The Deficit Myth

August 27, 2021

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Stephanie Kelton. The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. New York: Hachette Book Group, 2020.

How many of these statements do you agree with?

  • The federal government should budget like a household.
  • Deficits are evidence of overspending.
  • One way or another, we’re all on the hook [for the national debt].
  • Government deficits crowd out private investment, making us poorer.
  • The trade deficit means America is losing.
  • “Entitlement” programs like Social Security and Medicare are financially unsustainable. We can’t afford them anymore.

According to economist Stephanie Kelton, none of these statements is true. Together they create a “narrative of scarcity” that puts unnecessary restrictions on our government’s ability to build a “people’s economy” that works for all of us. What is especially disappointing is that politicians invoke this narrative selectivity, using it mainly to cast doubt on the affordability of programs like Social Security or universal health insurance. “Somehow, there’s always money for war and tax cuts. For just about everything else, however, lawmakers are expected to show that they can ‘pay for’ their spending. At least on paper.”

Kelton wants to replace this narrative with what she calls a “narrative of opportunity.” She challenges us to think outside the box about government’s role in the economy, and does it with simple and cogent arguments. (She credits her editor with saving her from herself, resisting the temptation to fill her book with formulas and charts.) Kelton is a leader in the school of Modern Monetary Economics (MMT). Her arguments should appeal to progressives, but not to free-market conservatives who want to minimize government’s role in the economy, or to cynics who have lost faith in democratic government’s capacity to work for the general good.

Here I will examine the first three of her six economic myths.

Myth #1: The federal government should budget like a household

I have often written that living within one’s means is the first rule of personal finance. Spend less than your income, and your savings will build wealth. Spend more than your income, and you will run up debt and see your net worth deteriorate. And you’re not allowed to paper over the difference by printing money in your basement!

Conventional wisdom applies the same reasoning to government. As President Obama said in his 2010 State of the Union Address, “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” The argument of this book rests on the idea that the federal government is not the same, and does not have to adopt the same kind of frugality. “Unlike a household, the federal government issues the currency it spends.” That difference applies to countries with monetary sovereignty, “where the government is the monopoly issuer of a fiat currency.” That has been the fact ever since the United States left the gold standard in 1971, but most citizens and policymakers have yet to grasp its full implications and possibilities.

Governments without monetary sovereignty have to follow the rule Kelton summarizes as (TAB)S, shorthand for the requirement that taxing and borrowing must come before spending. But the federal government can follow the rule S(TAB), where spending can be somewhat independent of taxing and borrowing. Government does not have to take a dollar out of the economy for every dollar it puts into it by spending, and it usually doesn’t. The country’s money supply does not consist of a fixed number of physical dollars, backed by a supply of gold or any other commodity. When the government makes a major purchase, such as military hardware from Lockheed:

…the US Treasury instructs its bank, the Federal Reserve, to carry out the payment on its behalf. The Fed does this by marking up the numbers in Lockheed’s bank account. Congress doesn’t need to “find the money” to spend it. It needs to find the votes! Once it has the votes, it can authorize the spending. The rest is just accounting. As the checks go out, the Federal Reserve clears the payments by crediting the sellers’ account with the appropriate number of digital dollars, known as bank reserves.

It’s the digital equivalent of printing money in your basement, with the important qualification that it’s perfectly legal and ordinary.

The need to balance such spending with revenue is not absolute, and it’s only one of the reasons for taxation. If the government puts much more money into the economy by spending than it takes out by taxing, that can be inflationary, as discussed in the next section. But government has other reasons to tax, such as redistributing income to those who need it and modifying behavior with tax penalties and credits.

Similarly, the government sells treasury bonds not just because it must borrow to cover deficits, but to reward people for saving and investing, in this case investing in their government. That helps to insure that savers can invest safely and with a reasonable rate of return. As I’ll explain more later, it also helps keep interest rates from falling below the Federal Reserve’s target for purposes of controlling inflation.

Kelton is not saying that government can engage in unlimited spending. Instead, she is asking us to think differently about what the real limit on spending is. Strictly speaking, it is not the revenue collected or some balanced budget requirement. Historically, deficits have actually been better for the economy than budget surpluses, which have always been followed by economic recessions. So how do we draw the line between responsible and irresponsible spending?

MMT redefines what it means to engage in fiscally responsible budgeting….“It’s the economy’s real resources, stupid!” We are a nation rich with real resources—advanced technologies, an educated workforce, factories, machines, fertile soil, and an abundance of natural resources.

Instead of balancing spending with revenue, government’s more important task is to balance it with the productive resources of the economy.

Myth #2: Deficits are evidence of overspending

Instead, MMT says that the actual evidence of overspending is inflation, which deficit spending may or may not create.

If inflation is a condition of too much money chasing too few goods and services, that suggests two logical ways of fighting it. The first is to restrict the money government puts into the economy, so it won’t outrun economic growth. That calls for fiscal and monetary restraint, with controls on deficit spending and high interest rates to discourage borrowing. The alternative is to expand the real economy to keep it growing along with the money supply. That calls for government spending that increases the production of goods and services.

Kelton believes that federal policy has relied far too much on austerity to fight inflation, and far too little on growing the real economy. She feels that Obama’s fiscal conservatism and the Fed’s premature hikes in interest rates slowed the recovery from the Great Recession. (The Fed began raising interest rates when unemployment was still around 5%, but inflation was under 2%).

