Michael Hudson’s Model for Latvia

Ed. Keith Wilde


The following article describes a plan for the economic development of Latvia prescribed by Michael Hudson (Distinguished Professor of Economics at the University of Missouri, Kansas City). It has been endorsed by the government and central bank, and Dr. Hudson has been engaged as a visiting professor in Riga to guide a new generation of policy analysts and managers in the conduct of the research required to initiate and operate the plan. This text was digested with his permission from a statement prepared as background for discussions with Latvian officials and journalists:

My general approach can be described as advising Latvia to adopt practices that have encouraged development in other countries and to avoid some that have been destructive.

I focus on three related targets:

• A tax system that promotes investment in economic infrastructure;

• A financial system that encourages tangible capital formation and avoids parasitic bleeding of its earnings;

• Protecting exchange rates from international financial flows.

The targets illustrated by experience with national policies:

An Efficient Tax System

The most successful model of economic development is that of America. Since the late 19th century, its basic strategy has been to create public infrastructure – roads and other transportation, power and water utilities, radio and broadcasting, telephones and other communication – and provide these basic inputs at a low enough cost to make the United States competitive. These public utilities are important because their costs influence the economy’s cost structure across the board.

The basic rule is that whereas private investment is run to make a profit, the return to public-sector investment takes the form of lowering basic costs throughout the economy. This is called the "Patten Principle," named for Simon Patten, the first economics professor at the Wharton School of Business at the University of Pennsylvania. Patten became the mentor of economists who played a role in Franklin Roosevelt’s New Deal in the 1930s, which saw the government pick up many "external" costs that the private sector otherwise would have borne, including Social Security and medical care.

Equity Versus Debt Finance

The fact that basic infrastructure tends to take the form of natural monopolies requires a system of regulation if it is to be privatized. In the United States, this was begun with the Sherman Anti-Trust Act of 1890, and subsequent legislation. The aim was to prevent private owners from introducing "watered costs" that were not necessary for production, and would have increased the cost of basic services.

The traditional purpose of stock markets was to raise equity capital in preference to borrowing. This enabled companies to minimize their fixed overhead costs of doing business. It also gave them the flexibility to cut back dividend payments in economic downturns.

But in the 1980s corporate raiders in the US sold "junk" bonds at high interest rates to buy out stockholders and "take companies private." This practice was encouraged by tax rules. Companies were taxed on dividends, but not on their interest payments. This meant that with a 50 percent income-tax rate, they could pay out twice as much income in the form of interest to bondholders and bankers as they could pay as dividends to stockholders. This contributed to the fourfold rise in US national debt during the 12-year Reagan-Bush administration, 1981-92. It meant that the stock market became a vehicle for retiring equity capital and replacing it by debt. This made industry more financially fragile, as well as raising its break-even costs. To protect themselves against these unwanted takeovers, many companies switched to debt-financing themselves in preference to building up equity via retained earnings.

At the end of the 1980s, Congress ruled that debts taken on to finance corporate takeovers were not a "necessary cost of doing business," and hence had to be paid out of after-tax income. But by this time the damage had largely been done.

A "Financial" Rate of Exchange Compared to an Appropriate "Real" Exchange Rate

Switzerland illustrates the problems that tend to develop between finance and industry. After World War II it became a major banking center – in practice, a flight-capital center. Money flowed in from Europe, Africa and North America to avoid taxes and regulation, and in many cases, criminal prosecution.

This was good for Swiss banks, but the more money flowed in, the higher the franc rose. In a world where a Coca Cola sold almost everywhere for a dollar, it cost $3 in Switzerland. The stronger the Swiss franc became, the weaker the business sector became. It was harder for pharmaceutical firms, machinery companies and other industries to compete in the global marketplace. Ciba Geigy, for instance, set up plants in Germany, just over the border. Ultimately, the company dissolved.

The moral of the Swiss experience is that money can pour into a country’s banks, and not provide a source of employment for most of its labor.

An expansion on the principles illustrated above.

My knowledge of international finance and trade theory came primarily from working at Chase Manhattan Bank, the Arthur Andersen accounting firm and some global companies. When I was asked to teach the subject, after a decade on Wall Street, I found that academic textbook economics did not have much that was helpful to explain how the world economy worked. I therefore designed a new curriculum at the New School for Social Research in New York. The focus was balance of payments and the factors that determined competitive advantage among nations.

America got strong by developing its own unique economic practices – above all, industrial and agricultural protectionism, and an avoidance of foreign debt. Also strong was its development of public utilities in private hands – but with firm regulation to prevent monopoly pricing.

