The System is the Problem

From the BBC:

US credit ratings agency Moody’s has put the UK on negative outlook, meaning it thinks there is more chance the economy may lose its triple A status.

France and Austria, who also share a top triple A rating, have been similarly graded. Italy, Spain and Portugal’s ratings have been lowered.

Moody’s blamed the eurozone crisis for the adjustments.

The UK chancellor remains committed to his policy of austerity whilst the opposition warns this could backfire.

The negative outlook for the UK means Moody’s thinks there is a 30% chance of a downgrade within 18 months.

BBC economics editor Stephanie Flanders said there was no suggestion that the agency would prefer the UK government to change its economic policy of austerity.

Now, I believe that the idea that a Western government bond can today be a AAA investment is very dubious. Simply, the current phenomena of negative real interest rates and debt saturation, and the problems of deleveraging mean that it is very unlikely that an investor in government debt will get back their purchasing power: either by inflation, or by default, most such investors in the next decade will probably lose the skin on their noses. But that is a side issue.

Since David Cameron and George Osborne announced their policy of austerity, my thinking on fiscal policy has somewhat evolved. Given that we know that a high residual debt load has a damaging effect on growth, my view has always been that we need to reduce the debt load as fast as possible. The question was always how we should best go about doing so. I knew from the beginning that there was always a danger that in an economy already dependent on high government expenditure, fast and hard cuts — especially in an already-depressed economy — would probably lead to a contraction in tax revenues, thus producing higher deficits and less debt reduction.

This prospective problem has been expressed quite well in this graph:

Furthermore, because of the high residual debt load, cuts in spending would merely go toward paying down debt. This means that the government will still be sucking just as much capital out of the economy as before. While cutting taxes might prove a huge plus , the presence of a huge debt load means tax cuts will be unaffordable, and thus there would be no such boost.

The greater problem, of course, is that in an economy that is greatly centralised around government, cutting spending very often translates into cutting real output, and real economic activity. Now during an economic boom, this is fine — the growing market can pick up the slack. But during an economic contraction, this just takes the problem of falling output and exacerbates it.  One only has to look so far as Germany under Heinrich Brüning,( or the problems currently afflicting the Euro Zone) to understand the problem:

Bruning applied the [austerity] medicine to Germany, and the resulting backlash was so intense he suspended parliamentary democracy and ruled by emergency decree, setting a fine example for the next guy who took power. After just two years of “austerity” measures, Germany’s economy had completely collapsed: unemployment doubled from 15 percent in 1930 to 30 percent in 1932, protests spread, and Bruning was finally forced out. Just two years of austerity, and Germany was willing to be ruled by anyone or anything except for the kinds of democratic politicians that administered “austerity” pain. In Germany’s 1932 elections, the Nazis and the Communists came out on top — and by early 1933, with Hitler in charge, Germany’s fledgling democracy was shut down for good.

Of course, in the modern world there is a larger problem even beyond fiscal contraction leading to a contraction in real output. This is the problem of fiscal contraction leading to financial collapse. Simply, as Greece have enacted more and more austerity, they have collected less and less taxes. And this means that they are closer to closer to default. Now, because Greece’s debts have been securitised and spread around the European banking system, a default on Greek debt could lead to mass bank insolvencies in European, which could lead to mass bank insolvencies around the world as more and more counter-parties default on their obligations.

As I wrote last month:

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. Those $18 billion that Greece owes might be owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more.

That is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

This is a bizarre situation. The intuitive response to excessive debt — belt-tightening; spending less, and saving more — is not only wrong, but it is potentially dangerous.

Modern Keynesians believe that the answer to these problems is stimulus and monetary expansion: that government ought to increase spending, and that monetary authorities ought to print more money. Essentially, both of these ideas amount to reinflating the bubble. Stimulus allows for the economy to keep ticking over while the private sector deleverages. Money-printing and inflation shrinks the debt relative to the amount of money in the economy. There is a real advantage here: bondholders — as opposed to taxpayers — take a hit as their lendings are repaid in debased currency. As I have noted in the past, I believe (as did Jesus) that creditors are the ones who ultimately must take the hit when it comes to addressing the problem of debt saturation. After all, in a market economy, all investments — even those made to very wealthy debtors — carry risk. Unfortunately, the inflationary Keynesian method hits savers and investors, and those living on a fixed income.

