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The Wealth Of The Nation

March 2023
16min read

The most influential economist in the United States talks about prudence, productivity, and the pursuit of liquidity in the light of the past

TWENTY YEARS AGO , the American economy hummed like a well-oiled machine. We actually exported automobiles and oil. Economists worried about the “dollar gap”—whether the rest of the world would have enough dollars to buy from us—and the inflation rate was one percent. The economists of John F. Kennedy and Lyndon Johnson spoke of “fine-tuning” the economy. Today the economy moves only by sputters and spurts. We have idle capacity; interest rates have been in double digits, and recently so has inflation. Economists seem to have lost their faith, and there seem to be no easy or ready answers. What happened?

Henry Kaufman is an economist who finds himself both famous and powerful, even though he has never held public office. As the American economy began to slide, it was Kaufman who delineated the reasons, particularly the piling up of debt. Born in Germany, Kaufman had taken economics, finance, and banking degrees at New York University, Columbia, and the New York University Graduate School of Business. He worked briefly in commercial banking, then in the research department of the Federal Reserve Bank of New York, and he joined the Wall Street investment banking firm of Salomon Brothers (now a subsidiary of Phibro-Salomon) in 1962. As a major international underwriter and trader of bonds, stocks, and money market instruments, Salomon Brothers needed the best of intelligence on the credit markets. Kaufman became a partner in 1967 and a member of the executive committee in 1972. Throughout the 1970s Kauf man’s reputation grew, until finally his predictions of interest rates had a major influence on the bond and stock markets. Because these predictions, based on the statistical analyses of his staff and himself, were frequently gloomy, he was called “Dr. Doom” on Wall Street, albeit with affection.

Adam Smith is an interpreter of world financial markets. His 1968 book, The Money Game , was called “a modern classic” by the Nobel Prizewinner Paul Samuelson. His most recent book is Paper Money , published in 1981, which, like Kaufman’s work, delineates the pyramiding of debt. Adam Smith is the pseudonym of George J. W. Goodman, who was trained at Harvard and Oxford. This interview took place early last summer—before the astonishing mid-August stock market advance that was partly triggered by Kauf man’s prediction that interest rates would tend to decline through the rest of the year.

You spent close to nine years as a little boy in Germany before emigrating. What was it like?

I was born in 1927 in a small town about an hour away from Frankfurt and I went to grade school there for a couple of years. Thus, part of my childhood in Germany was during the period when Hitler rose to power. I remember a day in the early thirties when all the schoolchildren, including myself, were asked to line up as the army passed through and Hitler came along in his open car. Everybody in town cheered; the jubilation was just unbelievable. His car passed within a few feet of me. I will never forget it. It’s as vivid as the memory of when the Nazis broke into our house.

While you were in it?

Yes. The Nazis loved to stage torchlight parades. After they were all fired up, they would seek out Jewish homes. It was a January night. We were sleeping upstairs. My father escaped through the back into the fields, and although they did not break into our bedrooms, they tore apart everything downstairs.

It must have been terrifying.

It certainly was. It was about three or four in the morning and icy outside. Afterward, some neighbors down the block, also Jews, came to our house in their pajamas. They were bleeding from beatings by the Nazis. That is when we decided to leave. That was in early 1937.

Was it easy to leave?

It was not easy for my grandparents, who had lived all their lives in Germany. But we were fortunate that my grandfather had several sisters who had come to the United States at the beginning of the century. They were our sponsors.

You must have thought about what that experience has meant to you, how it carries into your work or how you see life.

I think we’re all products of our past in some way. Because of that experience and because of my studies, I believe that it is very important to have an orderly economic system and to have a relatively strong middle class. It is very dangerous when societies become polarized.

When you look around you today, do you see anything that worries you?

I would say that one of the great strengths of this country has always been its diversity of people, who, in a variety of ways, have amalgamated through economic opportunities into a large middle class. In the United States there is opportunity to grow and, therefore, to expand the wealth of everyone. This helps to maintain a well-balanced society.

