover’s announcement that he intended to sign a tariff bill was hardly without controversy. The October 1929 stock market crash had already put Americans on edge about an upcoming recession. Although the country was not to enter the most tragic phase of the Depression yet in mid-1930, banks were curtailing credit, industrial output was falling, and unemployment was already creeping up. 

Meanwhile politically connected manufacturers were for the tariff, but other manufacturers who would pay higher prices for imported materials were mostly against it. A good example is the auto industry which would be forced to pay higher prices for countless chemicals, metals, oils, paints, and rubber. Executives also worried that possible foreign retaliation could hamper export sales of American cars. Henry Ford reportedly told Hoover in person that the tariff was “an economic stupidity.”

Banking and financial industry leaders warned Hoover that post-WWI America was now the world’s largest creditor nation and that if trading partner nations were unable to export goods to the U.S.A their inability to pay back American loans risked destabilizing the entire international financial system. Hoover advisor Thomas Lamont of J.P. Morgan recalls “I almost went down on my knees to beg Hoover to veto the asinine Smoot-Hawley Tariff.”

Even as the bill awaited Hoover’s signature, vocal opposition still emanated from Congress. Senator John Nance Garner (D-TX), FDR’s future Vice Presidential running mate, expressed his opposition arguing that the tariff…

“…violates every precept of common sense, justice and sound economics. Under the guise of protecting the products of agriculture, the Republican majority in both Houses has inflicted upon the country industrial rates that are indefensible; rates that can only serve to add to the burden the farmers and consumers have carried for years; rates that will tend to reduce, and in fact eliminate, the foreign markets for many of our products, both industrial and agricultural.”

In support of the tariff, Rep. Frank Crowther (R-NY) countered predicting:

“Once this bill becomes law, business confidence will be immediately restored. We shall gradually work out of the temporary slump we have been in for the last few months, and once more prosperity will reign supreme. Foreign reprisals will vanish into thin air and we shall continue to raise the standard of American labor and American wages. We shall dissipate the dark clouds of your gloomy prophesy with the rising sunshine of continued prosperity.”

Public opinion polls showed that large majorities of Americans were against the tariff. Having read for over a year stories of special interests lobbying intensely for protectionist favors and logrolling for votes between politicians, public sentiment had long turned negative towards the bill.

A majority of American newspapers spoke out against the tariff. In a survey of newspaper editors, a consistent majority of 70-75% responded that “The Smoot-Hawley bill is not in the best interests of the American people,” “Farmers in general will not benefit from the Smoot-Hawley bill,” “U.S. foreign trade will fall off if the tariff bill becomes law,” and “The long discussion of the bill in Congress has had an adverse effect on American business and prosperity.”

In May of 1930 a group of 1,028 economists from 179 colleges and universities sent a signed statement to the White House and Congress urging both branches to defeat the measure. The statement raised four general objections which were:

1) The tariff would raise the cost of living by “compelling the consumer to subsidize waste and inefficiency in [domestic] industry.” 

2) The farm sector would not be helped since “cotton, pork, lard, and wheat are export crops and sold in the world market” and the price of farm equipment would rise. 

3) “Our export trade in general would suffer. Countries cannot buy from us unless they are permitted to sell to us.” 

4) The tariff would “inevitably provoke other countries to pay us back in kind against our goods.” Finally, Americans with investments abroad would suffer since the tariff would make it “more difficult for their foreign debtors to pay them interest due them.” (from Phalan, Yazigi, Rustici)

In summary the statement argued...

“Already our factories supply our people with over 96 percent of the manufactured goods which they consume, and our producers look to foreign markets to absorb the increasing output of their machines. Further barriers to trade will serve them not well, but ill.” And the economists predicted that higher tariffs would “inevitably inject… bitterness” into international relations and “plainly invite other nations to compete with us in raising further barriers to trade.”

And America’s trading partners watched with nervousness. The country with the most to lose—America’s largest trading partner: Canada—was led by the Liberal Party government of Prime Minister Mackenzie King. King’s party had generally supported pro-free trade policies with the U.S.A and low tariffs. But even as early as November 1928, upon hearing of Herbert Hoover’s election victory, King wrote in his diary he feared that Hooverian trade policies might lead to “open border warfare.” 

Nevertheless King still considered a further tariff reduction on U.S. goods in early 1930, but delayed the vote pending the outcome of Smoot-Hawley. King expressed his personal concerns about the tariff to Herbert Hoover, and in late 1929 he gave a widely publicized speech warning that if American raised tariffs on Canadian imports, Canada would be compelled to respond.

Despite all the public, political, and international opposition, Herbert Hoover signed the Smoot-Hawley Tariff into law on June 17, 1930, raising tariffs on dutiable imports and changing the status of hundreds of previous duty-free items to dutiable as well.

III. INTERNATIONAL REACTIONS

During the 19th and early 20th centuries the United States also routinely imposed tariffs on imports, but the world largely ignored them. That changed after World War I when America emerged as the world’s leading creditor. The U.S. was also technically the world’s largest economy beginning in the 1880’s, but it assumed a new economic leadership role after the Great War.

The Fordney-McCumber Tariff of 1922, being a post-WWI duty, could have been viewed as an anathema to the international community, but in 1922 the U.S. was rebounding sharply from the deflationary Depression of 1920-21 and American buying of imported goods was increasing, so the tariff was mostly dismissed. By contrast in 1930 both the U.S. and the world were falling into depression, and international reaction to Smoot-Hawley was decisively more negative.

