Economies are analogous to ecosystems. Environmentalists’ base state is an ecosystem in a state of nature, unsullied by man. Economists’ base state is an economy in which, other than establishing and maintaining essential conditions—protection of property and contracts rights and physical security—the government is absent. Both systems rely on the autonomous actions of their constituent elements, organically adapting to the myriad stimuli and signals around them. Analyzing the changes and distortions caused by humans on ecosystems is a big part of environmental science. Similarly, much of economics analyzes the perturbations caused by governments in economies.
Money can be broadly defined as whatever enjoys widespread acceptance as a medium of exchange and store of value—a means of saving—within an economy. Demonstrably more efficient than barter, money plays a central role in any advanced economy. A distortion virtually every government has introduced into their economies has been the production of fiat money—money not backed by and therefore not exchangeable into a set weight of a metal or other good—whose acceptance is compelled by legal tender laws.
The ostensible reasons advanced for fiat money are mostly specious; governments do it because they benefit from doing so. Money buys things, and if government is the source of money, it also has an issuer’s advantage. While monetary depreciation eventually leads to price inflation, the government is ahead of the curve. It purchases goods and services with the money it is creating and debasing before the resultant inflation sets in (this issuer’s advantage is known as seignorage).
Fiat money has another benefit for governments, dwarfing seignorage: it supports deficit financing. A government that cannot borrow must extract taxes or fees from its populace, which is never popular and often resisted. Monetary depreciation allows the debtor to repay with money that is worth less than it was when the debt was incurred. If government is a debtor, it realizes that benefit, which is why inflation has been called a hidden tax.
More insidiously, a government can either issue its debt directly as money, or—the more modern approach—a central bank can “monetize” the government’s debt by buying that debt with money it creates. The central bank buys debt either with currency it produces or by increasing the selling counterparty’s account with the central bank (the latter practice is far more prevalent). With fiat money, a government’s debt represents a promise of repayment with either more debt or fiat money, and nothing more.
The central bank is a large, interest-rate insensitive buyer of its government’s debt. Its buying pushes the rate the government pays below what would prevail if there were only interest-rate sensitive private buyers in the market, and lowers most other rates, which are often benchmarked to the interest rates on government debt. A below-market interest rate increases borrowing and decreases saving below what would have prevailed at a higher rate. It is a misleading signal for investment; a lower cost of capital leads to more investment, and consequently more production, than if the economy had a true market cost of capital. Mis-priced money also encourages consumption and speculation in excess of what would have prevailed under higher rates.
Governments and central banks around the world have stretched ultra-low—or in some cases negative—interest rates, sovereign debt, debt monetization, and the promotion of consumption and speculative bubbles to historic extremes (see “A Skyscraper of Cards,” 10/19/14). Metaphysically, just stating the idea that value and real economic growth can be created by governments borrowing money, creating money, and using that created money to buy their own debt casts heavy suspicion on the whole enterprise. It sounds like magic, and it is. Reality confirms the skeptics. While these policies can produce short-term increases in growth and goose financial markets, in the long run those effects are reversed and the net effect is contractive rather than expansionary.
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No nation has practiced this “magic” longer than Japan, whose economy has cycled from recession to anemic recovery to recession since the early 1990s (it just reentered recession). The Japanese once had one of the world’s highest savings rates, but the government has been drawing down its citizens’ savings on a two decade debt binge. Now it is the most indebted government, in terms of debt-to-GDP ratios (227.20 percent), in the developed world. Ultra-low interest rates (the Japanese 10 year interest rate is .47 percent) make saving an exercise in masochism. The central bank owns most of the government’s debt, and has expanded its purchase to private financial assets, including equities.
Japan offers ample proof that in the long term, debt and money magic retard production and growth. Despite a five-year rally, the Nikkei 225 stock index is not even half of what it was in 1989. As for a telling economic indicator, nothing captures people’s assessment of economic prospects and the future so well as the decision whether or not to have babies. Reflecting dwindling opportunities, Japan has one of the world’s lowest birthrates; its rapidly aging population now buys more adult than baby diapers. The elderly cohort will be yet another drain on Japanese savings as it pays for retirement. “Magic” economics requires running ever harder just to stay in place. The world’s financial markets got a Halloween treat when the Japanese central bank announced a 60 percent increase in asset purchases with funny money, but the prior, already massive, purchases have not stopped Japan from sliding back into recession.
