The Federalist Number 24 and the Scope of Government

In the Federalist Number 24 Hamilton makes the following statement about the powers that the Constitution confers upon the federal government:

"The powers are not too extensive for the OBJECTS of federal administration, or, in other words, for the management of our NATIONAL INTERESTS; nor can any satisfactory argument be framed to show that they are chargeable with such an excess."

Are the powers that we have granted the federal administration today impractical for the management of national interests? I refer to the myriad of large-scale administrative tasks that the President and Congress are asked to review: Social Security, the Federal Reserve monetary system, Housing and Urban Development and the Department of Education. These are broad, comprehensive programs of such scope and extent that no group of people, much less a single person, could competently oversee all of them.

Compare the problems of the federal government to the problems of General Motors. The president of General Motors is beset with complex details and administrative challenges concerning a handful of products: automobiles, parts, financing and some additional products. Yet, the management of this handful of products has proven too difficult for the management of General Motors to handle all that well, and the firm seems to be drifting to bankruptcy.

Are the politicians who serve in Congress or the President that much more capable than the executives of General Motors? Are the people whom the president appoints to his cabinet and to senior posts in the federal agencies that much more competent than the management of General Motors? In the case of Hurricane Katrina, it seemed that the government agencies are not competent at all. Yet, the public has burdened the federal government with such extensive powers that the management problems, ranging from control to budgeting to personnel selection are orders of magnitude more complex than the problems that confront the executives of an automobile company.

When Hamilton, Madison and Jay wrote the newspaper articles that form the Federalist Papers, the United States of America had a population of three million. Today, the average state has a population of six million. Yet, the powers of government have been federalized to a much greater extent than Hamilton anticipated. This enormous concentration of managerial demands resulted from the perceived threat that industrial concentration posed to the economy. Yet, the concentration resulted in enhancing such concentration. The New Deal intensified the extent of concentration by establishing federal programs that replaced state discretion in fields like social security. The concentration was also enhanced by the civil rights struggles of the 1950s and 1960s, which required a degree of federal intervention to end Jim Crow laws and discrimination.

Today's problems are managerial as much as strategic or political: how to make social security work; how to best combine incentives for innovation with an equitable tax system; whether to extend or contract the scope of government; how to manage the nation's money supply to limit economic crisis and corruption. All of these are managerial problems that lend themselves to a range of strategic choices. The political arguments about them become more emotional and cantankerous as the various protagonists, Democratic and Republican, know less about each question. The expertise that fields like economics, sociology and business offer do not offer one or another optimal solution to any of these problems. In industry, trial and error has proven to work better than grand theory. Yet, subjects of considerable subtlety from the Iraqi War to the management of Social Security are pronounced upon with dogmatic rigidity in the pages of the daily newspapers and in the blogs.

Why can't a pragmatic delegation of complex managerial decision making to states, which are on average twice as large in population as the entire nation was in Hamilton's day, permit a multiplicity of solutions? Such a multiplicity would serve (a) to afford experimentation and learning about solutions; (b) to test alternative ideological approaches; (c) to resolve bitter conflict among Red and Blue proponents (d) to reduce and contain the risk of failure; and (e) to enhance democracy.

Howard S. Katz's Portflolio Performance versus Fund Managers'

Katz's performance in blue, fund managers' in red. The data can be viewed here. Katz's newsletter can be purchased at http://www.thegoldbug.net.

Stock Prices, the Fed and America's Win-Lose Economy

What is the role of the Fed in generating income inequality because low interest rates boost the stock market while the monetary expansion that causes low rates creates inflation and so reduces real wages? In a web page on stock market returns Jeremy J. Siegel in the Concise Encyclopedia of Economics notes:

"The average compound rate of return on stocks from 1802 through 1991 was 7.7 percent per year: 5.8 percent from 1802 to 1870, 7.2 percent from 1871 to 1925, and 10.0 percent from 1926 to 1991. The increase in the rate of return of stocks over time has fully compensated the equity holder for the increased inflation that has occurred since World War II. "

However, these numbers do not follow the contours of changing American policy concerning the Fed. Before 1913 there was no Fed. From 1913 to 1932 there was a Fed whose inflationary power was limited by a gold standard. From 1932 to 1971 Roosevelt had abolished the gold standard but the Bretton Woods monetary regime required that the US convert foreign dollar holders' dollars into gold. In 1971 Richard M. Nixon abolished the international gold standard.