Well, what I’m thinking of is a piece that Kevin Phillips wrote in New York Review . He said that Reaganomics is a failure and then drew parallels to the Germany of the twenties and thirties.

That is rather extreme. But I have been greatly concerned about high rates of inflation and associated excessive growth of debt, and their adverse economic consequences. To some extent these concerns may reflect the influence of my past. I recall my grandfather telling me many times about the 1920s in Germany when he had accumulated substantial capital. It was in a variety of assets that did not appreciate with the hyperinflation of that time, and he was wiped out. In addition to the personal experience, my business experience has led me to the conclusion that financial institutions play a crucial role in society. Financial institutions have fiduciary and entrepreneurial responsibilities.

How should the financial system shepherd things?

Its primary role is as intermediary between the saver and the so-called demander of money. Therefore, the financial intermediary holds both the temporary and permanent savings of the private sector. That is quite a trust. The financial institution, therefore, has to be judicious in its decisions.

In the fifties and sixties, the savings pattern was stable. People didn’t rush around deciding whether to invest in money market funds or in Treasury bills or commercial paper.

You’re talking about banks and savings and loans?

All financial institutions: insurance companies, pension funds, mutual funds. Small institutions as well as large ones. They all do their best if they balance the fiduciary responsibility with the entrepreneurial drive. If the entrepreneurial drive exceeds the fiduciary responsibility, then the credit system helps generate excesses. As you leverage the use of credit more and more, you eventually begin to jeopardize the system.

Is that what’s happened in the United States?

Some of that has happened, but it is difficult at this time to estimate the magnitude of the change.

Then let’s ask a larger question. Do we have a major economic problem now? If we do, what is the problem and how did we get to it?

We are confronted with the problem of disengaging from long periods of economic and financial excesses. As we went through the sixties into the seventies, the rate of inflation began to accelerate. Business and financial practices as well as personal rules of conduct were liberalized. Some economists offered painless solutions to complex economic issues.


We did not arrest quickly the acceleration of inflation. In finance, for example, innovative techniques were devised to hide the leveraging of balance sheets. We developed in economics a phraseology that suggested a high degree of accuracy that really didn’t exist. Such phrases as “fine tuning,” “rolling readjustments,” and “soft landing” were coined to describe a presumed nearscientific precision in economic policy. This misapplied language was utilized and politicized to give false comfort in an economic setting that was becoming increasingly complex. When you can give seemingly precise words like “soft landing” to a political leader, it is much easier for him to handle an economic issue than to say that we have serious trouble that will be difficult to solve.

So you are saying that the economists were telling the Presidents what they wanted to hear?

Some Presidents took what they wanted from that language. It should also be remembered that in the past fifteen years or so we moved from the period of the forties and fifties when we were relatively cautious—cautious because the people in power at that time all remembered the 1930s. There is nothing like the memory of a debacle to put you in a cautious frame of mind for an extended period of time. Then we went through the fifties with only a moderate economic recession and a small debt structure overhanging the economy. Gradually a new group of managers assumed responsibilities, and the lessons of the thirties began to fade. We became much more aggressive in our national economic policies and in business and financial decisions.

You mean business and financial people, investors, savers?

Everyone. Standards were gradually compromised—in personal, business, and financial life.

Do you think there is a parallel between what went on in people’s personal lives—the sexual revolution and the fragmentation in the nuclear family and all of those things that happened in the sixties—and what happened in financial life?

I think that would be very difficult to prove, but the liberalization was certainly coincident. There was a lessening in the standards of economic morality at the same time there was a loosening of social and personal morals.

The traditional economic morality would be “A penny saved is a penny earned” and “Work hard, get your reward”?

That’s right.

But now it was the speculator instead of the saver and the worker who benefited?