The United States made effective use of principles developed in classical British economics. Its policy goal was to minimize economic rent, that is, the "free lunch" in the form of income that had no counterpart in necessary costs of production. Public utilities were developed and operated by private investment, but these were recognized as natural monopolies for which a system of regulation was required. The legislation that created this system aimed to minimize financial costs and payments to managers in excess of what actually was needed to produce and distribute electric power, transportation, radio broadcasting and telephone networks, etc.

The basic rule for tax policy is to tax the rental value of land and other revenues that are not economically necessary. The reason is that the land is supplied freely by nature. Taxing it will not take it out of circulation, whereas taxing industrial capital or wages will constrain employment and production.

London provides an example. It recently discovered that a new subway tube line raised real estate values along the route by billions of pounds sterling. Economists therefore propose that London finance its tube and city transport system by issuing bonds secured by taxes levied on the rising real estate values of property along new routes to be built. This means that transportation does not have to be financed by raising fares, which would squeeze living costs. Landlords owning property along the routes find their rental value enhanced, and pay a portion of this rental value as an additional "windfall" tax.

This is how the United States financed its basic urban infrastructure for over a century. Every American city has a tax department that makes land maps and uses them to tax the rise in property prices. Rental income that was taxed was not available to be pledged to bankers as interest on loans to buy homes and office buildings. Hence, while the value of real estate – and hence, the tax base of US cities – rose, land taxes for many decades kept property prices within reason by limiting the growth of mortgage debt.

Counter-examples: Consequences of Failure to Apply the Principles

The United States departed from its own successful experience with land taxation, from about 1992. Since then a real estate bubble has emerged, as taxes failed to keep pace with property prices. Lower tax rates have encouraged higher real estate prices, for rental income freed from taxation has simply been pledged to mortgage bankers as interest. Rising real estate values entail bigger mortgage loans and consequently a higher degree of general indebtedness in an economy. Failure to levy taxes on windfall rents therefore makes the economy more financially fragile as well as less competitive in terms of the cost of living and doing business. Housing and office space have become the largest cost variations in global competitive advantage today, playing the role that grain and other food played in international pricing prior to the 20th century. This makes groundrent the major consideration in determining a nation’s employment functions and hence economic destiny.

Another defect of tax systems is illustrated by London. It has recently experienced a great property boom that is pricing its workers out of the market. It is estimated that almost three-quarters of central London property is owned outright without a mortgage, primarily by "foreigners." Britain’s tax system permits offshore entities to own property and to thereby avoid capital-gains taxes. Since most of this "capital gain" is a reflection of rising land prices, it is a windfall gain that can be taxed away without reducing the supply of such land. In general, economies should try to minimize or even avoid absentee ownership. It is a dead economic loss and a balance-of-payments drain.

When England and other countries moved to privatize public utilities after 1980, they did not apply the successful US experience. Their governments sold off public enterprises without first putting regulatory guidelines in place. The result was a financial giveaway to the buyers and managers of these enterprises. The system became worst in Russia, where US advisors had a free hand in applying the so-called Washington Consensus.

Distortion of the principles by special interest political influence.

The failure of post-Soviet policy in Russia exemplifies that of the neoliberal World Bank/IMF model. "Junk economics" is spreading along with the Junk Science that special interests invoke in the debate about global warming, environmental pollution, health care, the proper funding of pension systems, financial deregulation and monopoly re-regulation. The doctrines touted as a theory of free markets turn out on closer examination to be special-interest pleading to lobby for special tax favoritism and the abolition or avoidance of anti-monopoly legislation and the kind of regulation that the United States pioneered. The political implications of economic doctrine tend to be overlooked outside of the United States.

A danger in the global reach implicit in the "Washington Consensus" is that foreigners are able to take over country financial systems, public infrastructure and business through financial manipulation. All too often such takeovers close down local industry and turn it into a real estate venture. Latvia should maintain a strong system of domestic credit creation.

Savings are not necessary to create bank credit; in fact, it is bank credit that creates savings. American financial strategists are more aware of this principle than are European central bankers. Budget deficits being run up by the neoliberal Bush administration in the United States pump money into the economy while creating unprecedented private-sector debt levels as well. The resulting non-saving has made US consumers the "engine of growth" for Europe as credit created in the United States finances the demand for goods and services that European economies fail to generate. This difference might be attributed to European fear of hyperinflation, but it is more accurate to say that economic theory has been politicized by special interests.

Latvia should avoid the financial policies imposed by the European Central Bank, whose monetarist operating philosophy has been criticized in the United States and even Britain for its mistaken view that deliberate unemployment, cutting back on public infrastructure spending and lowering real wages makes economies more competitive. This deflationary policy is needlessly wasteful, and threatens to retard European growth and increase its dependency on foreign countries.