Worst of all, these aids ignore the real problem, which is not the recession at all, but the thing that caused it — the huge preceding credit-fuelled bubble. And therein lies the problem.

As I wrote way back in October:

Modern economics has been a great experiment:


Economic history can be broadly divided into two eras: before Keynes, and after Keynes. Before Keynes (with precious metals as the monetary base) prices experienced wide swings in both directions. After Keynes’ Depression-era tract (The General Theory) prices went in one direction: mildly upward. Call that a victory for modern economics, central planning, and modern civilisation: deflation was effectively abolished. The resultant increase in defaults due to the proportionate rise in the value of debt as described by Irving Fisher, and much later Ben Bernanke, doesn’t happen today. And this means that creditors get their pound of flesh, albeit one that is slightly devalued (by money printing), as opposed to totally destroyed (by mass defaults).

But (of course) there’s a catch. Periods of deflation were painful, but they had one very beneficial effect that we today sorely need: the erasure of debt via mass default (contraction of credit means smaller money supply, means less money available to pay down debt). With the debt erased, new organic growth is much easier (because businesses, individuals and governments aren’t busy setting capital aside to pay down debt, and therefore can invest more in doing, making and innovating). Modern economics might have prevented deflation (and resultant mass defaults), but it has left many nations, companies and individuals carrying a great millstone of debt (that’s the price of “stability”):

The aggregate effect of the Great Depression was the erasure of private debt by the end of World War 2. This set the stage for the phenomenal new economic growth of the 50s and 60s. But since then, there’s been no erasure: only vast, vast debt/credit creation.

And that is the real problem we face today: the abolition of deflation, the abolition of small defaults, the abolition of the self-correcting market.

Neither austerity, nor stimulus are a sufficient remedy for today’s financial problems (let alone today’s economic ones). What is needed is liquidation, so that the old rubbish is cleared out, the system is no longer congested by debt saturation, and new opportunities are opened up.

Simply, everything we have experienced over the last twenty years — from Japan in the ’90s, to America in ’08, to the ramifications of Greece’s default, to the growing trade war between America and China — is a lesson that credit-based money is not robust. It is so weak to the problem of credit contraction that — once the point of debt saturation is inevitably reached — every time there is a contractionary event, monetary authorities must pump the market with new money, and highly-indebted governments must (unless they are foolish like Britain’s present government, and want to see falling consumer confidence, business confidence, real GDP, industrial output, and productivity) maintain or increase spending instead of reducing spending and saving money. Otherwise, the system itself is endangered. It is a fundamentally fragile system. 

Ultimately, nature always wins. Ultimately, the debt saturation problem will be taken care of either by currency collapse, or by defaults (and probably systemic collapse, and a new global financial order), or by war, or by some kind of debt jubilee. I don’t know which. I hope for the latter. It seems kinder.


Did Cameron Just Kill the Euro?

I find it hard these days to praise any establishment political figure. Too often their actions are devoid of principle, too often their words are hollow, and too often their demeanour smacks of a rank ignorance on matters of economics and liberty.

And undoubtedly, Cameron’s austerity policies are not sound. As I have noted in the past, the time for austerity at the treasury is the boom, not the slump.

But today David Cameron seems to have bucked that trend.

From the BBC:

David Cameron has refused to join an EU financial crisis accord after 10 hours of negotiations in Brussels.

Mr Cameron said it was not in Britain’s interest “so I didn’t sign up to it”.

But France’s President Sarkozy said his “unacceptable” demands for exemptions over financial services blocked the chance of a full treaty.

Britain and Hungary look set to stay outside the accord, with Sweden and the Czech Republic having to consult their parliaments on it.

A full accord of all 27 EU members “wasn’t possible, given the position of our British friends,” President Sarkozy said.

There is an obvious fact here: scrabbling to reach an agreement in the interests of political and economic stability — which is exactly the path Japan has taken for the past 20 years, and America for the past 3 — allows broken systems to continue to be broken. All this achieves is more time to address the underlying issues, which as we are discovering is something that does not happen, because markets and policy makers fool themselves into believing that the problems have been “solved”, and that there is “recovery”.