I would not characterize the change in those terms. Here is what I mean: In the fifties and the early sixties the dominant individual in the business corporation was usually the one who understood operations of the business—the manufacturing process, marketing, production, distribution, and so on. Finance, in the corporate structure, ranked relatively low in influence. In recent times, however, the financial aspect of business has become increasingly important. In personal financial affairs in the fifties and sixties, the savings pattern was stable. People didn’t rush around deciding whether to invest in money market funds or in Treasury bills or commercial paper. People were not preoccupied with this. Nevertheless, economic life produced generally good results for both business and householders. Today, American industry is under pressure, and our personal activities as savers and investors are occupying much more of our time, with less rewarding results.

Doesn’t this hurt us as a country? Like lawyers, financial people don’t contribute to the efficiency of the product.

Yes, I have always believed that financial people are not innovators of products. Financial people quickly follow the productive innovative process in the real world, but they don’t engineer it. We are middlemen. Incidentally, there has always been an aspect of the history of American finance that has fascinated me: Somehow the business world dealt with the financial world at arm’s length. Many business leaders were not intimate with the financial world. They went to the financial world whenever they needed money, but otherwise the relationship was distant and formal. I think that was a good relationship. Now we have a much greater intimacy between the financial world and the business world, and we’re moving more toward the European pattern, where the financial world has much greater influence on the business world. In Europe, it’s direct. For example, the German banks are both lenders and equity holders. In the United States the pattern is more subtle. The volume of lending to business corporations is increasing. Debt is increasing more rapidly than equity. Therefore, the relationship of the creditor to the debtor is becoming closer. In addition, most of the huge volume of commercial banks’ loans to business corporations is being rolled over.

And nobody ever says, “Now pay it back.”

It isn’t self-liquida ting as it used to be. That is, the loans aren’t gradually being paid back. And because they are not self-liquidating, the relationship between borrower and lender becomes closer.

You mean the bank really becomes a part owner of the business?

Well, we aren’t quite there yet, but in some instances the banker has become a part owner even though the credit instrument is called a debt obligation. At some point, when the credit quality of the company deteriorates enough, the new role of the lender as an owner becomes more evident.

What is the harm in it?

The great discipline in our system has been the existence of two markets in our credit structure—the open credit market and the negotiated market. The open credit market consists of marketable securities—bonds, stocks, commercial paper, and the like. The negotiated market involves the direct relationship of lenders and borrowers. The American credit structure provides a sort of check and balance. In this system you can very quickly spot a deterioration of credit. For example, if there are bonds outstanding, one can watch how those bonds trade in the secondary market. Most bonds carry a credit rating, and even if the credit rating isn’t lowered quickly enough, one can sense by the way that obligation trades whether that credit rating is going to break or not.

What you’re saying is that the markets judge how good the credit is. They sell the bonds down if credit quality is deteriorating so that the price of the bonds drops?

Yes. So you have a disciplinary force working. On the other hand, if there is only a direct relationship with lenders, then that discipline isn’t there. It isn’t visible to everyone. It is important to preserve both the open and the negotiated credit markets—for the benefit of both lender and borrower. For a long time the markets in stocks, bonds, and commercial paper were a source of liquidity—cash—for commercial banks and other institutional lenders.

I’ve got a footnote question to this and I haven’t seen the answer anyplace. And that is this visibility of the discipline. If the corporation sees that its bonds are being marked down in the marketplace or one of the rating agencies marks down its bonds, then a director or a shareholder is likely to ask a question. Money will cost us more, and you have this disciplining force that you talked about, whereas if you just keep going back to the bank, they’re cozy with you, you’re cozy with them, and they’re glad to lend you more money. But don’t the Japanese have a very high ratio of debt?

Yes, they do.

And they’re certainly cozy with their banks, and yet their businesses seem to keep their operating leanness even without this discipline.

I’ve visited Japan numerous times and I also have visited with many Japanese here. I suspect that the Japanese have their own type of accounting system, which is difficult for Westerners to fully comprehend. The linkages among government, labor, and business are unique. The Japanese are extraordinary planners, working with great flexibility. How they allocate profits among the financing institutions, the business corporations, and the government is very difficult for us to understand.

