Hera : unemployment

Why Financial Repression Will Fail

Ron Hera — Fri, 16 Nov 2012 17:53:00 GMT

Excessive leverage and risk in the financial system, e.g., using customer funds to speculate, never ends well. Stock market crashes, bank and investment firm failures or economic recessions are all potential consequences. Following the failure of the United States to regulate over the counter (OTC) derivatives and the repeal of the Glass-Steagall Act, U.S. banks became the largest financial business entities in history. The U.S. real estate bubble, sub-prime lending and mortgage backed securities (MBS), along with unregulated OTC derivatives, then lead to bank insolvencies, a historic stock market crash and a near collapse of the global financial system.

Central banks and governments intervened to prevent systemic collapse but governments were saddled with enormous debts due to bank bailouts, lost tax revenues and massive social welfare costs. Rather than systemic collapse, and perhaps another Great Depression, the post crisis period came to be characterized by (1) market interventions, (2) direct government control over the economy, and (3) ongoing monetization by central banks. Longer term solutions that would have allowed a return to putatively free markets failed to emerge and government debt, particularly in Europe, became a crisis in its own right.

Measures that began as emergency interventions became routine suggesting a new economic paradigm. In the new paradigm, big banks, politicians and academics would decide what market outcomes, e.g., bankruptcies, interest rates or bond yields, would be permitted, as well as when to apply accounting rules, regulations and laws. Despite increased centralization of decision making and greatly expanded powers, however, policymakers were unable to repair the financial system. Instead, mounting government debt led to de facto financial repression.

Financial repression occurs when governments channel funds into their own sovereign bonds in order to reduce debt levels through mechanisms such as directed lending, caps on interest rates, capital controls, debt monetization, or by other means. Economist Carmen M. Reinhart, et al., brought the term back into popular usage in 2011 after a long hiatus. Past examples of financial repression include several South American countries, such as Argentina. The promise of financial repression is that it will hold down government borrowing costs and reduce government debt levels, but critics argue that financial repression merely targets the producers of society, i.e., the middle class, and therefore harms the economy.

The Liquidation of Government Debt , Carmen M. Reinhart and M. Belen Sbrancia (NBER 16893, 2011)

Debt monetization, which can be a tool of financial repression, destroys savings while a zero percent interest rate policy (ZIRP), which reduces government borrowing costs, deprives savers and pensioners of interest income and can lead to inflation. What is more important, however, is that financial repression prevents capital formation. Of particular concern in the U.S. is the link between capital formation and new business creation, which is primarily a middle class phenomenon. The vast majority of corporations in the U.S. are small businesses and they account for the majority of jobs. By preventing capital formation, financial repression short circuits the engine of new business creation, increases unemployment and threatens to bring down the middle class.

Governments cannot supply entrepreneurship or innovation in the marketplace, nor can they effectively replace savings (genuine capital derived from surplus production) or private investment with bank credit or with public funds, which represent debt and a transfer of wealth, respectively. The deployed capital, inventions, products and services of new businesses drive innovation, fuel competition, provide jobs and increase the wealth of society. In contrast, financial repression can only produce economic stagnation and result in a net loss of wealth to society.

Crisis and Consequence

Substantially as a consequence of the financial crisis and global recession, Europe was engulfed in a sovereign debt crisis characterized in the European periphery by austerity measures and Great Depression levels of unemployment. In the U.S., the real estate collapse and stock market crash represented a direct loss of household wealth while bank bailouts represented a transfer of wealth from proverbial Main Street to literal Wall Street. Deficit spending, debt monetization and the Federal Reserve’s purchases of MBS and U.S. Treasury bonds expressed a radically inflationary monetary policy and, although much of the money is idle in the banking system, the overall increase in the supply of U.S. dollars is concerning. The True Money Supply (TMS), formulated by famed economist Murray Rothbard, represents the amount of money in the economy that is available for immediate use in exchange.