Cameron’s intransigence could well be the spark that Europe — and perhaps even the globe — needs to degenerate to the point where the necessary action — specifically, some kind of debt jubilee — can occur.

Inflating Away the Debt?

Some commentators believe that the best way for Greece — and by extension, everyone with a debt problem — to deal with debt is introducing some mild-to-moderate inflationary pressure (or least, the expectation of such a thing).

The problem is, the evidence (thanks to regular reader Andrei Canciu) suggests this isn’t in the least bit effective:

The real solution for the terminally indebted is not to get into debt in the first place. Once you are there, the pressure of creditors means that the chosen path will generally be a succession of unsuccessful Keynesian can-kicks (or, in Europe, crushing austerity) up to a slow, painful default.

As Keynes put it:

The boom, not the slump, is the right time for austerity at the Treasury.

Ron Paul & Austerity

Regular readers will be aware that on the topic of austerity, I generally agree with John Maynard Keynes:

The boom, not the slump, is the right time for austerity at the Treasury.

Regular readers will also know that I like Ron Paul — a Presidential candidate who promises a $1 trillion spending cut in his first year in office.

Is that a contradiction? I don’t think so.


In comparison to most austerity-stricken nations, the United States under Ron Paul would be a special case, for one key reason.

Ron Paul’s cuts — rather than destroying productive output like Brüning in the 1930s, or Papandreou today — are aimed at cutting the two greatest wastes of productive output: financial sector corporate welfare, and imperial military spending.

This topic cuts to the heart of the Keynesian and Rothbardian views on recessions in general, and depressions in particular.

Essentially, the Keynesian position (and its later monetarist adaptation) is that a slump in aggregate demand (i.e. GDP) is — for whatever reason — the problem, and that this can be remedied by the government doing whatever it can to raise aggregate demand (Keynesian stimulus, quantitative easing, nominal GDP targeting).

The Rothbardian position is that the problem is caused by government-led malinvestment, and that the junk must be allowed to liquidate before an organic recovery can ever take hold (zombification).

Both views have something to them, but both views overcomplicate the problem. The real issue is the drop in productive output.

As I have shown before, it is perfectly possible (and actually quite common) for monetary and fiscal policy to raise or stabilise aggregate demand without actually addressing the underlying productivity issue — leading to superficial (and hollow) recovery, like Japan in the 90s and (probably) America today.

Austerity policies during a recession can often totally choke off productivity (Brüning, Papandreou, etc). This is particularly true in nations that are very centralised, and where government has become a very important economic actor.

Now Austrian economists may say that government spending is always a misallocation of capital. Well, I agree that central planners lack the information of the free market. But government is useful in supporting underlying productivity (as Adam Smith noted) through infrastructure creation, the rule of law, etc, and withdrawing that support during a slump for the purpose of paying down debt is detrimental.

So the key here is that government should do what it can to support productivity. What the Keynesians (and monetarists) got wrong is the idea that aggregate demand was somehow a good reflection of underlying productivity, and that underlying productivity can be effectively supported with money pumping, or by digging holes. My model is that the best means to sustain and increase underlying productivity is that government should let failing economic systems completely fail, end wasteful and capital-destroying activities like imperial adventurism, and recapitalise the broader people of the nation. Ron Paul’s aim of cutting taxes and simultaneously cutting military adventurism and corporate welfare would do that.  His policies are not the austerity policies of tax hikes and spending cuts which constrict the economy by sucking money out to pay down creditors without putting anything back in.

Default vs Austerity

Last week I asked:

So will America continue to tread the bone-ridden road of austerity, high taxation and crushing economic contraction, leading to excessive money-printing, and ending in the death of the dollar and an inflationary firestorm? Or will it choose the sustainable route of default, low taxes, a return to productive, organic growth, and the opportunity to decrease reliance on foreign energy and goods?

Today I present a case study in austerity (Latvia) vs default (Iceland). And I think it’s clear which is the path that clears the way for new growth and prosperity.

Here’s GDP:

And here’s unemployment:

Iceland is a shining example of a nation willing to shun the narrow interests of creditors in the name of its people’s prosperity.