Well, the direction of my question was that when you say we’re missing this disciplining force, you’re suggesting a healthy adversarial relationship. After all, if you have a disciplining force, it’s adversarial in its nature.

Somebody blows the whistle.

Right. And so what you’re saying about the Japanese is that if they don’t have this system, with its discipline, they just don’t operate under the same rules of the game.

Their entire decision-making process is different from ours. Their decisions float up. Our decisions drift down. We Americans—particularly at the management level—all want to rush to make decisions. There’s something either Western or American or macho about it, and we never seem to make a decision quickly enough. The Japanese operate differently. Their decisions are made by a slow upward movement through the organization. This takes time. By its nature the management decision-making process is tedious. I know from my own organization that many of my partners would prefer to make a trading decision rather than a management decision.

I haven’t always been pessimistic, and some day I may become optimistic again. From 1974 to the present, the economic and financial patterns have not been good.

What’s the difference? What would a management decision be? How many more people to hire or what areas to move into?

What activities should we move into or eliminate, whom should we promote, the compensation structure of the firm, the measurement of performance, the limits to risk taking, et cetera. These are areas in which the consequences of your decisions aren’t forthcoming very quickly. On the other hand, if you make a trading decision, you get the answer right away. It’s clean.

It’s really two different kinds of personality, isn’t it? Good managers are not necessarily good traders?

Yes, but at the same time, good managers better know what it takes to be a good trader.

How do you define what you do?

As you know, Salomon Brothers is a very large international firm, trading and underwriting institutional securities here and abroad, advising governments and corporations, and conducting extensive research. If there’s a corporation that seeks to finance, we will buy the securities at a price, at a stated interest rate, and take the risk of selling them at that time. We will also buy or sell securities to or from investors out of and into our inventory. We carry very large positions relative to our capitalization. There is a very large turnover. Our gross value of transactions last year exceeded a trillion dollars. To back up our decisions, we probably have more proprietary information on interest-rate developments and relationships than anyone else in the country.

And your testimony before Congress always makes headlines.

I never really know ahead of time which conclusion of mine will “make headlines” and which will not. It’s mystifying. I do try to limit my testimony before Congress to no more than two times a year and preferably once a year. Appearing before Congress requires extraordinarily detailed preparations.

Is it an ordeal?

Let’s say it’s a rugged exercise. My last congressional appearance was before the House Budget Committee in March. I was the only one who testified before the committee that morning. It was a session that lasted from ten o’clock to a quarter to one. My prepared remarks took thirty-five minutes to read. Over two hours was devoted to fielding questions.

But isn’t that exciting and challenging? Isn’t it the most gratifying of all activities to be a friendly witness to a congressional committee?

“Friendly” is probably an incorrect description. I try very hard to be helpful and objective.

Some businessmen are surprised to find a Wall Streeter like you criticizing a Republican President.

I think it’s very dangerous in a society to have only a uniformity of views. I lived for a while in a society where there was also a kind of a unanimity of views.

You mean in Hitler’s Germany?

Yes, and a suppression of criticism. Nothing like that is happening here, of course, but I would find it worrisome for the future of our society if it were monolithic in its viewpoints. It’s a healthy environment to have differences of views. In the early part of last year the administration seemed to be saying, “Let us all believe and pledge allegiance to the economic approach postulated by the administration,” as if it were the patriotic thing to do. The important consideration, however, is what will this new approach produce. If you believe the administration’s plans may not work out, then it is your duty and obligation to speak up.

I’m not going to ask you what’s going to happen in the short term. But taking the long view, where do you see us going in the 1980s?

I think there is some room here for hope and there’s room for questioning. Immediately ahead we are faced with an interim problem. We must disengage from the problems of the past, disengage from a combination of policies that binds us in a kind of sputterand-spurt economic environment for a while. Three or four years from now the setting probably is going to be better. At that time I think the oil problem will be even further behind us than it is today.