Kelton also believes that economists have been too tolerant of unemployment, believing that low inflation requires a relatively high “natural rate of unemployment.” They often attribute high unemployment to a mismatch between job requirements and job skills in a rapidly changing economy. Kelton wants to lay the blame more heavily on misguided inflation-fighting policies themselves. She says that “the majority of economists remain wedded to a fifty-year-old doctrine that relies on human suffering to fight inflation.” Instead, she wants to have a federal job guarantee that spends what it takes to put people to work doing useful things. Again, the government can put in more money than it takes out in taxes as long as the spending actually increases real output.

This argument got me thinking about what it is government actually does and how we account for it. The standard formula for GDP distinguishes private investment (I) from private consumption (C), but lumps together all public spending (G). If we think of government as a big consumer, then deficit spending adds to economic demand while neither adding to supply nor curtailing the demand from other consumers through taxation. That can stimulate aggregate demand when the economy is operating at less than full capacity, but becomes inflationary as the economy heats up. But if we think of government as an investor in the country’s productive capacity, some forms of spending add both to demand (by providing income people can spend) and to supply (by building some form of capital). Spending on infrastructure adds to the country’s physical capital, and spending on health and education adds to the country’s human capital. That’s the kind of spending that is most likely to be good for the economy even if it is not “paid for” with higher taxes. I think that Kelton could have helped her case by distinguishing different kinds of government spending more clearly.

Although Kelton wrote this book before President Biden took office, these points are directly relevant to the debate over his budget proposals. His plan for “human infrastructure” faces serious opposition, both from some Democrats who fear it won’t be paid for, and Republicans who fear that it will be paid for—with tax increases. If Kelton is right, both fears are overblown, since the plan sounds like just the kind of spending most likely to increase employment without inflation, whether the spending is balanced by higher taxes or not.

Myth #3: One way or another, we’re all on the hook

According to conventional wisdom, each taxpayer owes a share of the national debt, so as it goes up our individual net worth goes down. Kelton asserts to the contrary, “The national debt poses no financial burden whatsoever.” How can that be?

If you have a retirement plan or other investments, you may own shares in a corporate bond fund. A corporate bond is a liability for the corporation that issues it, but it’s an asset for you. Such debt is an ordinary feature of capitalism, and it only becomes a problem when a company’s debt burden becomes so great that it defaults on its obligations.

Similarly, the national debt is a liability of the federal government, but it is an asset for owners of treasury bonds. And it is an especially safe asset, since the federal government has never defaulted on a financial obligation and has no reason to do so. A government with monetary sovereignty cannot go broke. It can pay off its debts anytime it likes by replacing bonds with cash it creates. Instead, it chooses to offer people an interest-earning opportunity if they are willing to invest in the government. “There’s nothing inherently dangerous about offering a safe, interest-bearing way for people to hold on to dollars.”

West 43rd Street in New York City has a large clock that displays the national debt as it accumulates. We could just as well call it a savings clock, except that we fail to grasp that in this case, “good old” savings is the flip side of “bad old” debt.

What about the future? Don’t the taxpayers have to pay off the debt to the holders of treasury bonds someday? No. The government is obligated to pay the interest, but it can roll over the principal indefinitely. Even at very low interest rates, treasury bonds always seem to have lots of willing buyers. And if the interest payments were to become a burden, the government could create the money to pay off some or all of the debt. Traditional monetarists would expect that to be inflationary, but MMT economists disagree. Eric Lonergan points out that trading cash for bonds would have no effect on the public’s net wealth. Bondholders were choosing to save their money, and they could still save their money by putting it in some other form of savings. Only if they ran out and spent the cash would they create a situation of too much money chasing the same goods and services. But if that’s what they want to do, there’s nothing stopping them from cashing in their bonds now. Taxpayers needn’t fear that spending to address national needs will force the government to take on too much debt and then make the taxpayers use their limited dollars to pay it off.

The next post will deal with three other myths Kelton tries to dispel.


Kochland (part 3)

August 8, 2021

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The “corporate power” referred to in the subtitle of Kochland is not just economic power, but political power. The Koch brothers became poster boys for the role of big money in the political process. They played a leading role in pushing the Republican Party toward more libertarian, pro-market and anti-government policies, and in blocking collective efforts to address national problems like climate change.

David Koch declared his views publicly, running for vice president as a Libertarian in 1980. Kochland author Christopher Leonard characterizes the Libertarian platform as “calling for the abolishment of everything from the US Post Office to the Environmental Protection Agency to public schooling.” Charles preferred to operate behind the scenes, quietly funding a wide range of conservative organizations and campaigns. The Charles Koch Foundation, created in 1974, soon changed its name to the Cato Institute, but its policy positions were also libertarian, with relentless support for tax cuts and privatization of public programs like Social Security.

The “Kochtopus”

Leonard describes Charles Koch’s political influence machine, nicknamed the “Kochtopus,” as a multifaceted operation “including think tanks, university research institutes, industry trade associations, and a parade of philanthropic institutions to support it financially.”

In part, this is a traditional political operation, working to elect candidates and lobby legislators. But it is especially large and well-funded. Leonard compares Americans for Prosperity, the main Koch advocacy group, to a franchise business with “semiautonomous state chapters” all serving “products from the same menu.” Its organization as a tax-exempt “social welfare” entity spares it from having to disclose its donors. It can easily create the appearance of spontaneous, grassroots movements at the local level. Also, today’s corporate lobbyists do not just provide information and persuasive arguments; they organize lavish fundraisers for politicians who vote their way. Another focus of Koch political influence is education, but it is education of an economically and politically motivated kind. The Koch-funded Mercatus Center at George Mason University promotes free-market economics, while the Law & Economics Center at the same university provides a forum for legal scholars who take a dim view of government regulation. It appears to have shaped the views of a generation of judges by inviting thousands of them to its seminars. By blurring the distinction between education and political contributions, Koch has circumvented the restrictions on campaign contributions.