In May of 1930 (before signing of Smoot-Hawley) the Mackenzie King government of Canada had called for a new election in July. With the signing of Smoot-Hawley, Parliament’s Conservative Party members began criticizing King for being too soft on American trade and called for Canada to respond. King, in an effort to placate the Tories and improve his image with Canadian voters, raised tariffs on sixteen imported goods—mostly agricultural—which represented approximately 30% of imports from the U.S. 

However King still lost the election over the trade issue and the new Conservative government immediately launched emergency tariffs against a much wider array of U.S. products (both agricultural and manufacturing) representing 70% of U.S. imports. All throughout the Canadian political drama neither the Liberals nor the Conservatives publicly referred to their policies as “retaliation,” but that was in effect what Canada was doing.

The Conservatives had long advocated moving away strategically from the United States and closer to Britain so the tariffs on U.S. goods—as well as reduced tariffs on British imports—were perfectly aligned with their larger foreign policy objectives. The Smoot-Hawley Tariff is widely considered to be the deciding factor in the overthrow of the King government that enabled Canada to strategically shift its alliance across the Atlantic.

In Cuba the Smoot-Hawley duties on imported sugar led to more serious consequences. Cuba was heavily dependent on sugar exports to the U.S. Even though the amount of sugar exported was not significant compared to the enormous U.S. market, it was a major source of income and jobs for the Cuban economy. The resulting sharp dropoff in sugar sales to America and general depression led to the overthrow of Geraldo Machado’s pro-U.S. government in 1933. Although the revolution was short-lived, the messy outcome resulted in the quick overthrow of the Marxist Ramon Grau presidency by military strongman Fulgencio Batista. And Batista’s two tenures as Cuban President, particularly from 1952-1959, famously led to major foreign policy headaches for the United States later.

Europe was particularly incensed by the Smoot-Hawley Tariff. In European eyes, the United States was not only the world’s leading economy and leading creditor nation, but it was also running a large trade surplus. America had experienced a prosperous 1920’s decade while much of Europe had struggled with postwar economic reconstruction. Yet here the U.S. was putting up trade barriers to products that Europeans needed to export to pay back their World War I debts. 

Since the larger European economies were engaged in Most Favored Nation (MFN) agreements with the U.S., they could not simply slap tariffs on American goods but not similar products from other countries. So they targeted products that were imported largely from the U.S., resorted to import quotas, or used other political excuses to target U.S. imports. For example, almost immediately Britain stopped the import of all American apples due to “sanitation” and “public health” reasons. Argentina, although a Latin American country, banned the import of U.S. eggs for the same reason.

France and Germany, trying to avoid direct diplomatic confrontation, announced few tariffs but in mid-1931 began quietly imposing import quotas on American goods. France also began moving away from the United States and brokering more favorable trade deals with the rest of Europe. Germany, which had already suffered from the effects of paying back WWI debts and reparations under the Versailles Treaty, moved towards economic autarky.

Great Britain responded in 1932 with the “Imperial Preference” system of duty-free trade between itself and its former colonies and Dominions. Canada quickly joined Imperial Preference as the British Empire and Commonwealth—representing close to a quarter of the world’s population and land mass—walled itself off economically from the international community.

To the extent that European nations raised tariffs on imports that were largely American in origin (due to MFN rules against targeting a specific country), there was still some collateral damage to similar imports from other countries even if their export levels were smaller than America’s. This built resentment between European neighbors which ultimately led to the raising of trade barriers even within the continent.

Other European nations, which were not part of MFN agreements, were more direct in their use of retaliation. Spain launched a tariff on American cars and within three years U.S. auto exports to Spain fell by 94% while imports from Britain, France, and Germany surged. Spain also raised duties on American sewing machines, razor blades, tires and tubes, and even American movies. 

Benito Mussolini raised Italian tariffs on automobiles (80% of its auto imports came from the United States) and American agricultural products such as wheat and cotton, causing Italy’s wheat imports from Russia to surge instead. 

Switzerland, which was hurt by Smoot-Hawley duties on watches, did not impose a formal retaliation, but its citizens organized an informal boycott of American goods which was just as effective. Portugal announced a variety of new duties on U.S. goods. All in all the European response was overwhelmingly negative and retaliatory.

Stay tuned for Part 2 of this installment where we will examine the Smoot-Hawley Tariff’s economic consequences and recent reassessments of its impact by modern-day economists.

Venezuela’s Economy Was Falling Apart Years Before Oil Prices Collapsed

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4 MIN READ - CO very much enjoyed this Economic overview of Venezuela from the Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff.

As Venezuela suffers from chronic inflation, shortages of food, basic consumer staples, and running water, power blackouts, shrinking oil production, empty shelves, dwindling foreign reserves, hunger, street violence, and long lines outside stores, we’ve seen an explosion in excuses from socialists and left-wing progressives blaming anything other than socialism itself. Economist Lawrence Reed discusses the constantly moving target for socialists—the definition of socialism itself—here:

https://fee.org/articles/socialism-force-or-fantasy/

But I’d like to address some of the common excuses parroted to exonerate Venezuela specifically:


1) “It wasn’t real socialism.” 

During the first few years of Hugo Chavez’s nationalizations and lootings, the same apologists claiming it’s not real socialism today were praising Chavez’s “Socialism for the 21st Century” then—as he showered the poor with seized wealth (while it lasted). Hollywood celebrities, left-wing academics, and even a Nobel Laureate incessantly lauded Venezuelan Chavismo as proof-positive that socialism works... until it didn’t. At which point it suddenly wasn’t “real socialism” anymore.