Why do you think that?

We have set in motion a certain amount of energy conservation, exploration, and productivity that is not going to be reversed. For example, there is a strong drive for energy substitutes for oil and for more efficient usages of energy so the system can operate with less oil. Also, three or four years from now, more of the current high defense expenditures should be behind us. Moreover, I believe that the young people who are coming into the labor force now are better prepared. The graduates are well trained in mathematics and the sciences, and many of them are quite ambitious.

But what do we face between now and the middle eighties?

We probably face a period of some subnormal economic growth, the same sputter-and-spurt type of economy that I’ve talked about. We need to be very careful that we don’t weaken the financial structure any further.

Do you think there’s a chance that the financial structure will become unraveled?

Of course there’s always a chance. What you’re really asking is whether we can have a repetition of the 1930s. If you had asked me twenty years ago, I would have said that the odds were a thousand to one against such an event. Ten years ago, a hundred to one. Now I would guess it’s now eight or ten to one. The odds are against it, but the odds are shrinking. The trouble in answering your question is that we in the economic and financial world don’t have the analytical skills to quantify the economic outlook completely. A Great Depression is an event that occurs at the most once in a lifetime, and therefore it is difficult to estimate the likelihood of it happening. We have to be very careful that we don’t further weaken the financial fabric of the business entity.

Are you surprised that business, financial, and governmental people turn to you as a sort of oracle?

I’m always surprised when there’s some market response to what I say. Why it happens I don’t know.

You also became known as a kind of symbol of gloom or doom.

The fact is that I haven’t always been pessimistic, and some day I may become optimistic again. Most of the time from ’74 to the present, the economic and financial patterns have not been good. Now the dilemma with being bearish is that it goes against human nature. In business and finance, objectives are set on optimistic assumptions. So bearish views are not welcome.

Do you think people have lost faith in the ability of the government to manage our economic and financial problems?

I’m not sure about that. The United States is different from Europe. Many Europeans are very skeptical about their governments and the environment in which they live. That’s why it’s such a great pleasure when I return to the States from a trip abroad. Americans by nature are more constructive, more optimistic, more outward going, more positive. Maybe it’s part of our heritage, part of our tradition, the wealth of the country, the size of the country, the diversity of our people. These are among the great qualities of the United States. I don’t think one can say, therefore, that Americans have lost their confidence in government. Even the election of President Reagan was a kind of a search for new confidence, for change, for a leader who would take us out of the morass we had fallen into.

In an era like the one you see ahead, what about a small investor? What is prudent and what is not for him?

I think when it comes to an individual coping with the environment, it is a matter of preserving his income stream. In most instances, an individual is preoccupied with his or her endeavor.

In other words, you should think of yourself as a set of skills rather than the owner of a set of assets.

That’s right, you are a set of skills.

That is a philosophy that would have carried one through a great inflation in Germany or through other economic times of turbulence. But it is not a philosophy that was popular in very stable times like Victorian England.

Stable times are difficult to define. If you had lived between 1910 and 1920, would you have had a valid vision of what was going to happen in the 1920s? If you were in the middle of the 1920s, what would your vision have been of the middle of the 1930s? Or in the early 1960s, when the U.S. Treasury bill rate was 2.5 percent and long-term government bonds were 4 percent, if I had said that in the 1980s the bill rate is going to be 16.5 percent and the long bond 15.25, what would you have said?

We could not survive. Well, projecting ahead to 1985 or 1990, what can you see?

I would think, given the kind of economic and financial turbulence we have, that there will be a move to financial reregulation rather than more deregulation, even though most are talking about deregulation.

Let me end by asking what is it that motivates you?

I think that we’re put on this earth to make a contribution, and it’s a terrible waste not to try to do your best. I know people who are very smart and talented, but they’re operating at 50 percent of capacity. I find that a waste. Also, it seems to me that you cannot stand still. The moment you feel that you’re standing still, you are really going backward, and so the need always is to push on.

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