In 1996, Koch Industries created a nonprofit group called the Economic Education Trust. The group did not need to disclose its donors because it was not ostensibly a lobbying or campaign finance organization…. The Economic Education Trust gave $1.79 million to a company in suburban Washington, DC, called Triad Management Services Inc. Triad was supposedly a political consulting firm, but it had a strange business model: it offered its services for free, to Republican candidates. A US Senate report in 1998 concluded that Triad was “a corporate shell funded by a few wealthy conservative Republican activists.”

Instead of just helping elect legislators and influencing their votes, corporations have sought a direct role in writing legislation. Koch has been a major contributor to the American Legislative Exchange Council (ALEC), originally founded by Paul Weyrich of the religious right, which writes model laws to be adopted by state legislatures. Leonard says it has evolved into a “pay-to-play” organization, allowing its largest contributors to write the bills that its member legislators try to get passed.

Energy deregulation

In the 1990s, ALEC developed model legislation for energy deregulation. Koch Industries and other companies that stood to gain from the legislation (notably the notorious Enron corporation) had a large role in writing it. Utility companies, who were more comfortable with the traditional system, opposed deregulation, but Koch and Enron had their way on ALEC’s energy task force. Leonard tells the story of deregulation in California, one state that adopted ALEC’s general approach.

Before deregulation, utility companies were essentially regulated monopolies. Having more than one utility trying to deliver energy to the same house wasn’t practical, but state regulators could protect the public from price-gouging by setting rates to allow a comfortable but not exorbitant profit. When energy prices became more volatile and the need for both conservation and pollution control more pressing, price regulation became more challenging. Setting prices too high would burden consumers, while setting them too low would dampen supply by discouraging producers from bearing the costs of production and pollution control. The free-market solution advocated by ALEC and the libertarians was to let the market set the price. The California deregulation law, passed in 1998, created a competitive market for power, the California Power Exchange:

The law was radical in nature. It instantly broke apart the state’s big utility companies. The utilities became glorified middlemen, buying energy on an open market from traders at Koch and Enron and then selling it to the utility’s customers. The utilities had to sell their power plants to outside companies—many of them in Texas—that operated the plants as independent companies. The utilities also lost their transmission lines, which were taken away and turned into something that resembled a railroad or a pipeline. Anybody could now schedule power to run across the transmission lines, making them the common carrier of power.

In theory, competition among the producers to sell their energy would keep prices under control for consumers. And the competition among utilities to buy energy would keep prices high enough to incentivize production. The price mechanism would balance supply and demand, as in any competitive market.

But what if demand rose faster than supply, pushing up prices? With many other products—let’s use electric cars as an example—some people would just have to wait to buy one until supply caught up and prices went down. But electricity is special, because it has become a necessity. People can conserve energy up to a point, but they need a lot of it all the time. It won’t do to have too many customers seeing their power cut off because they can’t afford it, or to have utility companies going broke trying to buy power on the open market. So, in order to protect the utilities and their customers, California put a cap on the wholesale price charged by producers to utilities, and a floor under the retail price charged by utilities to customers. The retail price was supposedly high enough for utilities to profit, but not so high as to make energy unaffordable for consumers.

What if shortages occurred because the producers would not or could not produce at the capped price? Then another agency—the California Independent System Operator (ISO)—could step in to buy and sell energy for more than the capped price on the exchange. The system was still partly regulated, but with the good intentions of protecting consumers and avoiding blackouts.

Then the energy traders found a way to game the system, in effect creating make-believe shortages so they could sell energy at the uncapped ISO price more often. The game was called energy “parking”, and it worked like this:

Enron traders seem to have invented the parking scheme sometime in the late 1990s. To execute a parking trade, a trader at Koch or Enron sold electricity from a power plant in California to a customer outside the state, like PNM in Arizona. This sale was made in the day-ahead market, where prices were capped. But the sale was bogus. The next day, when power was supposed to be delivered from California to PNM, the utility would suddenly sell the exact same amount of power from Arizona into California, and into the much pricier ISO hourly market.

Such a sale was fraudulent because no actual megawatts were delivered to the out-of-state utility, which simply collected a fee for participating in the deception. Energy prices skyrocketed, and utilities couldn’t pay those prices and remain profitable without being allowed to charge exorbitant rates to customers. The state began to experience both budgetary strains and rolling blackouts.

Enron eventually went bankrupt after this and other fraudulent practices were discovered. The Republican governor who had championed deregulation was out of office, so the political blame fell mainly on his Democratic successor, Gray Davis. Voters recalled him and replaced him with another Republican, Arnold Schwarzenegger. Koch Industries was a lesser offender than Enron, but did settle charges of market manipulation by paying $4.1 million to the state. Only when the Federal Energy Regulatory Commission stepped in was the California energy crisis brought to an end.