Japan has been the pacesetter, but Europe and the United States are not far behind. Despite mammoth expansions of the European Central Bank’s and the Federal Reserve’s balance sheets in pursuit of unprecedented asset monetization, growth rates have been far below historical trend. European growth in 2013 was .1 percent, and the continent currently has either no growth or is in recession, depending on how many statistical angels are dancing on which pin heads and who is doing the counting. In the US, 3 percent plus growth used to be routine; 2 percent is the new normal. The last time the US saw 3 percent annual growth was 2005.
The labor market demonstrates the ongoing deterioration of the US economy. Taking the seasonally- and business-birth-and-death-adjusted, subject-to-future-revision employment statistics as offering a passable approximation of reality (perhaps a heroic assumption), there has been job growth, but the labor force is shrinking. However, it is the qualitative aspect of the labor market where the real story is told. David Stockman recently did a masterful analysis. Since the turn of the century, jobs in what Stockman terms the Breadwinner Economy: construction, manufacturing, white collar, finance, insurance, real estate, transport, information, and trade, have shrunk, replaced by much lower-paying jobs in hospitality, food service, and medical care. Readers are referred to Stockman’s article for a full analysis and explication (http://davidstockmanscontracorner.com/the-feds-paint-by-the-numbers-delusions-about-the-labor-market/ ). During the greatest Federal Reserve balance sheet expansion in history, labor market fundamentals and the economy have deteriorated. It’s no mystery why a plurality of voters in the last election cited the economy as their chief concern, despite the much ballyhooed “recovery.”
Adding to labor’s pain: below market interest rates have promoted the substitution of capital for labor, and by promoting consumption, have fueled the US’s perpetual trade deficits, which create jobs in foreign countries. In a world where money is not the whimsical creation of central bankers, no country would be able to run trade deficits in perpetuity. Pressure on the currency and withdrawals of whatever stands as the government’s reserves backing it would force a deflationary price adjustment, including in wages, and an increase in interest rates to make the country’s economy more competitive in world markets.
No such adjustment is necessary when the world must accept an ever expanding supply of dollars, the so-called “reserve” currency, backed by no reserves but redeemable for more dollars or treasury debt. The usual do-gooders lament the state of the labor market, but champion a higher minimum wage. However, wages in this country must come down relative to wages in other countries—the flip side of years of living beyond our means—before the employment situation can meaningfully improve.
The liquidity that is not promoting economic growth is promoting bubbles in select financial markets, primarily sovereign debt and equities. Paraphrasing President Nixon, we are all speculators now. Central bankers have been candid about one of their motivations for microscopic interest rates: they want to push savers farther out on the risk spectrum, forcing them to buy either lower quality or longer-dated bonds, or equities. Everybody is speculating, from retirees switching money out of money market funds to stocks or bonds to earn a return, to corporations, who can find nothing better to do with their cash than buy their own stock. The expected rate of return on productive investment has equilibrated with the corporate cost of funds—close to zero—due to many years of overinvestment and overproduction. The theory has been that rising asset prices, particularly stock prices, produce a wealth effect, which prompts beneficiaries to go out and spend, in turn producing economic growth.
If, in light of dismal economic growth, that sounds like holding a lit match to a thermometer to heat up a room, it is—more magic. It reverses causality, trying to put the stock price cart before the economic growth horse. Thus, after a four-year rally, in 2013 the US stock market gained almost 30 percent (S&P index) while economic growth was 2.3 percent. Even if one buys the theory that stocks are a discounting mechanism, or predictor of future economic trends, last year’s strong rise has “discounted” growth so far this year of 2.2 percent, or slightly less than last year. Since the turn of the century, neither the wealth effect nor debt “magic” have produced the kind of trend growth during expansions that most of the developed world had taken for granted for at least four decades prior.
Central bankers have been less than candid about two other motivations for microscopic interest rates. Although some central banks are ostensibly independent, like the Federal Reserve, even the Fed can be considered an arm of the government when to comes to the government’s debt. Low rates ease the government’s debt service burden, and central bank monetization provides a ready buyer of debt.