Recommendations for Latvian Development

Economic and legal managers need tools for understanding and recognizing the economic realities that affect real growth and generate sustainable wealth. As a starting point, I propose the construction of a balance-of-payments model.

I created such a model while working for Arthur Andersen in the 1960s, and published it through New York University’s Institute of Finance. I then worked with the US and Canadian governments in the 1970s to set up a system of such accounts, and later did this with the United Nations Institute for Training and Research (UNITAR), and trained graduate students at the New School in New York.

Few countries make this kind of model, relying instead on the balance-of-payments accounting format that was developed to dovetail into national income statistics. This arrangement artificially segregates capital flows from trade flows. To see the inter-relationships, one must re-organize the statistics into functional categories: a consolidated government account, industrial sector, agricultural sector, financial sector, and personal sector. My aim for Latvia is to establish a working group to make an annual set of statistics and charts to analyze these payments. Part of this effort should be the creation of land-value maps of major cities. These would show rising land values concentrated around the major transportation nodes, parks and major business districts. The next step would be ownership profiles to differentiate among absentee owners (rental properties)and owner-occupants, and to show the proportion of property owned by non-Latvians. Then, a financial profile of the mortgage debts attached to these properties.

Condensed and edited by Keith Wilde

Brief Editorial Comment (from Economic Reform)

Although much of what Michael Hudson has proposed to Latvia is excellent, and his designation "junk economics" for what is practised by most governments today is sheer bull’s eye, there are at least two very important areas that he leaves untouched.

One is the need of replacing the bookkeeping of practically all central governments until the mid-1990s with serious double-entry bookkeeping – more specifically accrual accountancy, a.k.a. "Capital budgeting." When private firms purchase a building the usefulness of which will last for decades, they depreciate it over its useful life and carry its depreciated value on their books to balance the remaining debt for its acquisition. Not so governments until the US broke ranks in 1996. They treated the building of a road, a bridge, a building, to say nothing of investment in human capital – education, health, social services, the same way as they do their purchase of floor wax or insect repellant. The result was a fake deficit that bond agencies used to drive up interest rates – which is just what the governments intended.

For any increase in the price level is still considered an instance of "inflation." However, a higher price level, may be due in whole or in part not to an excess of demand over available supply, but to an increased layer of taxation in price reflecting: (1) the actual increase in government investment in essential infrastructures, paid for by taxation, (2) even the attempt to depreciate government investments in a single year seriously exaggerates this effect; (3) the high interest rates raised to flatten prices contribute to costs of production and impede the maintenance of existing infrastructures, let alone the creation of necessary additional ones.

Elsewhere in this issue, the reader will find this repeated too often – because others fail to mention them a single time. For example, an explanation of how the false policy tailored to the interests of speculative finance planned by the Bank of International Settlements (BIS), brought in the Risk-Based Capital Requirements for financial institutions that declared the debt of developed countries risk-free and thus requiring no additional capital for banks to acquire. This allowed banks to load up with completely leveraged government debt. At the same time, the same BIS in the 1991 annual report of its manager of the day, Alexandre Lamfallusy declared that absolute "zero inflation" had to be achieved rather than settling for 1% or 2% as even the "best" central bank heads have been satisfied with.

What BIS overlooked was that if you drive interest rates high enough the market value of pre-existent bonds take a beating. This oversight almost brought down the international monetary system. What saved it was the US government as of January 1996 introducing accrual accountancy, but in stealth, calling it additional "savings."

That carried back some years, retrieved some $1.3 trillion for Washington’s books. But that still did not recognize the vast government investment in human capital.

What We Repeat Too Often because Others Fail to Mention Them Once

An essential part of the Roosevelt economic policy that Hudson describes so well was his Bank Act of 1935, that required commercial banks to redeposit with the Federal Reserve a modest portion of the deposits tey take in from the public. On this no interest is paid for several reasons, an important one of which was that these statutory reserves provided the central bank with an alternative, less damaging means of reining in perceived inflation than higher interest rates. This, and many other aspects of the Roosevelt reform were phased out leaving higher interest the one "blunt tool" to "fight inflation."

Especially for a small country like Latvia, it is important for the government to finance as much as possible of its investment – especially investment requiring only national currency through a nationally-owned central bank – like that of the Bank of England or the Bank of Canada. For in that case the interest paid on such debt returns to it as dividends. That is a point that should be made, for it is a matter of faith of "junk economics" that governments can make no investments, but only waste money.

Please extend our congratulations to Professor Hudson on his appointment. We will be happy to put him on our complimentary mailing list upon his request, and send him a selection of books published by COMER on these matters.

William Krehm

– from Economic Reform, June 2006