Climate-change legislation

In 2008, Congress was considering environmental legislation that took a “cap-and-trade” approach to controlling carbon emissions. “The concept was simple. The government capped the total amount of a certain pollutant that could be released. But then it gave companies a license to release that pollution.” Companies that wanted to exceed their cap had to pay to buy credits to do so, while companies that reduced their emissions below their cap earned credits they could sell. Because it relied on a more-or-less free market in pollution credits, it had the support of many Republicans as well as Democrats. George H. W. Bush had initiated a similar approach to controlling sulfur dioxide and acid rain in 1990, with apparent success.

But even that much regulation was too much for Koch Industries. It conducted its largest lobbying effort yet in order to defeat the proposal, working through a new subsidiary, Koch Companies Public Sector. Not only that, but Koch waged a large-scale (dis)information campaign to convince the public that climate change wasn’t real, and that efforts to curb carbon emissions could only impose unacceptable costs on the economy. Between 2006 and 2009, as the planet warmed, the percentage of Americans believing in climate change dropped from 77 percent to 57 percent. Other oil companies, especially Exxon, also participated in this effort, but Koch outspent Exxon by a wide margin. Koch’s political arm, Americans for Prosperity, got many climate-denying Republicans elected by targeting their more moderate and reasonable opponents with negative advertising. Cap-and-trade lost Republican support and died in 2010. Americans for Prosperity also helped Republicans win the 2010 midterms, and one of the first things the Republican-controlled House did was cut off funding for the Select Committee on Energy Independence and Global Warming, the committee that had originated the cap-and-trade bill.

I have little doubt that the Koch brothers’ enthusiasm for libertarianism was genuine, and that they sincerely believed that what was profitable for Koch Industries was good for the economy and the country. I also have little doubt that in this case and others, they were very, very wrong.

Koch and Trump

Both Charles Koch and Donald Trump held extreme political views, but they did not agree on everything. Trump’s nationalism sometimes conflicted with Koch’s commitment to free trade. Leonard says that “the Koch political machine employed a strategy that could be called ‘block-and-tackle,'” blocking Trump’s proposals where they disagreed, but helping him tackle the problems they agreed on.

The “Kochtopus” supported Trump’s 2017 cuts in corporate and personal income taxes, which by one estimate saved Charles and David Koch personally over $1 billion dollars a year. It also supported Trump’s efforts to withdraw from the Paris Climate Accord and roll back environmental regulations.

Trump claimed that he could repeal Obamacare and replace it with something better but less expensive. Charles Koch just wanted to repeal it without replacing it with any government initiative on health insurance. Neither had his way on that issue, as Obamacare survived by one vote in the Senate.

Koch did not approve when Trump interfered with free trade by abandoning the Trans-Pacific Partnership agreement and imposing tariffs on foreign products. He also opposed the proposed Border Adjustment Tax intended to favor companies that operated in the U.S. rather than in other countries. Under existing law, companies could escape U.S. taxation by producing things abroad—or using accounting gimmicks to shift profits to foreign tax havens. Koch Industries often avoided taxes in that fashion, headquartering many of its operations in the Cayman Islands. The proposed Border Adjustment Tax would have taxed profits based on where products were sold rather than where they were produced. That would be costly for a company like Koch that imported oil and other products for sale here. In this case, Koch’s efforts to kill the bill succeeded.

One conclusion to draw from Leonard’s detailed history of Koch Industries and its political machine is that the radicalization of the Republican Party was well under way before Donald Trump came on the political scene. The ascendant philosophy was libertarian rather than nationalist, but many of the goals were the same—lower taxes for corporations and the wealthy, no action on climate change that would inconvenience the fossil-fuel industry, and a minimal role for government in regulating the economy. The political transformation of the late twentieth and early twenty-first centuries was only partly a grass-roots movement, but heavily a top-down effort directed and financed by wealthy plutocrats.

Kochland (part 2)

August 4, 2021

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After the National Labor Relations Act of 1935 recognized the right of workers to organize and bargain collectively, labor unions became a fixture in corporate life. Author Christopher Leonard says, “It was a losing game to take on unions; their power was too great to challenge. Most companies chose to accommodate organized labor.” But when Charles Koch consolidated his father’s businesses into Koch Industries in 1968, he brought with him a new willingness to take on the unions and subordinate them to his management philosophy and goals.

Pine Bend

The difference became apparent in the early 1970s at the Pine Bend refinery on the Mississippi River in Minnesota. Its workers were organized by the OCAW—the Oil, Chemical and Atomic Workers Union. Leonard acknowledges that by this time, many unions had become “bloated power structures” in their own right. The OCAW at Pine Bend had a lot of say over work rules, and some of their rules created inefficiencies by making extra work or imposing additional costs. For example, if workers were asked to work overtime without two hours notice, they had to receive bonus pay on top of their overtime pay.

When management insisted on rewriting all the work rules without union input, the workers went out on strike. Koch broke the strike with a combination of hardball tactics. The company managed to operate the plant with supervisors and other non-union labor. They bullied other unions like the Teamsters to cross the picket lines by threatening to replace their services (such as delivery services) with non-union suppliers. When violence broke out on the picket line, Koch obtained an injunction limiting the union to four picketers. The OCAW eventually capitulated and accepted the contract offered.

Now the work rules favored the company. My favorite example—even if an employee won a grievance against the company, all he won was the right to work extra hours to earn back the money Koch owed him!


Leonard devotes three chapters to the long, losing struggle of workers at the Georgia-Pacific warehouse complex in Portland, Oregon. Before it was acquired by Koch Industries, he describes it as an “economic island: one of the last employers in the region to offer solid work and solid pay for people who didn’t have a college degree.” Then “this island began to sink, slowly and steadily, as workers’ pay, benefits, and job security were stripped away further, year after year.” He sees this story as typical of the fate of blue-collar workers in the age of corporate acquisitions and private equity.