In other words, it’s socialism until it isn’t.


2) “Venezuela isn’t socialism. It’s dictatorship.” 

First, all socialism—with the exception of Karl Marx’s vision of the final stage of history: full communism, which no socialist economy has ever come close to attempting—is dictatorship by definition. Even so-called democratic socialism is a form of dictatorship since the seizing of wealth to be distributed and downward price controls must be enforced at gunpoint. Marx himself, who Chavez endlessly cited in public speeches, called the first stage of socialism the Dictatorship of the Proletariat.

https://en.wikipedia.org/wiki/Dictatorship_of_the_proletariat

But more importantly the same apologists weren’t calling Venezuela a dictatorship years ago either—because they thought it was working. Even though as soon as Hugo Chavez was swept into power he began practicing dictatorship—sending armed troops in to seize foreign energy assets, domestic steel plants, cement plants, department stores, grocery stores, farms, power stations, and more. He seized radio and television broadcasters and took control of the mass-media dissemination of information. 

The Marxian Dictatorship of the Proletariat was established to seize the means of production, and left-wingers in the Americas and Europe praised it as “democratic socialism” (not “dictatorship”) until the predictable result of economic dysfunction and collapse became too obvious to ignore. At which point the problem suddenly became “dictatorship,” not socialism. 

Just as it’s socialism until it isn’t, it’s not dictatorship until it is.


3) “Socialism would have worked, but the USA/CIA has declared economic war on Venezuela by manipulating the world price of oil downwards.”

If the U.S. government really had the power to manipulate the worldwide price of oil downwards from $100 to $26, it would never have allowed oil prices to remain high for the first fifteen years of the Socialist Party’s rule (1999-2014). And if the USA really wanted to “declare war” on the United Socialist Party of Venezuela, wouldn’t it have done so right away—instead of hesitating for fifteen years first? 

With all of Hugo Chavez’s belligerence towards the USA, calling U.S. President George W. Bush “the devil” at the United Nations in 2006, wouldn’t the White House have wanted its pound of flesh and taken revenge before Chavez died in 2013? 

Or did Barack Obama simply wake up one day in late 2014 and capriciously decide, after nearly six years in office, that now was the time to hurt Venezuelan socialists with oil price manipulation? 

For that matter, since the U.S. has been a major oil importer for the last several decades, why has it ever allowed oil prices to rise at all? After all it’s to America’s benefit to manipulate oil prices downwards all the time. The whole idea that one country—even the United States—can simply push a button and ratchet world oil prices down by 75% or more ($26/barrel at the early 2016 bottom) is ridiculous.


4) “OK maybe the USA wasn’t behind it, but the collapse of oil prices is what brought Venezuela down, not socialism.”

But one of the timeless claims going back to Karl Marx is that socialist central planners, being disinterested philosopher-kings whose thoughts only dwell on the good of society and never their own bank accounts, are more forward-looking and adept at anticipating future economic trends than short-sighted, myopic capitalists who only care about the next quarter’s profits. In other words, socialists are better planners.

Venezuela’s socialists came to power in 1999 and have yet to give it up. So in the sixteen years they were in power before oil’s decline, did they never once plan for the eventuality that oil prices could fall one day? Which begs the question: Are socialists better planners than capitalists or not? And is the failure with the price of oil, or with socialism itself which by its very nature is looking much worse at planning than capitalism?

Ironically the evil, shortsighted capitalist energy firms like ExxonMobil, Chevron, Shell, BP, Statoil, Total, etc… are even more dependent on selling oil than the entire sovereign nation of Venezuela which at least has some exports and domestic production other than energy, yet oil companies are faring much better. In fact, the large capitalist energy firms, many of whom had their Venezuelan assets seized, are still profitable (even though profits are down) while socialist Venezuela is bankrupt.


5) “OK they may not have planned as well as they should have, but socialism was really working very well in Venezuela at first. If it wasn’t for the collapse in oil prices it would definitely be a Workers Paradise today.”

Also not true, as anyone who read the news in 2006, 2007, 2008, 2009… all the way until the oil collapse began in 2014… already knows. Venezuela’s economic dysfunction began long before oil prices started their dramatic decline. Here is just a sample of news stories about long food lines, empty shelves, blackouts, and inflation going back to 2006 (more than eight years before the oil price collapse started). A whole lot more can be found simply by Googling keywords like “Venezuela,” “shortages,” “inflation,” “blackouts,” “long lines,” and be sure to enter a random pre-2014 year number like “2006” or “2008.”

2006 (food shortages)
https://www.ft.com/content/e0d7320e-7e39-11da-8ef9-0000779e2340

2007 (food shortages)
https://www.theguardian.com/world/2007/nov/14/venezuela.international

2008 (milk shortages)
https://www.npr.org/templates/story/story.php?storyId=91680886

2008 (power blackouts)
https://www.reuters.com/article/us-venezuela-blackout/power-blackout-in-venezuelan-capital-oil-province-idUSN0145186220080901

2009 (shortages, inflation)
http://www.mcclatchydc.com/news/nation-world/world/article24523447.html

2009 (water shortage)
https://www.reuters.com/article/us-venezuela-chavez/chavez-urges-3-minute-showers-to-conserve-water-idUSTRE59L0OU20091022

2010 (food shortages, rotting stockpiles)
http://www.economist.com/node/16326418

2010 (power blackouts)
http://www.washingtonpost.com/wp-dyn/content/article/2010/04/28/AR2010042805712.html

2013 (hyperinflation)
https://qz.com/125339/hyperinflation-is-forcing-venezuela-to-print-hundreds-of-millions-of-extra-banknotes/

2013 (food shortages)
https://www.theguardian.com/global-development/poverty-matters/2013/sep/26/venezuela-food-shortages-rich-country-cia

Lessons from the Great Depression: Wages (Part 2 of 2)

Click here to read the original Cautious Optimism Facebook post with comments

11 MIN READ - Here is a Dispatch from the Cautious Optimism Correspondent for Economic Affairs and other Egghead stuff in his continuing series on lessons learned, unlearned and never learned from the Great Depression

CO is sure that you will find it as interesting, informative and provocative as he has.