Austerity (the bankers get their pound of flesh) is a nonsense path to misery — it is rather like expecting a heroin addict to go cold turkey. If your patient is hooked on government intervention and handouts, withdrawing those handouts will lead to riots, and just as significantly, a crushing contraction in both confidence and GDP. Getting junkies off their fix of government intervention requires organic growth and prosperity — hard to achieve in an economy strangled by excessive levels of public debt, and high taxation to pay interest on that debt.

The free market alternative to austerity is default — all lending, even lending to “Quadruple A” debtors — has risks, and the chief risk is that the debtor can’t afford to pay its debts. And if the debtor can’t afford to pay the debt, then either the debt should be renegotiated, or tough nuts. The people of the nation who have come (for better or worse) to depend on government services shouldn’t suffer for the malinvestment of bond traders and foreign creditors. Should the time come, it is the bond traders and creditors who must take a haircut.

The True Cost of Zombification

Hank Paulson, George W. Bush & Ben Bernanke killed Western capitalism. During the 2008 crash, when the banking system was failing (as is entirely predictable and natural in a hyper-levered house-of-cards economy) they decided to end market-led creative destruction, and institute a system of government-led bailouts, bailouts and bailouts — or, more accurately, uncreative stagnation.

Uncreative stagnation deserves its name for a number of reasons:

  1. As Steve Jobs put it: “Death is very likely the single best invention of Life. It is Life’s change agent. It clears out the old to make way for the new.That is just as true for businesses, markets and governments as it is for organisms. When businesses, systems and markets fail, they open holes to be filled by new businesses, systems and markets.  Without allowing for the natural death of failed systems and businesses, governments close the door to new — and often necessary — innovation.
  2. Without the market (i.e. the preferences of people in the economy spending their money) determining what businesses and systems work, those decisions are transferred to central planners and bureaucrats — in this case those who decide who gets bailed out (and who gets state subsidies) and who doesn’t. This means that capital will be allocated to things that people out in the market don’t want or need.
  3. The high debt-acquisition levels necessary to “save the system” necessitate higher taxation, which means that significant quantities of capital — instead of being reinvested into new businesses and ideas — go toward paying down interest on debt. Broadly, because American and Western debt is often owned by Eastern manufacturing nations, this means that productive capital that could be used by Western businesses is being siphoned eastward. So the capital will still get invested, but in businesses in the East.
  4. The money-printing necessary to “save the system” necessitates inflation, which discourages saving and investment and encourages spending on consumption, transferring more capital from Western consumers to Eastern producers.

Just how much debt and money-printing was necessary to “save the system”?

Here’s a chart Nomi Prins produced in 2009. The spending levels (and therefore debt levels) are truly staggering:

So not only did the bailouts disable creative destruction (the engine of innovation and social progress), they also created so much debt that they have already damaged the ability of future generations to save, invest and innovate.

Worse, they did nothing to address the fundamental fragility of the system. All of that interconnected debt means the system is still fragile to a default cascade, which means that if the system is to be “saved” again, it will require more bailouts and more debt-acquisition, further eroding the ability of taxpayers to save and invest, as governments tax and inflate the currency to pay down the debt.

I expect future generations to look back on this episode as a bizarre aberration. America — surely the greatest producer and innovator in the history of human civilisation — forgot how markets work and the notion of creative destruction, forgot that an empire dependent on hostile partners (i.e. China and the Arab world) is hugely fragile, and then forgot the fact that America emerged as a superpower as a direct result of its status as a great creditor and manufacturer, and that the old European empires lost their superpower status through loss of productivity and massive debt acquisition.

Future historians in the post-American epoch may attribute this bizarre lapse of concentration to a desperate desire for stability, in the wake of the world-shattering events of 9/11. The public and the establishment simply could not face radical change. America got too old, too stubborn, too rich and too established to face the kind of creative destruction that had historically shaped American politics and civilisation. America traded the liberty of creative destruction for the “security” of bailouts, the security-state, and governmental paternalism. As we shall see in the next decade (and contrary to Japan’s experience thus far) this is a totally false security.

Default & the Argentinosaurus

One thing is clear:

A huge mountain of interlocking, interconnected debt is a house of cards, and a monetary or financial system based upon such a thing is prone to collapse by default-cascade: one weak link in the chain breaks down the entire system.