Here the union was the IBU—the Inlandboatmen’s Union, originally named after workers on river barges. It was absorbed into the ILWU—the Longshoremen’s union—in the 1990s. When Koch Industries acquired Georgia-Pacific, it started cutting costs by reducing the workforce while trying to get more work out of each remaining worker. In addition to an inventory system called the “Warehouse Management System,” it introduced a “Labor Management System” to exert more control over the workers. The system would issue precise instructions to a forklift driver, maintain a precise record of every movement through the warehouse, rank the workers by performance, and post the rankings on a bulletin board. Drivers had to keep their own written log of every minute they were not “on the grid” carrying out the instructions of the system. From management’s point of view, productivity and profits were rising. From the workers’ point of view, the job had become more demanding and more stressful, while wages failed to keep pace with inflation. The situation in the country as a whole wasn’t much better. Productivity and wages used to go up together, but between 1973 and 2013, productivity rose 74.4 percent, but real wages rose only 9.2 percent.

When the time came to renegotiate the labor contract in 2010, the union was looking for big gains, but Koch brought in tough negotiators who were “trained to beat back unions for a living.” Every request by the union was met by a counterproposal that asked the workers to give back something of equal or greater value. If they wanted a decent raise, they would have to replace their health insurance plan with a less desirable one or replace their traditional guaranteed-benefit retirement plan with a riskier 401(k) plan. When the union voted down what Koch proposed, the Koch negotiators stopped coming to meetings. After over a year without a new contract, and in fear of being replaced by non-union labor, the workers backed down. The Labor Management System would stay. The workers would get minimal pay increases, but have to contribute more to keep their health insurance and pension plan.

The 2015 negotiations did not come out any better. By then the number of unionized workers had been cut almost in half. A new worry was that accidents and deaths at the warehouses had been increasing, and Georgia-Pacific’s safety record ranked relatively low in the industry. Again, management wanted to make wage increases conditional upon replacing the health insurance and pension plans. In the end, workers got only 2% raises for two years and the prospect of $1,000 bonuses for the next two years. (The bonuses were less valuable than raises, since they didn’t become part of base pay and grow by compounding). The workers were disgruntled but resigned. Support for the union itself suffered, no doubt as the Koch brothers intended.

Leonard has provided a ground-level look at what happens when bargaining power shifts from labor to management. While business consolidations made workers in many industries dependent on a smaller number of big employers, the decline in unionized manufacturing jobs intensified the competition among workers for a dwindling supply of good jobs. As profits rose but pay stagnated, the share of the national income going to labor declined accordingly, especially after 2000.



August 3, 2021

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Christopher Leonard. Kochland: The Secret History of Koch Industries and Corporate Power in America. New York: Simon & Schuster, 2019.

Christopher Leonard has done us all a favor by amassing and organizing a great volume of information about Koch Industries. The company has not usually gotten the attention its wealth and power deserve, because it is the family business of a highly secretive family. But it is a massive company with many subsidiaries producing a wide range of products, and it is the second largest privately held company in the United States. It branched out from its original focus on oil refining and petrochemicals into businesses like agricultural products and building materials.

Koch traders sell everything from fertilizer, to rare metals, to fuel, to abstract derivatives contracts. Koch Industries’ annual revenue is larger than that of Facebook, Goldman Sachs, and US Steel combined.

The profits from Koch’s activities are stunning. Charles Koch and his brother David own roughly 80 percent of Koch Industries. Together the two men are worth $120 billion. Their fortune is larger than that of Amazon CEO Jeff Bezos, or Microsoft founder Bill Gates [as of 2019]. Yet David and Charles Koch did not invent a major new product or revolutionize any industry.

The book is a detailed portrait of one company, but its subtitle reveals how the author sees that company—a prime example of growing corporate power in America over the past half century. Many of the book’s themes are central to recent economic history—the ascendancy of a free-market, antigovernment philosophy, the victories of capital over labor, the reliance on corporate acquisitions and asset speculation for corporate profits, the growing political muscle of big business, and its effective resistance to environmental legislation. The book gives life to these abstractions by showing how one company has accomplished them.

Origins of a corporate powerhouse

Fred Koch founded the company in 1940 in Wichita, Kansas. He had four sons, the oldest of whom, Freddie, was more interested in art than the family business. That made the next son, Charles, the heir apparent, and he took over the management shortly before his father died in 1967. The third son, David, served on the board of directors but devoted himself more to politics, eventually running for vice president as a Libertarian. David’s twin brother William was also on the board, but feuded with his brothers over corporate policy and dividend payments. Charles and David succeeded in getting him fired by the board, and the company bought out both Freddie and William’s ownership shares.

Charles Koch took the lead in consolidating his father’s holdings under the name of Koch Industries. Although it began as mainly a refiner and transporter of oil, the company became more diversified and flexible in order to adapt to increasing economic volatility, such as wild swings in oil prices. Charles created a development group specializing in new acquisitions, which the author compares to a private equity firm, but one within an existing company. “The group would come to embody modern American capitalism in the early twenty-first century, an era when private equity and hedge funds scoured the landscape in search of acquisitions.”