Despite the 2008 financial crisis, global recession and inflationary policies, confidence in the U.S. dollar, the U.S. stock market, the U.S. federal government and the U.S. economy remained largely intact. Inflationary policies reduced certain risks, such as the risk of a deflationary collapse, and increased liquidity from central bank monetization lifted financial markets, but the effects were only temporary. Confidence was also boosted in Europe by the European Central Bank’s (ECB) outright monetary transactions (OMT) program and in the U.S. by the Federal Reserve’s quantitative easing III (QE3) program. In Europe, the risks of sharply rising sovereign bond yields, sovereign defaults and the potential breakup of the euro were muted by OMT while European leaders putatively moved toward a permanent solution, such as a fiscal union. Thanks in part to the Federal Reserve’s ZIRP and ongoing “operation twist,” U.S. Treasury yields remained near historic lows.

On the surface, the fallout of the 2008 financial crisis was effectively managed, but the basic causes of the crisis were never addressed. The lines between depository institutions and securities firms, erased in the U.S. by the final repeal of the Glass-Steagall Act in 1999, were not restored and the U.S. Financial Accounting Standards Board’s (FASB) mark-to-market rule was never reinstated.

Although bank capital ratios have improved, leverage remains excessive, bank balance sheet assets remain troubled and economic conditions have deteriorated compared to the pre-crisis period. Banks deemed “too big to fail” in 2008 have become bigger and the gross credit exposure associated with high risk OTC derivatives is roughly as large as it was before the financial crisis. By the end of 2013, the Federal Reserve’s balance sheet will have exceeded $3.4 trillion. At the same time, the U.S. federal government faces a so-called “fiscal cliff.”

The Road to Stagflation

For 2012, the International Monetary Fund (IMF) projects GDP 2.2% growth in Japan and the U.S. and 3.5% globally. Based on the Baltic Dry Index (BDI), which reflects the price of moving major raw materials by sea, the global economy has slowed in 2012. Nonetheless, there has been some improvement in comparison to the depths of the global recession in 2009.

The BDI is a leading indicator of economic growth because it reflects the demand of manufacturers for raw materials. A decline in the BDI signals falling global demand for manufactured goods. In the U.S., rail carloads also indicate falling demand.

In contrast, removing potentially optimistic projections, the U.S. Energy Information Administration’s (EIA) liquid fuels consumption data suggests an anemic recovery in the U.S. on a par with 2011.

Despite the recent uptick in U.S. manufacturing, manufacturing currently accounts for only 11.7% of U.S. GDP. In the past few decades, U.S. corporations moved production offshore, eliminating domestic jobs. Credit expansion masked the lost income of U.S. consumers but the process inexorably reached its logical conclusion in 2007. The shift of U.S. workers to often lower paying service sector jobs was counterproductive because debt levels rose while income flowed out of the U.S. following on the heels of jobs.

Although policymakers, including Federal Reserve Chairman Ben Bernanke, deny it, in fact, U.S. unemployment is a long term, structural problem linked to the still ongoing outflow of U.S. consumer incomes to net exporter countries such as India and China.

The current surplus of U.S. labor, abundant capital and somewhat less expensive energy (partly due to advances in hydraulic fracturing that have increased U.S. domestic oil production) are insufficient to stimulate a broad-based economic recovery. In addition to the U.S. federal government’s growing debt and need for increased tax revenues, U.S. consumers remain burdened with high debt levels.

A U.S. manufacturing renaissance, for example, is unlikely to take hold unless the U.S. dollar weakens significantly and global demand also rises. In a global slowdown it remains unclear where new customers might come from for new U.S. products or services.

Although the financial system has continued to function due to massive infusions of liquidity, economic activity, with some exceptions, has not generally recovered or has continued to deteriorate, e.g., the shrinking number of U.S. citizens participating in the official workforce. Ignoring improvements in the unemployment rate related to the shrinking size of the workforce, much of the U.S. economic recovery in the post crisis period can be attributed to government deficit spending.

U.S. GDP has been boosted by government deficit spending in excess of $1 trillion per year. Removing the temporary effects of extraordinary deficits, U.S. GDP remains negative. Compounding the problem, loose monetary policies, rather than spurring lending to consumers or small businesses, have created inflationary pressures and have lead to stagflation.

Rather than putting Americans back to work, inflationary policies have helped to push prices higher. Based on U.S. Consumer Price Index (CPI), the official inflation rate in the U.S. is roughly 2%, but the CPI does not accurately measure the cost of maintaining a constant standard of living. Using the same methodology as in 1980, the CPI should be 9.3% currently.