To track the effects of Fed policy on real wages, inflation and stock market returns, I computed Dow Jones Industrial Average returns for four periods: the pre-Fed period from 1896 to 1913; the Fed/gold standard period from 1913 to 1932; the Fed/international gold standard only period from 1932 to 1971; and the gold standard-free period from 1971-2008. I also computed as best as I could with rough and ready Internet data (a) the inflation rate, (b) the Dow returns less inflation, (c) the compounded return on the Dow, (d) the change in real (inflation-adjusted) hourly wage, (e) the compounded real wage change and (f) the compounded inflation change for the four periods.

I was searching for income inequality data (the usual method of measuring income inequality is the "Ginni coefficient") but could not find a measure on the Web that goes back to 1896. I did find a partial measure in an article by Jared Bernstein and Laurence Mishel. To estimate the compound rates I relied on the 1040tools future value calculator here. Data on real hourly wage changes from 1896 to 1913 are available here. The Dow Jones website makes available its Dow Jones Industrial Average index from 1896. There are estimates available of stock returns from 1802, but what is gained in longitude is lost in comparability. Corporations prior to 1890 did not have the same legal attributes as they did after. Moreover, prior to 1880 stocks were limited as to their breadth of circulation, the nature of the firms for which they were traded and the risk involved because of changes in the corporate form of organization. Therefore, the 1896-1913 period will have to do as a pre-Fed measure to compare with subsequent periods.

The chart below (column A--see here for better view) shows that inflation was lower in the pre-Fed period than in any period since the establishment of the Fed in 1913. From 1896-1913 inflation averaged one percent (column H), while from 1913-1932, the Fed/gold standard period it averaged 1.7%. From 1932-1971, the international gold standard period it averaged 2.82% and during the gold standard- free period, thanks to Republican President Richard M. Nixon, it averaged 3.92%, the highest sustained inflation in American history. The media story that the Greenspan Fed achieved low inflation is but puffery by historical standards. The post-1980 era has a poor record with respect to inflation. At the same time, stock market returns have been boosted since the abolition of the gold standard in 1932 but not before. Column C shows that the Dow increased 108.1% from 1896 to 1913; it fell 23.32% from 1913 to 1932 because of the Great Depression and then it rose 1,143.7% from 1932 to 1971 and 1,266% from 1971 to 2008. Adjusting for inflation and compounding, stock market returns were 3.83% during the 1896-1913 period, -2.9% from 1913 to 1932, 5.93% from 1932 to 1971 and then 5.9% from 1971 to 2008. The key change seems to have been in 1932.



The establishment of the Fed and the abolition of the gold standard seem to have coincided with at first a dramatic increase in real wages and then a reduction from 1971 onward (see Columns F and G). From 1896 to 1913 real hourly wages increased 30.2% over 17 years or 1.6% compounded. From 1913 to 1932, the gold standard period of the Fed, real wages increased 45.5% or 2.12% compounded. This is in part due to reduced inflation during the Depression. However, and this contradicts my theory, from 1932 to 1971 real wages increased 171.8%, a compounded real wage change of 2.6%. Then, from 1971 to 2008, the gold standard-free period compounded real wages fell 27% or a compounded rate of -1.1%. This is a unique 37-year period, but it follows a period of very high wage growth from 1932 to 1971.

Despite the extensive discussion of income inequality, I could not find readily historical data available on Ginni coefficients or other income inequality measures going back to 1896. It is clear from the Bernstein and Mishel article that since 1972 income inequality as measured by the 90-10 cutoff has been increasing.