Charles Koch ran his company according to a philosophy he called “Market-Based Management” (MBM) which was formalized and taught to every manager. Although he was well-read in a variety of subjects, his philosophy seemed to rely mostly on what he had learned from his domineering father and from free-market economics in the Austrian tradition of Friedrich Hayek. Fred Koch had been a founding member of the John Birch Society, which was considered the far-right fringe of the Republican Party in the 1950s and 60s. Hayek was a well-known critic of the New Deal, and Leonard says that Hayek “was almost religious when it came to describing what the market could do when left to its own devices. He believed that the market was more important, and more beneficial, than the institution of democracy itself.” Charles Koch saw his company as a kind of internal market that should also reward personal initiative motivated by economic reward. He encouraged the manager of each unit to be on the lookout for new opportunities that could benefit the bottom line. He took his philosophy beyond the company as well, working with Wichita State University to establish the MBM Center there. And on Sunday mornings when many Wichita residents were in church, Charles was in the family library, schooling his own children in “a curriculum that taught them about his systematic view of human behavior and how best to organize human society.”

Growing pains

By the mid-1990s, Koch Industries had developed what Leonard calls a “bias toward acquisitions.” Like private equity firms, the company had discovered that they could make more money by buying existing companies then by developing new products on their own. When it worked best, the acquisition strategy could unlock hidden value in underperforming companies, managing them or reselling them for high enough returns to justify the costs of acquiring them. But Koch Industries wasn’t immediately or consistently successful at this.

In the case of Purina Mills, acquired in 1998, Koch paid much more than Purina appeared to be worth, financing most of the deal with bank loans. Koch tried to characterize the loans as “non-recourse” debt, so that the banks would have no claim on Koch’s assets, only those of the Purina subsidiary. But when a collapse in hog prices threw Purina into bankruptcy, the banks successfully sued, claiming that Koch was not independent enough of Purina to justify non-recourse debt. Koch lost its own $100 million investment in Purina, plus another $60 million.

Koch had many other legal problems. In 1989, a report by the Senate Select Committee on Indian Affairs described the company as “the largest purchaser of Indian oil in the country” but also “the most dramatic example of an oil company stealing by deliberate mismeasurement and fraudulent reporting.” The federal case against Koch was eventually dropped for lack of evidence, but a federal civil suit over the same allegations was more successful.

Violations of environmental regulations were another problem. The company employed environmental engineers, but Koch’s Market-Based Management assigned them only advisory roles, while decision-making authority was reserved for the organization’s profit centers. When too much ammonia showed up in the Pine Bend refinery’s wastewater, Koch maintained production by illegally discharging it into the river anyway or letting it spill onto surrounding land. “Koch industries racked up a shocking number of criminal charges and civil complaints throughout the 1990s, branding the company as a kind of corporate outlaw.”

Leonard attributes such failures to the downsides of Market-Based Management, especially its single-minded emphasis on corporate growth and profits.

The culture inside Koch industries…borrowed some of the worst impulses from Wall Street—a hunger for high-profile deals, a desire for giant paydays, short-term thinking—and combined them with Koch Industries’ mandate for growth.

Reinvention and mastery

In 2000, Koch Industries went back to the drawing board and revised its corporate structure and growth strategy, though without abandoning the MBM philosophy. Koch Industries became basically a holding company, owning many smaller firms. The company took pains to segregate those firms from the parent company, so that the latter could avoid the kind of liability that had arisen in the Purina case. Koch Industries would profit from a strategy similar to that of private equity firms—buy a struggling company using mostly borrowed money, but structure the deal so that the debt was the responsibility of the acquired company; then use the company’s cash flow to make the debt payments. If they came out ahead, Koch got the profits. If they didn’t, they could let the acquired company take the fall. “In a matter of just a few years, Koch Industries would execute some of the largest private equity deals in America, with acquisitions worth nearly $30 billion.”

Another lucrative activity was speculation in futures options. If Koch could acquire more accurate information about future conditions than other traders had, it could profit on the difference. Since the demand for energy depends heavily on weather conditions, Koch hired the best meteorologists it could find. One Koch trader speculating on insurance policies made almost five times as much in a year as Koch’s entire pipeline company.

Surprisingly, for those who thought of Koch Industries as a corporate outlaw, Charles Koch began to insist on what he called “10,000 percent compliance,” which meant that everyone in the company would obey 100% of the laws 100% of the time. Sounds great, but what it may also have meant is that the company learned how to shape the law and use the law to its advantage, rather than risk breaking the law. The Clean Air Act had grandfathered in the pollution standards for refineries, so that old companies like Koch could operate, but newer ones found it too expensive to compete. Deregulation of energy prices opened up new opportunities for profit. Proposed regulations to combat climate change were a threat, but the company could use its considerable lobbying and media campaigns to defeat them.

In the early twenty-first century, Koch Industries was thriving. It seemed to have mastered the financial and political challenges of a complex and volatile economy. The Koch brothers were not simply producing something of obvious value and getting paid for it, like a Henry Ford. As Leonard said, they “did not invent a major new product or revolutionize any industry.” One wonders how much of their vast fortune was earned by making real economic contributions, and how much was a matter of using financial, intellectual and political capital to take advantage of those with less capital. With that in mind, I turn to Koch’s labor practices and political operations in my next posts.


Ages of American Capitalism (part 5)

July 13, 2021

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Continuing with the last of Jonathan Levy’s four ages, the “Age of Chaos,” I turn now to the present century and the period including the Great Recession of 2007-2009, the worst economic crisis since the Great Depression. Someday, Americans may look back and see it as the start of a new era in economy and government. So far, however, Levy observes mostly continuity since 2009, and not the new “democratic politics of capital” he would like to see. More on that later.