Inflationary central bank policies support government borrowing and the banking system but increased liquidity resulting from low interest rates, central bank asset purchases or debt monetization can have destabilizing effects. Excess liquidity can result in price inflation, fuel financial speculation or asset price bubbles, or provoke competitive devaluations (currency wars). Asset purchases and debt monetization by central banks alter the distribution of money, thus of purchasing power over the economy and therefore redistribute wealth. Monetary inflation erodes the value of savings replacing genuine capital distributed throughout the economy with credit concentrated in banks. In the U.S., one of the Federal Reserve’s policy assumptions is that asset purchases will help small businesses by making more credit available. While it is true that small businesses rely on bank credit for operations and expansion, it is savings, not credit that fuels small business creation and therefore job growth. Since most U.S. jobs are in small businesses, QE3 and similar policies destroy jobs by redistributing wealth from savers, entrepreneurs and investors to banks and stifling new business creation. The combination of reduced new business creation, continuing high unemployment and inflationary price pressures set against a backdrop of high debt levels precisely defines stagflation.

Reign of Repression

The stagflationary environment in the U.S. is a mild example of financial repression. Countries in the European periphery, e.g., Greece, Italy, Spain, Portugal and Ireland, where high taxes and austerity measures are already in place, are more pointed examples. In the case of Greece, which has descended into an economic depression, the natural market outcome would have been a Greek default and an exit from the European Monetary Union (EMU) accompanied by losses for European banks and quite probably a number of European bank failures, along with the systemic impact of associated OTC derivatives, such as Credit Default Swaps (CDS). To prevent bank losses and failures, however, policy decisions replaced market outcomes. The normalization of market interventions, direct government control over the economy and ongoing monetization by central banks represented a transition from a market based status quo to a policy based status quo which maintained or increased otherwise unworkable government debt levels. Maintaining the status quo, however, requires financial repression.

Like the emergency measures that preceded it, financial repression has become a fixture in a new economic paradigm, but it is no more likely to provide a permanent solution. Financial repression will remain in place as long as bank failures and sovereign defaults continue to be prevented, e.g., through bailouts, asset purchases or debt monetization by central banks. Overall economic conditions in Western countries can therefore be expected to remain stagnant or to deteriorate. The continued debasement of major currencies, such as the U.S. dollar and the euro, will reduce the real value of debts but monetary inflation cannot create a genuine economic recovery as long as bank balance sheets and government finances remain impaired. Without robust economic growth, however, both the banking system and the finances of Western governments certainly will remain impaired. In other words, financial repression in the U.S. and in Europe is set to remain in place indefinitely.

Under an ongoing regime of financial repression, savings, jobs, economic opportunity and living standards will all suffer. The middle class will be reduced as generations of socioeconomic progress are gradually reversed. Younger people, mired in stagflation, will be left behind in terms of income and economic opportunity, which will have a long term negative impact. Since U.S. banks stand to profit from financial repression, it will increase income disparity and the concentration of wealth. The destructive forces set in motion by financial repression will greatly increase the burden on government social welfare programs. Thus, financial repression will fail to alleviate government debt unless tax increases and austerity measures follow, which could turn the United States into another Greece. In theory, financial repression, together with other measures, can liquidate government debt but, in practice, it is a destructive and highly destabilizing approach that will result in a net loss of wealth to society.

Financial Crime Is A Systemic Risk

Ron Hera — Tue, 23 Oct 2012 11:38:00 GMT

Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur.

While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate result. There are three general ways in which the U.S. dollar system could break down: (1) rejection of the U.S. dollar as the world reserve currency, or (2) as an eventual consequence of U.S. federal government insolvency and (3) a domestic failure of confidence. Of the three, U.S. federal government insolvency is the most serious because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a new threat to the U.S. dollar has emerged which could trigger a hyperinflationary collapse before the U.S. federal government’s finances become unworkable, e.g., when debt service begins to crowd out military and Social Security spending. Specifically, the perceived legitimacy of the U.S. financial system has not merely been tarnished by recent scandals but is in danger of collapsing. The consequences of a domestic breakdown of confidence and trust in the U.S. financial system cannot be overstated.