IV. FDR TRIES RAISING WAGES AGAIN AND THE DEPRESSION OF 1937-38

With the collapse and overturning of the NIRA the Roosevelt administration became more combative with its anti-business rhetoric and the New Deal Brain Trust was replaced with more progressive, more radical, and more interventionist bureaucrats. One of FDR’s first moves to replace the failed NIRA was the passage of the National Labor Relations Act (NLRA, aka. the Wagner Act) in the summer of 1935.

Widely considered the single-most important piece of labor legislation of the 20th century, the NLRA created the National Labor Relations Board to enforce new bargaining powers granted to labor unions. Among the NLRB’s enforcements were a guarantee to collectively bargain with management, businesses were prohibited from refusing to collectively bargain, businesses were prohibited from firing, demoting, or transferring workers who attempted to unionize or collectively bargain, businesses were compelled to rehire striking workers under most conditions, and businesses were prohibited from setting promises not to unionize as a condition of employment even as unions were free to bargain for “closed shops” where employees could not be hired without joining the union.

The NLRA was also challenged in the courts, but since FDR had threatened to pack the Supreme Court with extra pro-New Deal judges in the fallout of the NIRA legal battle the high court justices became more compliant during the remainder of his presidency. In fact according to the Tenth Amendment Center, from 1937 to 1995 not a single piece of federal legislation was declared unconstitutional by the Supreme Court. A new era of acquiescence to executive power had begun. With the NLRB v. Jones & Laughlin Steel Corp case of early 1937, the Supreme Court validated the NLRA’s constitutionality and it has been enshrined in federal law ever since.

The NLRA, while not explicitly mandating wage increases, did vastly strengthen the hand of labor to not only collectively bargain, but also to strike against “unfair labor practices” without fear of losing employment when the strike was resolved since the NLRA guaranteed their reemployment. The result was a hyperbolic jump in strikes in 1937. BLS statistics from 1936 and 1937 reflect this:

Number of strikes 1936 to 1937: 2172/4740 (+118%)
Number of striking workers 1936 to 1937: 789K/1.86M (+136%)
Number of work-days lost to strikes 1936 to 1937: 13.9M/28.4M (+104%)

(sources)
https://www.bls.gov/wsp/publications/annual-summaries/pdf/review-of-strikes-in-1936.pdf
https://www.bls.gov/wsp/publications/annual-summaries/pdf/analysis-of-strikes-in-1937.pdf

Furthermore federal enforcement of labor laws was skewed in labor’s favor under the Roosevelt administration. For example, unions quickly launched “sit-in strikes” where employees not only refused to work, they also refused to leave the factory floor while physically impeding replacements and management from using company machines and equipment—all while the NLRA’s enforcement arm looked the other way.

Unable to conduct business with striking workers and physical blockage of its workfloors and factories, businesses were forced into the intended and successful consequence of the legislation: an assured hefty raising of wages for union labor over 1936 levels—yet again above the market clearing equilibrium wage.

Combined with FDR’s top marginal income tax rate hike from 63% to 79%, and the Federal Reserve’s tightening policy requiring a doubling of commercial bank reserve ratios (both in 1936), the Wagner Act’s new artificial wage floor ushered in the famous Depression of 1937-1938 or the so-called “Depression within the Depression,” the third worst downturn of the 20th century behind the Depression of 1920-21 and the Great Depression slump of 1929-1933. Unemployment predictably ballooned from an intrayear low of 11% in early 1937 to an astonishing 20% in the summer of 1938.

And the Depression of 1937-38 is undoubtedly why unemployment at the beginning of 1940 was still higher than at the end of 1930 (16% vs 11%). For the third time in less than a decade, forcing wages above the market equilibrium level not only failed to deliver the promised recovery via greater spending power, it reversed the previously improving employment trend and set the economy back into its third technical recession since 1929.

Although the Wagner Act is still with us today, the extent of the NLRA's reach changed quickly during the postwar Truman administration. Harry Truman, a moderate with no interest in upholding the most radical elements of FDR’s New Deal, wasn’t willing to look the other way from violent union abuses or “sit-in strikes.” The practices, which had been stopped during WWII industrial production, were not allowed to resume in peacetime.

And in 1947 Congress passed the Labor Management Relations Act (aka. Taft-Hartley), a law designed to return the balance-of-power between management and labor. Among its many provisions, Taft-Hartley prohibited so-called “closed union shops,” ended the prohibition of “right-to-work” laws in any state that passed them, strengthened provisions that prevented strikers from physically blocking a workplace to entry from customers, management, and replacement workers, and required a minimum number of days’ notice before unions could strike.