The “Great Moderation”

In 2004, Ben Bernanke, a governor of the Federal Reserve who would later become its Chair, used this term to describe the economic stability he believed had been achieved. (If this sounds familiar, I recently described Binyamin Appelbaum’s take on the “Great Moderation” in my third post about The Economists’ Hour.) At the time Bernanke was speaking, there had been only 16 months of recession in the previous 21 years. He credited this achievement especially to sound monetary policy, tight enough to control inflation but flexible enough to alleviate recessions by lowering interest rates as needed. Bernanke’s views expressed the capitalist confidence of the time—not only in the stability of the currency, but in the continued growth of economic demand and corporate profits.

Profits were growing rapidly in the 2000s; the bad news was that few of the economic benefits were reaching the average worker. Labor’s share of the national income was plummeting. Levy attributes that to another “credit-fueled and asset-priced” expansion, “which distributed, logically enough, more money to the property owners of assets, rather than to working people.”

Levy then provides a global perspective on this uneven expansion. Much of the world was experiencing an economic boom, but with some noteworthy imbalances. Manufacturing was booming in developing countries with historically low wages, led by China. Other developing economies prospered by meeting the increasing global demand for commodities like oil or iron. Countries of the new European monetary union were expanding their global financial services. The United States contributed a boom in housing and consumption heavily fueled by debt.

The relationship between the U.S. and China was pivotal. China’s communist leaders chose to save and invest much of the revenue from manufacturing exports. While holding down wages and consumption at home, they invested heavily in the United States, in effect financing the soaring U.S. trade deficit. (The federal budget also went from surplus to deficit as the George W. Bush administration cut taxes but increased military spending after 9/11)

The Federal Reserve had lowered interest rates as the economy slowed in 2000-2001. Now the combination of lower-cost loans in the U.S. and capital reinvested by the Chinese produced a “liquidity glut.” That fueled a speculative bubble in U.S. assets, especially housing. The moderation described by Bernanke gave way to a period of speculation and volatility, leading in a few years to financial breakdown.

Sources of profit

Levy does not claim that the American economy of the new millennium was based on speculation alone. Real businesses produced real goods and services and earned real revenue. Internet companies—so many of which had failed in the dot-com bust of 2000—were finding ways to become profitable. One way was to collect massive amounts of user data and sell it to marketers, as Google and Facebook did. Another was to gain a huge advantage over the competition by developing an especially powerful marketing platform, as Amazon did. Levy notes that such business concentrations challenge the thinking of the Law and Economics movement, which had weakened antitrust enforcement on “the assumption that short-term, rational profit maximization among firms would always increase competition to the benefit of all consumers.” One reason why labor’s share of national income declined was that big companies in highly consolidated industries had more power to set wages.

The benefits of the new economy were distributed unevenly, not only because of the growing power imbalance between business and labor, but because of the increasing premium placed on education and skills. The wage gap between college-educated and non-college-educated workers widened. Geographical disparities were also evident, as centers of technological innovation like Silicon Valley flourished, while old manufacturing cities and many rural areas declined. Unemployment remained stubbornly high in what was called a “jobless recovery,” since high-tech industries didn’t employ enough people to compensate for the decline in manufacturing employment. What job growth did occur was more in low-wage services.

A serious underlying problem was that the growth in profits was outrunning the growth in investment and productivity. Levy says that “productivity growth in general disappointed because few potentially productivity-enhancing innovations appeared.” Economic rewards flowed to the owners of intellectual capital (“Big Data”) and human capital (education), but not to enough workers. The investments that might have enhanced the productivity of ordinary workers were not, for the most part, forthcoming. But consumption could still grow if those with stagnant wages could compensate by assuming more debt. That’s where the liquidity glut came in, making it easier to extend debt to people at many income levels. That’s how the expansion of the 2000s turned into the great housing boom of 2003-2006.

U.S. housing prices shot up. Through a “wealth effect,” capital gains on leveraged property ownership could translate into new incomes for American homeowners. The housing stock thus became a new personal income flow. The age’s capitalism of asset price appreciation had found a new asset class to concentrate on, as many ordinary homeowners were given the chance to participate in the game of credit-fueled asset price appreciation. As in credit cycles before, it only worked so long as confidence was maintained, and prices kept going up. That was what the Great Moderation had come to depend on.

In booming cities, residential construction and home prices surged because of increased demand and short supply. But they could flourish in more depressed areas too because of riskier subprime mortgage loans (often with initially low but potentially very high rates). President Bush boasted about the “ownership society,” where ownership of a wealth-producing asset was open to all. The financial services industry constructed a $4 trillion pyramid of mortgage-backed securities on shaky ground. The securities became farther and farther removed from the real financial state of the borrowers and the affordability of the loans. Big banks created various classes of mortgage-backed securities, combined them in complicated ways until rating agencies underestimated their true risk, and even had them backed by insurance companies that also misjudged them.

Levy regards the economic expansion of the 2000s as a “wasted opportunity to make broad-based investments in economic life.” Too many dollars flowed into speculative real estate investments, based on the assumption that home prices would continue rising and workers with stagnant wages could make the payments on their subprime, adjustable mortgages. Meanwhile, “the alarm kept sounding that man-made climate change required long-term fixed investments in a new energy system to capture and reduce carbon emissions.” And climate change was not the only pressing national need being neglected.