But the next collapse of the debt-pyramid is a long-term trend that may be a long way — and a whole host of bailouts — away yet. A related but different problem is that of government spending. Here’s American government debt-to-GDP since the end of WW2:

After reducing the national debt to below 40% in the 70s and 80s America’s credit binges since that era have quickly piled on and on to the point that without a major war like World War 2, the national debt is above 100% of GDP, and therefore in a similar region to that period.

Simply, America’s government must find a way not only of balancing the budget, but of producing enough revenue to pay down the debt. This has inspired the current crop of Republican nominees to produce a slew of deficit-reduction plans, including Herman Cain’s hole-ridden 9-9-9 plan  which shifts a significant burden of taxation from the wealthy and onto the middle classes. Worse still, taxes on spending hurt the economy by discouraging spending. Want to expand your business with the purchase of new capital goods? 9% tax. Want to increase revenues through advertising? 9% tax. Want to spend your earnings on goods? 9% tax. That’s a hardly a policy that will encourage economic activity in an economy that is (for better or worse) led by consumption.

Whichever way the tax burden falls, the sad reality is that any plan that focuses on taxing-more-than-disbursing is just sucking productive capital out of the economy, constraining growth. The other “remedy” inflating the currency (to inflate away the debt), punishes savers, whose investment is necessary for productive growth.

Dean Baker shows a historical case of such an event. Argentina, crippled by its peg to the dollar, defaulted on its debt since 2001:

All the crushing weight of taking productive capital out of the economy crushed growth. Then Argentina defaulted on its debts, and rebounded, astonishingly. Of course, most of blogosphere is looking at Greece in this debate. I am not, because I recognise the Argentinosaurus in the room: America’s foreign-held debt load (payment for all those Nixonian free lunches) is undermining the dollar’s status as global reserve currency, a pattern of development that will ultimately force exporters — on whom America relies — out of exporting to America for worthless sacks of paper and digital. International trade has always been on a quid pro quo basis — and since 1971 that has worked fine for America — dollars have been a necessary prerequisite to acquire oil, other commodities and supplies and pay dollar-denominated debts.

So I think the time has come to explicitly advocate a radical solution to save the dollar — but just as importantly to save the middle classes, and productive capital from the punitive taxation (and welfare cuts) required by austerity.

America needs to balance its budget by gradually (and with negotiation) defaulting on its debts. The first prong of this is totally defaulting on the debt held by the Federal Reserve — this is simply just a circuitous way of cycling money from government to a private agency and back again to the government, while the private agency (the Fed) pays member banks 6% annual no-risk dividends. The second prong is to begin negotiations with international creditors to revalue American debt proportionate to what America can afford to pay in the long run.

Far from infuriating creditors, I think that the evidence shows that this move would benefit everyone. A strong American economy is important to Eurasian producers and exporters. An American-economy dragged down by debt-forced-austerity means a smaller market to sell to, and to gain investment from. The only significant counter-demand for such an arrangement might be a balanced-budget amendment, so that America could no longer borrow more than it can raise in revenues.

Of course, there are other avenues to explore: slashing military spending (and giving the money back to the taxpayer, or to the jobless, or to infrastructure programs) is one such avenue: as I have explained at length before, American military spending is subsidising a flat-market, and making non-American goods artificially competitive in America.

But the real issue today is that liberals mostly want to talk about higher taxes, and conservatives mostly want to talk about austerity. They’re missing the Argentinosaurus in the room: the transfer of wealth from the American public — and the productive American economy — to foreign (and domestic) creditors, and the downward pressure that this is exerting on American output.

Debts — even AAA-rates debt (or AAAAAAAAA as an Oracle once put it) — all carry risk: the risk that the debtor is getting into too much debt and won’t be able to pay back his obligations in a timely or honest fashion. Creditors are making a mistake to be ending money to a fiscal nightmare whose only economic refuge is money printing.

So will America continue to tread the bone-ridden road of austerity, high taxation and crushing economic contraction, leading to excessive money-printing, and ending in the death of the dollar and an inflationary firestorm? Or will it choose the sustainable route of negotiated default, low taxes, a return to productive, organic growth, and the opportunity to decrease reliance on foreign energy and goods?

What’s that sound? No, not the crashing Argentinosaurus.