Although simply repealing the Wagner Act (along with the Davis-Bacon and Norris-Laguardia Acts) and never signing Taft-Hartley at all would have been a cleaner way to level the playing field, the passage of Taft-Hartley did untie employers’ hands significantly given that the NLRA was still in effect.

V. FORCING WAGES UP: THEN AND NOW

The Great Depression was easily the worst economic downturn in American history. Compared to the next worst slump, the Depression of 1893, it took nearly three times as long to return to full private employment (seventeen years vs six), the peak unemployment rate was over double (25.9% vs 12.4%: Romer), and the loss of GDP at the slump's trough was more than double (-26.3% vs -10.3%).

Not coincidentally, at that time the Great Depression was also the only depression in American history where wages and prices were prevented by government from freely adjusting. In every other prior downturn when demand fell prices and wages were allowed to fall too. Nominally wages and prices dropped, but in real terms they were generally unchanged since all other prices fell together.

As elementary microeconomics teaches us, whenever any price is forced above the free market equilibrium level, supply outpaces demand and surpluses form. In the case of the Great Depression, the surpluses were not only unsold goods that were made too expensive by NIRA cartels, but also workers who became too expensive to fully employ. Newer demand-side economics and arguments that “higher wages will create greater consumer demand, compensate for the labor surplus, and lead to faster recovery than under free market conditions“ proved to be empty promises as the nation descended into unprecedented contraction and joblessness.

The historical lessons of forcing wages and prices upwards were painful but also resoundingly clear: wage and price controls don’t work. The market must be allowed to adjust and clear, and the sooner it happens the faster the recession will end.

Which brings us to today. Even though it was 80 years ago, the failures of the demand-side policies of the 1930’s provide a valuable guide to similar debates taking place even eight years in the wake of the Great Recession. For example, the argument that $15 minimum wage, raising taxes on the rich to prevent “income inequality,” and boosting the purchasing power or middle class and working Americans through higher government stimulus spending will all lead to a faster growing economy.

The $15 minimum wage is most closely related: many of the same economic stimulus arguments from the Great Depression have been rekindled by progressive forces. Predictably conservative and free market opponents have maintained that forcibly raising the price of labor results in lower demand for labor and reduced employment, ie. the classical argument. But just like in the 1930’s, progressives have countered that raising the minimum wage above the impersonal, heartless “free market” level (actually not even the free market level, just a lower minimum wage of $7.25) won’t induce job losses or reduce hours because the increased income will stimulate economic activity through greater spending power…which in turn will lead to more hiring. So once again the theoretical battle lines have been drawn. But more telling than theoretical argument is empirical evidence. And the Great Depression has plenty to guide us.

VI. MINIMUM WAGE ON THE GRAND STAGE (not just Seattle or San Francisco)

The present day laboratory for the $15/hr minimum wage experiment has been a handful of US cities—most notably Seattle—upon which both sides of the debate have descended to find evidence favorable to their case. And while so far the results in nearly all studies have suggested that hours have been reduced, jobs have been lost (or the rate of job creation has noticeably slowed) and benefits have been cut, the metrics are far from overwhelming.

One reason is that public support for minimum wage hikes tends to coalesce only when the economy is perceived as “sufficiently recovered” to withstand its impact. Therefore minimum wage hikes have been enacted in job markets that are already improving.

Also the higher minimum wage unemploys only a small segment of the workforce—namely the least productive workers whose hourly marginal revenue productivity falls between the old minimum wage and the new one. By contrast no doctor, lawyer, computer programmer, airline pilot, professional athlete, etc… gets thrown out of work simply because the minimum wage has risen from $7.25 to $15/hour. Those professions’ hourly marginal revenue productivity was well over $15 to start with. Also, workers with so few skills that their hourly marginal revenue productivity was already lower than the previous $7.25 minimum wage were largely jobless to start with since they had long been priced out of the market. Therefore they won’t be counted as a “job loss” after a minimum wage hike either.

(It's worth mentioning these two reasons expose a common error cited by both sides of the debate—looking at the overall unemployment rate to judge the effect of minimum wage. Rather one must look at the change in unemployment only in the low-skilled sector with pre-hike wages between the old minimum wage and the new higher one)

Given the small segment of workers effected, and the countereffect of job gains in the higher wage segment due to the already improving economy, the results have been statistically small enough to sway few people particularly the $15/hr crowd. So retorts of “flaws in the study” or “the overall economy is still going well” or “ten new restaurants have opened” (never mind that 15 closed in the same period) or “the employment numbers for the metro area are good” (even though the minimum wage was only law in the anchor city such as Seattle and many jobs were transferred to the unaffected suburbs) begin to impinge the conversation. Few people’s minds are changed because the experiment is simply not large enough in scale and the laboratory is too small.

But unknown to most people there already has been an experiment, a much larger experiment, in raising wages to help workers and stimulate economic recovery. It was conducted by Herbert Hoover and Franklin Roosevelt—on the grandest stage possible: not just Seattle and San Francisco, but the entire American economy.

From 1929 to 1939 three different nationwide campaigns were launched to raise not just the minimum wage but virtually all worker wages, therefore affecting the lion's share of America's workforce as opposed to just the lowest productivity workers in the minimum wage scale. Three times in the 1930’s the federal government pushed wages up for nearly all Americans: Herbert Hoover’s “high wage policy,” then FDR’s National Industrial Recovery Act price and wage floors and then the Warner Act's ensuing higher union wages—the latter two at a time of fragile recovery when unemployment was still in the double-digits.