The Great Recession

I have discussed the 2008 financial crisis and the associated recession many times, most recently in my summary of The Economists’ Hour, part 3. Levy’s interpretation is based on his understanding of the dynamics of capitalism, including the long-term, linear trend of technological advance and the shorter-term cycles of confidence and credit. The crash of 2008 marked the end of a particularly speculative credit cycle, when a liquidity glut suddenly gave way to a liquidity shortage.

The expansion of the 2000s came to depend heavily on the housing boom, which depended in turn on the extension of credit to home buyers whose low incomes limited their ability to repay the kinds of subprime, adjustable-rate mortgages they were getting. The risks were disguised by complex and overrated securities based on those mortgages. As long as buyers kept buying and confidence in rising home values remained high, the boom could continue. When housing prices peaked in 2006 and loan defaults increased, the bubble burst. Mortgage-backed securities suddenly lost value, and investment banks whose balance sheets were loaded with them could no longer raise cash either by selling them or borrowing against them. The collapse of Lehman Brothers in September 2008 triggered a massive contraction of credit.

Nervous, precautionary hoarding among the global owners of capital broke out on a massive scale. Capitalism regressed back to where it was during the Great Depression of the 1930s—mired in a liquidity trap. Across the board, spending of all kinds, whether for investment or for consumption, dropped off. Employment collapsed.

The “ownership society” celebrated by President Bush, in which Americans would prosper together by owning rapidly appreciating assets, had failed. “Due to collapsed housing prices, between 2007 and 2010 median wealth declined 44 percent—back, adjusted for inflation, to where it had been in 1969.” (That large a drop may sound hard to believe, but a family with a $300,000 home and a $250,000 mortgage has only $50,000 in equity, which drops by 44% if the house loses just $22,000 in market value. Many families have little net worth outside of their home.)

What was different in this financial panic was that the federal government quickly intervened to restore liquidity. The standard procedure of cutting interest rates to ease borrowing and expand the money supply was not enough. In addition, the Federal Reserve arranged and subsidized the buyout of investment bank Bear Stearns by JP Morgan. It made a large loan to AIG, the largest insurer of mortgage-backed securities. The Troubled Asset Relief Program (TARP) authorized the Treasury to buy “toxic assets” that companies could not otherwise sell. (Actually, Treasury injected the cash mainly by purchasing non-voting stock in the companies.) In 2009, the new Obama administration got Congress to pass the American Recovery and Reinvestment Act, which stimulated the economy with tax cuts, aid to states, infrastructure projects and government research programs. In 2010. the Federal Reserve adopted its policy of “quantitative easing,” buying up long-term Treasury and mortgage bonds in order to bring down long-term interest rates. (The higher the demand of lenders for bonds, the easier it is for borrowers to borrow at low rates.)

Although these measures alleviated the immediate crisis, economic recovery was slow. Little was done to prevent ten million homeowners from losing their homes to foreclosure. Nevertheless, a new conservative movement, the Tea Party, formed around the complaint that the Obama administration was doing too much to help “freeloaders” and not enough for “hardworking Americans.” Rather than rallying around Obama as earlier generations of Americans had rallied around Roosevelt, a substantial segment of the electorate still wanted less government, not more.

The limits of reform

On the other hand, Barack Obama was no Franklin Roosevelt either. He filled his administration with leaders associated with the moderate Clinton administration—economic thinkers who had trouble thinking beyond the restoration of financial stability. The Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) tightened regulation on the big banks and securities ratings agencies. But unlike Roosevelt, Obama didn’t have the benefit of many years of more sweeping proposals—in FDR’s case from the Populist and Progressive movements—and a public that was willing to try them. Even Obama’s rather moderate proposal for subsidized health insurance stirred up ferocious opposition.

Levy regards the Obama years as another lost opportunity. Because government could borrow money at near-zero interest rates, it was a great time to consider bigger public initiatives:

[M]any productive opportunities for spending cried out: to repair public infrastructure on dilapidated roads and bridges, to lay the foundations of a “green” energy grid, to invest in productivity-enhancing technology, or to support early childhood education to reverse the drastic effects of education gaps in the future labor market, to name some obvious candidates.

After Levy wrote those words, Joe Biden proposed such an ambitious agenda. But what Levy observed in the aftermath of the Great Recession was a “Great Repetition,” another expansion led more by asset speculation than by productive investment. This time it was an expansion of corporate debt that led the way.

Levy observes that each transition from one age of capitalism to another has required some form of state action. The victory of the Republican Party in 1860 and the Civil War ushered in the Age of Capital, as the nation transitioned from an agrarian economy based on land and slaves to a manufacturing economy based on steam-driven machinery. Then in 1932, the New Deal ushered in the Age of Control, as government tried to guide the economy with regulation, income supports, and fiscal or monetary policies to counter extremes of the business cycle. The “Reagan Revolution” of 1980 reacted against the reliance on government in the Age of Control and initiated the Age of Chaos.

A new age of capitalism—which Levy does not name and does not yet exist—would require more than an income politics focusing on the distribution of the benefits from capitalism. It requires a “democratic politics of capital,” giving citizens a voice in directing capitalist investments toward socially useful ends. Traditionally, government has directed investment primarily to wage war and maintain a military-industrial complex. Otherwise it has left major investment decisions to the private sphere and the owners of capital, who waste too much capital on short-term speculation. Now other urgent national needs may call for an expanded conception of public investment. Levy would probably like Biden’s concept of “human infrastructure.”

Readers who are not put off by the length of this book will find it historically informative and intellectually challenging. I highly recommend it.