World Reserve Currency Status

The most commonly cited challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.

At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower.

At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term.

Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss.

In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities

Setting aside the world reserve currency status of the U.S. dollar, the largest threat lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it.

Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’

Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

Domestic Confidence in the U.S. Dollar

Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people.

A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy.

An outlying but growing problem is the risk of a breakdown of confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to the U.S. dollar system.

Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending.

In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorist organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud.

Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial system.

A Black Swan?

Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement could trigger a hyperinflationary collapse. The result of a domestic breakdown of confidence and trust in the U.S. financial system would not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a rush out of dollars into hard goods due to runaway inflation but rather a run on financial markets. If investors, pensioners, private institutions and fund managers withdraw from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial markets. The failure of financial firms, the accelerated disintegration of the U.S. dollar’s world reserve currency status and the final bust of the U.S. government’s finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate the problems of the U.S. dollar. History may record yet again that “there is no means of avoiding the final collapse of a boom brought about by credit expansion” because the escalating moral hazard engendered by limitless bailouts is itself a cause of collapse.

How the U.S. Will Become a 3rd World Country (Part 2)

Ron Hera — Sun, 01 Jul 2012 19:50:00 GMT

The United States is quickly coming to resemble a post industrial neo-3rd-world country. Unemployment, lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth are major trends in the U.S. today. Behind these growing problems are monetary inflation created by the Federal Reserve's monetary policies, federal government deficit spending and the dominant influence of "too big to fail" banks and large corporations in Washington D.C., which has altered the direction of law in the United States. To make matters worse, the U.S. government faces a historic fiscal crisis.

High unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive policies are defining characteristics of 3rd world countries. Other factors include poor public health, nutrition and education, as well as lack of infrastructure-factors that deteriorate rapidly in a failing economy.

Apparently ineffective regulation and relatively little law enforcement action by the federal government in the wake of the sub-prime mortgage meltdown resulted in widespread speculation that special interests had taken priority over the rule of law. Critics have also charged that the federal government's policies threaten to eliminate what remains of the American middle class.

Accelerating Concentration of Wealth

In response to the economic downturn that began in 2007 and the start of the financial crisis in 2008, the U.S. federal government and the Federal Reserve resorted to a radically inflationary policy intended to save banks and to shepherd the U.S. economy through a recession. Instead, radically inflationary policies greatly increased the concentration of wealth.

Under ordinary circumstances, monetary inflation has the effect of redistributing wealth in favor of those who receive newly created money first. The value of money is reduced as a function of the number of currency units in the economy but recipients of newly created money can spend it before it loses value. In a declining economy, however, the wealth redistribution effects of inflation are magnified.

When the Federal Reserve or the federal government supports banks and financial markets through liquidity injections, bailouts, asset purchases, quantitative easing, etc., the lion's share of financial support, i.e., newly created money, is captured by the largest financial institutions and by the wealthiest 1% of Americans. Money printing skews the distribution of money over the economy while the value of money, i.e., the purchasing power of wages and savings, is reduced. The overall effect is a wealth transfer from proverbial Main Street to literal Wall Street.

Looming Fiscal Crisis

U.S. government debt and deficit spending have markedly accelerated over the past decade. For example, The U.S. Department of Homeland Security (DHS) was created and the U.S. military grew to 3 million active duty and reserve personnel, not including contractors. Since 2001, the U.S. spent approximately $1 trillion on military expansion while the total cost of the U.S. wars in Afghanistan and Iraq has been estimated to exceed $3.7 trillion.

Although the U.S. federal government remains in denial, the Congressional debt ceiling debate and subsequent U.S. credit rating downgrade on August 5, 2011 were only the tip of the iceberg. In fact, the United States faces a historic fiscal crisis.

As of 2012, the majority of new federal government debt will stem from interest on existing debt. Treasury bond issues totaled $2.55 trillion in 2010, roughly 2x the federal budget deficit of $1.3 trillion. Artificially low U.S. Treasury bond yields, created by the Federal Reserve's quantitative easing (QE1 and QE2) programs and by its current "Operation Twist," only slow the rate at which the federal debt balloons.