All three high-wage campaigns coincided with the only three major episodes of rising unemployment (see chart below noting rising joblessness in 1929-March 1933, winter 1933-summer 1934, and fall 1937-summer 1938). Plus there was no meaningful relief from the 1937-38 job slump until the European outbreak of World War II when the US military began its rapid hiring campaign in anticipation of an upcoming major conflict.

Furthermore demand-boosting policies weren’t limited just to forcing wages higher. The other two prescriptions of the trifecta—taxing the rich and redistributing the money to the working classes via increased government deficit spending—were also launched. Herbert Hoover raised the top income tax rate from 25% to 63% in 1932, and Franklin Roosevelt raised it again to 79% in 1936 and yet again to 84% in 1940. Herbert Hoover doubled real federal government spending in just four years, and Franklin Roosevelt added the entire New Deal atop it.

In this grandiose and novel witches brew of economic interventions, with all its demand-boosting policies launched simultaneously and unequivocally, the Hoover and Roosevelt administrations gave American history its greatest ever experiment in countercyclical economic policy. The result of the experiment and its conclusions couldn’t be any clearer. Was it, as progressives have argued for the last ten years, a rapid recovery from recession with unprecedented strength? No, it was America’s worst and longest economic catastrophe. With the aftermath of the demand-side policies of the 1930's so clear, can we learn from our history's blunders and avoid repeating them again?

Lessons from the Great Depression: Wages (Part 1 of 2)

Click here to read the original Cautious Optimism Facebook post with comments

11 MIN READ - Enjoy this highly informative piece from the Cautious Optimism Correspondent for Economic affairs and other Egghead stuff on the Great Depression and Wages.

Episodes of soaring unemployment correspond perfectly with government wage floor programs

The most crucial yet mostly forgotten job-killing government policies of the 1930's manipulated prices and wages. Although Herbert Hoover and Franklin Roosevelt’s hefty tax increases and profligate spending had extensive effects on unemployment, wage policy more directly influenced the fate of American workers. Federal intervention induced downward wage rigidity and precipitated unemployment levels never seen in American history then or ever since. This article examines those policies in detail.

I. NOVEMBER 1929: HOOVER ACTS DECISIVELY ON WAGES

The first major policy act of the Herbert Hoover administration after the October 1929 stock market crash was to convene a meeting of American business leaders to coordinate his novel wage policy. On November 21st, 1929 dozens of executives from an array of industries arrived at the White House to hear Hoover’s plan to mitigate any upcoming depression and hasten recovery. Among the delegates present were Henry Ford, Alfred Sloan (General Motors), Pierre Dupont, Julius Rosenwald (Sears), Owen Young (RCA), Walter Teagle (Standard Oil), William Butterworth (Deere Company) and many more.

Hoover’s pitch? In past depressions American business had always dealt with dwindling sales by selfishly cutting worker pay. But this, according to Hoover, was a mistake—precisely the opposite of what they should do. Instead American business should make a short-term sacrifice by keeping wages high for, as Hoover believed, higher wages were the wellspring of economic prosperity. In his own words:

“The very essence of great production is high wages and low prices, because it depends upon a widening range of consumption only to be obtained from the purchasing power of high real wages and increasing standards of living."

-Commerce Secretary Herbert Hoover speech on labor relations: May 12, 1926 (source: Hoover Memoirs Volume 2)

“I have instituted ... systematic ... cooperation with business ... that wages and therefore earning power shall not be reduced and that a special effort shall be made to expand construction ... a very large degree of individual suffering and unemployment has been prevented.”

-President Hoover address to Congress: December 3, 1929

Of course the labor market quickly learned that the reality is precisely the opposite. Greater production—the outgrowth of business investment in labor saving capital tools and machines that increase productivity per worker—is the true source of higher wages, not the other way around. Simply pushing up wages doesn’t create economic prosperity. Productivity gains leading to lower unit production costs and greater purchasing power per dollar earned does.

Nevertheless, Hoover sold his “new economic science” to American business with the added encouragement of patriotic exhortation—urging them to do their duty as Americans to keep wages high for the sake of the nation and to think of the [macro] economy before themselves. And that in the long run they would be rewarded as a high-wage policy would blunt the pains of the depression and translate into a healthier business environment.

American business leaders were duly inspired and vowed to maintain wage rates—all under the watchful eye of the Commerce Department. Henry Ford, in a brave moment of enthusiasm, emphatically pledged to raise wages. Hoover and his business cohorts appeared united before the press as the President announced that their coordinated plan of attack would hasten the arrival of prosperity. And in a separate meeting with railroad executives Hoover extracted the same pledge.

II. HARD LESSONS IN DEFLATION AND PRICE FLOORS

The consequences of Hoover’s high-wage policy, predictable for anyone who understands elemental microeconomics, did not bode well for the American employment picture. Not only do price floors, when set above market equilibrium prices, create unsold surpluses (“unsold” or unemployed labor), but America also suffered from the famous deflation of 1929-1933 which further exacerbated the impact.

The U.S. economy suffered three major banking panics (1930, 1931, and the largest by far in early 1933) during Hoover’s term, due to a combination of factors including restrictive unit banking regulations, the shocking suspension of gold convertibility by the Bank of England in 1931, and most importantly the Federal Reserve’s policy of refusing to carry out its lender of last resort role for banks suffering from temporary liquidity shortfalls—especially banks perceived as having loaned to fuel stock market speculation in the late 1920’s.