However, the primary reason for easy money is to promote inflation, which devalues governments’ massive debts. If unfunded pension and medical liabilities are added to nominal debt, it is clear that the only way governments can hope to keep their many promises is by substantially devaluing them through monetary depreciation. The 2 percent inflation mantra that central banks around the world chant as a policy goal has nothing to do with the real economy, and everything to do with a hoped-for escalation of inflation governments so desperately need.
That central banks have been unable to achieve even 2 percent inflation is another indication of their policies’ ineffectiveness. The marginal return of an additional unit of debt-based liquidity is actually negative. It is not producing inflation or economic growth, and the debt carries an obligation to pay back an amount greater than the original loan. Underlying the oft-expressed fear of deflation is recognition that it would crucify governments. Just as inflation devalues debt, benefitting debtors, deflation makes debt more expensive to pay back. Deflation would make governments’ mounting debt loads that much more onerous, thus the almost hysterical fear of it.
Part and parcel of shrinking private-sector opportunity is expanding public-sector rapacity. Although taxes and fees keep rising, governments keep running deficits. The productive have been increasingly milked for the vote-buying benefit of the unproductive, with the state taking its cut. Its dead-hand grip on economic activity is tightening, not for the purported public-benefit justifications, but to increase economic rents to the government and its officials. Individuals and businesses lobby, curry favor, donate, and bribe to get subsidies, tax breaks, and regulatory dispensations. It speaks volumes that the Washington D.C. metropolitan area is now the nation’s wealthiest. Obamacare promises bounteous new opportunities for payola, taxes, and regulatory extortion, which was the real reason it was passed.
When “magic” economic nostrums can no longer keep an economy running in place, it falls backwards, painfully. In “non-magic” economics, debt growth well in excess of economic growth for an extended period, rising taxes, and increased regulatory sand in the gears and government rent-seeking eventually produces an economy that not only stops growing, but contracts. Almost immediately, debt in the most leveraged sectors of the economy starts unravelling, and in a debt-saturated economy that unravelling spreads quickly, because virtually every financial asset is someone else’s debt (or equity, which occupies an even lower rung on the priority-of-payback ladder). In 2008, it started with mortgages and mortgage-backed securities and engulfed the world’s financial system with frightening speed.
For years the world has looked one way down the railroad track, watching for the inflation locomotive, oblivious to the deflation locomotive coming from the other direction. There are always quibbles about the accuracy of price indexes, but the just-around-the-corner outbreak of skyrocketing inflation has remained just around the corner, despite years of massive central bank balance sheet expansion. Debt has become the medium of exchange (even the US currency, which is not usually thought of as debt, bears the title: Federal Reserve Note) and the global economy runs on debt. When debt plays such a central role and the gross amount starts to shrink, the result has to be economically contractive and deflationary. Debt shrinkage acts as a margin call: assets are sold, economic activity curtailed, and debts repudiated as debtors try to reduce their debt burdens. Their creditors must write off assets, sell other assets, curtail their economic activity, and repudiate their debts as the vicious cycle gathers steam.
The collapse of the world’s skyscraper of debt will take prices and economic activity with it. If the crash is proportional to the debt build up that preceded it (and it wouldn’t be wise to assume that it won’t be), it will take down governments as well. The Orwellian nightmare of totalitarian government, amplified by the Edward Snowden revelations, may be another case of the world fixating on the wrong fear. Come the crash, most governments will be flat broke, unable to borrow except at prohibitive rates. Command and control—monitoring, repressing, incarcerating, and torturing the populace—is expensive and stifles economic activity. Destitute governments will have their hands full maintaining the barest semblance of public order.
The smart money bet for what emerges from the rubble is chaos and anarchy, not government-maintained order. Which suggests that investments in self-sufficiency and self-protection, including firearms and training in their use, are prudent (There are a multitude of organizations and internet sites that provide guidance and sell provisions.) The people who have made those investments have been derided as the fringe, but events will probably give them the last laugh, if anyone is laughing in such a world.
Reblogged this on Eatgrueldog.
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Excellent observations and the conclusion is very true.