The data support the idea that changing the monetary regime boosted the stock market. The 5.9% real stock market returns post 1932 are 35% greater than the real, pre-Fed stock market returns from 1896-1913. If you factor in the Fed/gold standard period of 1913-1932 the boost is greater still. There seems to have been a correction in wages but not stock market returns from 1971 to 2008.

But there is conflicting evidence for the Fed/real wage connection. From 1932 to 1971 real wages increased by 2.6% per year, faster than in the 1896-1913 period, but then from 1971 to 2008 they fell by 1.1% per year. Arguably, the New Deal institutions such as labor unions sustained real wage growth for roughly forty years. Thereafter, there was a shift in employers' bargaining power. This may be because of the dramatic boost to monetary and credit expansion that the elimination of the gold standard permitted. Price inflation from 1971 to 2008 was 432% compared to 196.5% for the 1932 to 1971 period. The increasing price inflation may have enhanced firms' ability to substitute technology and equipment for labor and to finance overseas expansion sufficiently to counteract the wage gains made during the 1932-1971 period. As well, the effects of monetary expansion on real wages may be cumulative over many decades, and it is possible that 40 years of inflation resulted in a 40-year stimulus of demand for labor followed by adjustments due to even longer term inflationary effects. It may be that 40 years is the time required for inflation to influence real wages. However, it is also possible that labor unions were weakened during this period and so lacked the bargaining power to counteract employers' strategies. It is also possible that globalization has increased wage competition and has forced firms to be more competitive.

Rather than view stock returns as resulting from investor demand, as Professor Siegel does, it might be more logical to view them as ensuing directly from the Federal Reserve Bank's subsidization of the stock market. The Fed subsidizes the stock market by depressing real interest rates, which increases stock valuations and enables firms to borrow cheaply. Lower interest rates enable firms to substitute machinery and technology for workers to a greater degree than they otherwise would and to finance moves overseas. As well, workers may not be completely aware of inflation's effects on pay, and accept wages under illusory price stability. Thus, the Fed may have served as a wealth transferal device from workers to stockholders. The one fly in this story's ointment is the sharp increase in real wages during the 1932 to 1971 period.

The Federalist 14 and Decentralizaton

In the Federalist 14, Madison argues that while direct democracy is possible only in a small country, a republic can cover a larger geographic area. Based on the transportation available in the 1780s, he shows that a federal republican form of government is possible since the delegates can travel the distance required. He adds that:

"It is to be remembered that the federal government is not to be charged with the whole power of making and administering laws. Its jurisdiction is limited to certain enumerated objects, which concern all the members of the republic, but which are not to be attained by the separate provisions of any. The subordinate governments, which can extend their care to all those other objects which can be separately provided for, will retain their due authority and activity. Were it proposed by the plan of the convention to abolish the governments of the particular States, its adversaries would have some ground for their objection; though it would not be difficult to show that if they were abolished the general government would be compelled by the principle of self-preservation to reinstate them in their proposed jurisdiction."

Madison's recognition of the principle of decentralization anticipated the evolution of large scale corporate enterprise in the twentieth century. In his classic book Strategy and Structure, Alfred Chandler argues that big business evolved from the functional into the decentralized form in the twentieth century in response to strategic shifts, notably the concentration of industry and the formation of conglomerates. The reason the decentralized form was necessary was that the informational demands and transactions costs of a large organization inhibit intelligent processing. Madison anticipated this development in the 18th century.

The information demands of government are greater than the informational demands of private industry. The flexibility required is greater and the scope of the market is greater, which implies the need for greater diversity of strategy. Yet, the modernist or progressive approach to organizing government has been to centralize decision making authority. This runs counter to the insight not only of Madison but of practical business strategists who have learned that efficiency as well as responsive, flexible strategy depend on integration of small scale with large scale and the loose coupling of federal and local units.