From 1929 to early 1933 the broadest US money supply measure fell by nearly a third, and prices fell by nearly as much. A purchase that required one dollar in October 1929 only cost 93 cents in December of 1930, 84 cents by the end of 1931, 75 cents by the end of 1932, and 72 cents by the final banking panic in the spring of 1933 (source: BEA). Therefore, maintaining a wage of one-dollar per hour from October 1929 at one dollar in the spring of 1933 was the equivalent of paying $1.39 in real terms.

As deflation set in across the country, nominal business sales/revenues fell accordingly. But due to their pledge to maintain wage rates, American business—at least American big business—kept worker pay inflexible and therefore wages actually rose in real terms. All labor employed by industrial America was getting a 39% pay raise!

British economist John Maynard Keynes, who was well aware of the effect of price and wage floors, toured America in 1931 praising the high-wage policy both publicly and in his reports to British Labour Prime Minister Ramsay MacDonald. According to Keynes, high wages would spur greater demand/spending power and rapidly end the slump. Clearly they were of the same mindset as Hoover who, even on the 1932 campaign trail, boasted:

“For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered. . . . They were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.”

But the reality on the financial books of American business painted a different picture. Companies could not endure revenues falling eventually by 28% due to deflation alone, plus business weakness due to depression, while wages remained constant. Losses quickly set in and widened every year as nominal prices fell further.

Corporations bravely tried to hold out, but the only way to maintain 1929 nominal wages in light of falling revenues was job cuts. Workers were steadily fired—first, the least productive but eventually even key personnel—and by the end of 1931 the unemployment rate was already 15.8%. By 1932 businesses started to defect from the plan entirely and began quietly lowering wages, but not enough abandoned ship before the notorious banking panic of 1933 which marked the nadir of the depression. At its early 1933 peak, the unemployment rate reached 25.9%.

III. FDR RAISES PRICES BUT RETURNS TO WAGE FLOORS

By the beginning of the Roosevelt administration American businesses had abandoned rigidly high wages and were entirely focused on survival mode. With the introduction of Federal Deposit Insurance, closing of insolvent banks over the Bank Holiday, and to a lesser extent the end of the dollar’s gold convertibility, the US money supply and prices stabilized. More importantly bank customers began to redeposit their cash in the financial system, encouraged by FDIC guarantees that their money would be reimbursed should their bank fail, and prices began to rise. 

Banks were able to begin normal lending operations again, free of worries that depositors would start a run that required them to boost reserves and curtail lending. And the high-wage commitment was all but gone. Wages and prices were, for the moment, flexible again and free to adjust to changes in supply and demand.

The recovery beginning in March of 1933 was staggering. Jason E. Taylor, Professor of Economics at Central Michigan University and a Great Depression specialist, calculates that from March to August of 1933 GDP and employment rose so quickly that at that continued rate the USA would have returned to 1929 levels of activity by the end of the year. And by early 1934 the US economy would be at levels that implied no Great Depression had ever occurred and that the USA had grown steadily at a 3% clip from late 1929 onward. There has been no five months of growth like March-August 1933 in American history.

But the new administration wasn’t ready to give up manipulating wage-rates upwards yet.

In a grand pattern of boom-and-bust the rally came to an abrupt halt in August of 1933 and promptly reversed course. In just four months during the fall of 1933, manufacturing retreated by a third and US GDP fell by over 5%, more than during the 2007-09 Great Recession. But instead of contracting 5% across a 19 month period as it did from December 2007 to June 2009, the 1933 contraction was compressed into just four harrowing months.

Ironically, since the downturn didn’t last six months—the official definition of a recession—it’s not recorded in any history books as the Recession of 1933, yet in that brief time the economy contracted more severely than during the 2007-09 Great Recession. And unemployment rose accordingly—up five percentage points in just five months.

What caused this giant U-turn in America’s economic fortunes? The frenzy of FDR’s famous “First 100 Days” of legislation was long over by the winter, so what other external factor or policy initiative could have caused such a negative reversal in the job market?

Taylor places blame squarely on the passage of the National Industrial Recovery Act (NIRA or NRA). Signed in June of 1933 but slow to ramp up, the NIRA is most famous for suspending antitrust laws and forcing big business to cartelize, collude, and artificially set prices above the market level. This misguided and patently absurd program had the effect of creating price floors for American goods and the result—much like unemployed labor—was a pileup of unsold merchandise. Faced with rising inventories due to falling demand, businesses cut back on production as well as jobs.

But what the NIRA is less famous for is the reintroduction of wage floors for workers—only this time coerced instead of sold via patriotic appeals by the Hoover White House. The NIRA authorized the “Presidential Reemployment Agreement” (PRA) which was enacted on August 1, 1933.

The PRA officially called for reducing hours to share labor across more workers—so-called “worksharing” agreements—but it also bullied businesses for a minimum pay rate of $15/week for workers in any city of greater than 500,000 people within a broad array of industries—20% above the average pay rate at the time and well above the equivalent minimum wage introduced in 1938 especially when considering the PRA’s reduced work hours provision and inflation adjustments for the 1933-1938 period. Smaller cities fared little better as the PRA called for a $14 to $14.50/week minimum wage for any city larger than 2,500 people. A new minimum wage had been created that went far above the level of the least skilled workers and encroached into salary levels in the nation’s factories.

Although the minimum wage was not technically mandatory, FDR offered businesses that agreed the right to display the NIRA “Blue Eagle” emblem on their storefronts, publicly encouraged Americans to shop at Blue Eagle businesses, and more importantly called for a nationwide boycott against businesses that didn’t display the emblem. The coercive message was clear and American business overwhelmingly complied out of fear of reprisals.