An impressive analysis, with but one small jarring note near the end: “Destitute governments will have their hands full maintaining the barest semblance of public order.” The whole article instead makes the case that governments DO NOT maintain public order. They destroy it.
What will happen at the end, is that governments will repress, destroying public order even more completely, while at the same time using public order as an excuse for that repression.
At least, that will be their intention. Whether they can accomplish that in a heavily-armed society is another question entirely. While the crash of empires is commonplace in history, the crash of an empire of a heavily-armed society is definitely sailing in uncharted waters. By all means, it is time to arm oneself if not that way already.
People have been writing variations on this article for at least this whole millennium. The example of Japan is that the weird flat-line, fiat driven economy can sustain itself for a long long time. Since early 1980s in the case of Japan. (Also it’s over simplistic to claim that sluggish growth is the cause of Japan’s baby bust.)
A certain class of people want the failure, because they feel we are not virtuous, and therefore deserve economic failure for our economic sins, the same way Sodom and Gomorrah deserved destruction for their depravity.
The writers of the Old Testament conjured up an all-powerful God to wreck their vengeance, today’s moralists posit iron-fisted economic rules that will eventually reap a bloody harvest. But will they? The rantings are also reminiscent of assurances of Marxists that “scientific materialism” was destined to carry the day and win the future.
I agree with the old saw that there is a lot of ruin in a nation. I think the author underestimates how much.
By the way, chaos and anarchy are not synonyms. One is bad, the other is good.
Although anarchy _can_ wreak chaos, in an immoral society.
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Since you have a link to Prechter’s website on your blogroll I assume you are familiar with the non-rational herd-behavior basis for what you’ve described. Those of us who embraced this hypothesis can only marvel in astonishment at the tenacity of “fifth wave” positive mood in clinging to a completely irrational narrative.
I distill this narrative to this: People now fervently believe that nebulous groups of men can alter physical reality, such that wealth truly can be created from nothing (central bank credit creation, borrowed into monetary existence in the form of bonds, represent actual wealth) and ours is a time when people can actually have their cake and eat it, too.
We see this belief everywhere we look for it, from political activity based on reality-altering legislation (words on paper, synonymous with magical incantations) to silly notions about money flowing in and out of stocks (it does nothing of the sort) and how debt allows us to “consume” the future (which is silly, since you can’t consume that which is not yet produced.)
Who among us could have imagined that this false narrative could last for four or five decades?!
Men (in the aggregate) live our lives in a flowing state of mind and not much more. AAPL has a market cap of nearly $1T because the hive-mind embraces this in a consensus, not because there is some physical bedrock on which the House that Jobs Built exists.
There can be no deflation until bond prices reflect a loss of belief in wealth-from-nowhere magic. Japan’s decades-long experiment has apparently lasted only because the belief in light magic and light wizards had to fully run its course across the rest of the planet. Now that everyone thinks Dumbledore runs the world’s central banks, it’s time for Voldemort’s resurrection. We’ll know that day has finally arrived when rates break out of their prison and attain the stature of Godzilla, then lay waste to the financial landscape in a way no movie maker can now imagine.
The Downward Spiral
Nov 7th, 2014
Mary, the Mother of Jesus speaks:
The events will rush in from every side, far beyond the capacity of the world to respond. A cycle will be created, one event feeding the other and leading to the next in a downward spiral.
The world will have no firm footing. Anxiety will be everywhere. Man will look to his own strengths and find them greatly wanting. They will then reevaluate all of their leaders. A sobering process will set in.
Into this setting, I will raise up people of integrity, whose hearts seek the good of the people and who walk in truth. A complete shift in thinking will occur and those who brought about these conditions will be in disgrace. Their foolishness will be unveiled for all to see.
But the response to these problems must go far deeper than choosing new leaders. America must return to the religious spirit which is has set aside for so long. There will be important religious leaders, who can lead millions back to faith.
These events will bring about the time for a great decision, because America will be at the crossroads. Those who choose the path of faith will find comfort and hope, even in the greatest trials. Those who seek secular solutions will experience only despair.
Prepare. Prepare. Prepare for this coming year. Do not delay. Make every effort to reclaim and to deepen your religious practices. I will give you surprising success and new helps.
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