(for the full text of the PRA mandates go to http://www.presidency.ucsb.edu/ws/index.php?pid=14492)

Once again, corporate managers were faced with expectations—indeed coercion this time—to pay many skilled and industrial workers above the market equilibrium rate—at a time when unemployment, while falling, was still at 17% and 18%. Wages on average were artificially boosted 20% overnight in contrast to the Hoover high-wage agreement where real wages rose a higher 39% but over a much longer period of 40 months.

Higher skilled manufacturing jobs weren’t as heavily affected, since their market wage tended to be above the PRA floor. But lower skill manufacturing jobs such as textiles and clothing saw wage increases of even greater than the 20% average. Suddenly millions of American workers became unemployable moneylosers for their employers.

FDR extended the PRA wage mandates again in January of 1934, but by 1934 legal challenges to the NIRA and PRA began to pile up. The National Recovery Administration went through several restructurings and lost its effectiveness. Many businesses soon calculated the higher operating costs were not worth the marginal gains in customers, especially as public support for the NIRA’s Blue Eagle campaign waned. Eventually the entire NIRA was ruled unconstitutional and overturned by the Supreme Court in 1935, but enforcement of the NIRA, uncertainty surrounding its legality, and a general lack of enthusiasm by the public had already set in by mid-1934.

“By the end of 1934, NRA leaders had practically abandoned the progressive interventionist policy which motivated the Act's passage, and were supporting free-market philosophies—contributing to the collapse of almost all industry codes.”

-from Wikipedia https://en.wikipedia.org/wiki/National_Industrial_Recovery_Act_of_1933#Criticism

Professor Taylor once again points to the NIRA—only this time via its demise—as the catalyst for a second recovery in the job market. By mid-1934 unemployment began a rapid decline coincident with the largest wage policy change at the time—the beginning of the unraveling of the NIRA. For the second time in two years government control over wage-rates was abandoned, allowing prices to adjust freely and the market for goods and labor to clear. Twice now a rapid recovery in employment was underway.

Stay tuned next month for Part 2 of this Great Depression installment on wages.

ps. For more information on Professor Taylor’s NIRA and PRA work analyzing late 1933 job losses, listen to his Mercatus Center interview here:

https://www.mercatus.org/podcast/2016/08/08/macro-musings-18-jason-taylor-great-depression-world-war-ii-and-big-push

…or read his more detailed research paper here:

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.568.244&rep=rep1&type=pdf

Robert Wenzel: An Austrian Speaks to and Criticizes the New York Federal Reserve

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3 MIN READ - From the Desk of the Cautious Optimism Correspondent For Economic Affairs and other Egghead Stuff

With Jerome “Jay” Powell, President Trump’s nominee to chair the Federal Reserve, having cleared Senate Banking Committee testimony and expected to pass the full Senate confirmation vote it looks as though monetary policy won’t change very much with his term starting in early February. Powell is expected to continue his predecessor Janet Yellen’s easy money policy of very low interest rates, gradual hikes in the Fed Funds rate (expected at one quarter-point, three times a year) and a slow unwinding of the Fed’s massive $4+ trillion balance sheet. 

Stanford economist John B. Taylor, who proposed placing the Fed on a rules-based interest rate policy and ending discretionary overreach, drew eleventh hour praise from Trump for a possible nomination nod, but in the end the president embraced the status quo of easier money.

So now that we know no major change is coming to the Federal Reserve for at least four years, maybe we should take a look at what’s been wrong historically with the central bank for decades—that’s also not about to change. Austrian economist Robert Wenzel did precisely that a few years ago… at a speech within the Fed itself! 

(to read Wenzel's wonderful speech go to...

https://mises.org/library/new-york-fed-leave-building)

Wenzel was invited to speak at the New York Fed by accident, his inviting host unaware of Wenzel’s anti-Fed positions, but by the time the mistake was realized it was too late and Wenzel was allowed to make his appearance. Wenzel’s policy criticisms were many and quite entertaining (perhaps not for the employees who attended) and included:

-Mathematical methodology: Treating the literally billions of daily economic decisions made by American consumers and businesses like variables and constants that can be plugged into a scientific equation, as if the capricious and constantly-changing preferences of consumers share the predictability of mathematical constants in physics or astronomy.

-Dogma that demand is the primary driver of economic activity/growth and not production.

-The inability of Fed economists to differentiate between “price and wage stickiness,” which they consider a market phenomenon, and government-induced price stickiness such as unemployment benefits, pro-union legislation, and historically the wage-rigidity policies enacted by both the Hoover and Roosevelt administrations during the Great Depression.

-Obsession with maintaining stable or rising prices and apoplithorismosphobia (aka. deflationphobia). If, according to Fed policymakers, deflation creates depressions, how on earth did the American economy grow at its fastest rates ever during the Gilded Age when prices were falling on average one percent per year? How do the computer, cell phone, and flatscreen TV industries not only survive, but actually thrive when both their nominal and inflation-adjusted prices plummet year after year?

-Spawning asset bubbles, financial crises, and major business cycles with a misguided monetary policy that creates vast amounts of credit from thin air, unbacked by voluntary saving (ie. deferred consumption) from the public.

Wenzel also had some interesting notes on the Q&A at the end of his speech. In fairness, many of the attendees were good sports about the critique although many of their questions revealed they had absolutely no knowledge whatsoever of economic theories outside the mainstream Keynesian and Monetarist schools that dominate today’s academic and policy landscapes.