The U.S. federal government's fast growing debt is $14.94 trillion, approximately 100% of GDP. Additionally, future liabilities total $66.6 trillion based on generally accepted accounting principles (GAAP accounting) and using official data from the Medicare and Social Security annual reports and from the audited financial report of the federal government.

Medicare: $24.8 trillion
Social Security: $21.4 trillion
Federal debt: $10.2 trillion* (not including intra-governmental obligations)
State, local government obligations: $5.2 trillion
Military retirement/disability benefits: $3.6 trillion
Federal employee retirement benefits: $2 trillion

The eventual insolvency of the U.S. federal government cannot be averted through any combination of taxes, budget cuts or realistic GDP growth. Inflationary policies, i.e., increasing deficit spending by the federal government and debt monetization by the Federal Reserve, would devalue the U.S. dollar and potentially trigger a hyperinflationary collapse of the currency. To stave off the inevitable, interim measures might include tax increases, exchange controls, nationalization of pension funds or other measures similar to those taken in 3rd world countries.

Dominant Corporate Influence

In a 2009 radio interview on Elmhurst, Illinois' WJJG 1530 AM, Senator Dick Durbin (D-Ill.) explained that "...the banks-hard to believe in a time when we're facing a banking crisis that many of the banks created-are still the most powerful lobby on Capitol Hill. And they frankly own the place." Senator Durbin was unequivocal in saying that the federal government of the United States is controlled by banks. Simon Johnson, former chief economist of the International Monetary Fund (IMF), had reached the same conclusion one month earlier in his widely read article The Quiet Coup. Johnson explained that the finance industry had effectively captured the U.S. government, a state of affairs typical of 3rd world countries.

Corporate influence over the political process, as well as over the tax and regulatory policies of the United States, is at an all time high. The federal government is the largest single customer in the U.S. economy and, through taxation or regulation, the government can grant or deny market access to private companies and can either prevent or mandate the consumption of their products and services. As a result, virtually every large corporation in the United States seeks to win the government's business and to steer government tax policies and regulations in their favor. Naturally, politicians who accede to the wishes of particular corporations are given campaign funds to ensure their reelection. In the past decade, the amount of money spent on lobbying has more than doubled and there are currently 24 lobbyists for every 1 member of Congress.

The interdependence of elected officials and the largest U.S. corporations reached a new high with the 2008 bank bailouts. The influence of private corporations and de facto industrial cartels (comprising the largest corporations in each major industry) over tax and regulatory policies creates significant economic distortions that ultimately compromise the sustainability and the stability of the economy. Ideally, the government would be an impartial referee, rather than an active business partner that overwhelmingly favors large businesses over small businesses, despite the fact that small businesses account for the vast majority of American jobs.

Impact on the Rule of Law

Corruption, cronyism and weak rule of law are typical of 3rd world countries. The United States exhibits a clear corporate influence over elections and legislation and, arguably, relatively little law enforcement action where large, legally well-equipped corporations are concerned. Reports of so-called crony capitalism have appeared in the U.S. news media, but the term "corruption" has been avoided, along with discussion of fundamental reforms.

A cursory examination of legal developments over roughly the past decade evidences a pattern in which U.S. federal law systematically favors the largest financial institutions, as well as a paradigm in which financial institutions heavily influence both the regulations that putatively govern their activities and the laws that apply to consumers of their products and services. The financial crisis that began in 2008 and the subsequent response of the federal government appear to follow logically from prior legislative events:

1999 Gramm-Leach-Bliley Act (GLB). The Act repealed key provisions of the Banking Act of 1933, commonly known as the Glass-Steagall Act. In the aftermath of the Great Depression, the Glass-Steagall Act prevented depository institutions from engaging in high risk financial speculation.
2000 The Commodity Futures Modernization Act (CFMA). The Act deregulated over-the-counter (OTC) derivatives, such as credit default swaps, referred to by Warren Buffett as "financial weapons of mass destruction." OTC derivatives were at the heart of the financial crisis that began in 2008 and are the root cause of the "too big to fail" doctrine. The Act preempted state gaming laws that had prevented banks from speculating in OTC derivatives with no connection to underlying assets.
2001 USA PATRIOT Act. The financial provisions of the Act allow banks to collect additional financial information about account holders, for example, linking business accounts to the personal financial records of business owners, thus weakening both financial privacy and the corporate veil. The Act enhances the ability of creditors to collect and allows federal authorities to monitor financial transactions and to obtain financial records without a subpoena.
2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The Act, which was sponsored by banks and credit card companies, effectively eliminated the concept of a "fresh start" by allowing banks and credit card companies to engage in collections activities, in effect, forever. As a result, small business owners who end in bankruptcy are less likely to ever start another business. The Act places banks in front of bankruptcy courts, creates liabilities for bankruptcy attorneys and contains many widely criticized, anti-consumer provisions.
2008 Emergency Economic Stabilization Act. The Act, commonly referred to as a "bank bailout," authorized the United States Secretary of the Treasury to spend $700 billion to purchase distressed assets, especially mortgage-backed securities (MBS). Instead, the funds were given to foreign and domestic banks to offset their risky MBS, OTC derivatives and other losses. The bank bailout set a precedent of socializing losses but keeping gains private. The Act effectively bound the fate of the U.S. Treasury to that of the largest U.S. financial institutions.
2010 Citizens United v. Federal Election Commission. The Supreme Court of the United States held that corporate funding of independent political broadcasts in candidate elections cannot be limited under the First Amendment, overruling prior case law and guaranteeing the ability of corporations to influence elections without meaningful restrictions. The Court's decision gave carte blanche to corporations to influence elections, legitimized the interdependence of elected officials and large corporations and created a precedent under which the rights of corporations supersede those of citizens.
2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act failed to restore critical provisions of the Glass-Steagall Act, significantly regulate OTC derivatives, break up "too big to fail" banks, prevent another financial crisis and prevent further bailouts. The Act created a Consumer Financial Protection Bureau, but did not repeal any provision of BAPCPA or restore the financial privacy of U.S. citizens removed by the USA PATRIOT Act. The Act failed to provide adequate funding to the government's watchdogs, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Federal Bureau of Investigation (FBI), potentially hobbling enforcement. The Act has also been criticized for the burden it places on smaller competitors in the financial sector, which could ultimately result in an increased concentration of financial power in "too big to fail" banks.

Critics have alleged that, underlying the sub-prime mortgage meltdown that triggered the financial crisis in 2008 was rampant fraud. Fraud has been alleged at virtually every level from the assessment of property values and credit risk; to the loans themselves and to their securitization as MBS assets; to the ratings of MBS assets as AAA; to hedging or betting against MBS assets in the OTC derivatives market (perhaps including financial firms allegedly betting against MBS assets that they themselves created and sold to clients as AAA assets). After the crisis, a seeming pattern of fraud continued apparently unabated in the robo-signing foreclosure scandal where documents submitted to courts were falsified. Despite an avalanche of alleged crimes under existing federal law, no firm or individual of any significance in the financial crisis has yet been prosecuted.

President Barack Obama said in October 2011 that the mortgage finance practices leading to the economic meltdown were "immoral, inappropriate and reckless ... but not necessarily illegal." Since fraud is, in fact, illegal, critics claim that the U.S. federal government has simply failed to enforce the law. Adding fuel to the fire, the Solyndra loan scandal could be construed to suggest corruption at high levels and the MF Global debacle could be construed as indicative of weak regulation and law enforcement and even of questionable market integrity.

In theory, selective enforcement of the law risks the creation of two sets of laws: one for big banks and corporations, and for their executives, i.e., those with connections in Washington D.C. or on Wall Street, and one for everyone else. Among other things, failure to enforce the law could create an environment in which crime pays, but, for ordinary citizens, hard work, prudent financial decision making, saving and investing for the long term do not.

More than any other aspect of America's progression towards 3rd world status, the federal government's low level of law enforcement action where "too big to fail" banks are concerned is perhaps the most insidious because it raises questions of legitimacy and of the social contract. A financial and legal system of moral hazard implies that victims face double jeopardy while they are deprived of legal recourse, i.e., those allegedly defrauded might face inflation and tax burdens stemming from preferential treatment of favored corporations or from further bailouts.

Destructive Tax Policies

In the face of rising government debt, the rapidly shrinking American middle class is the primary target of the U.S. federal government's tax policies. The eventual extinction of the American middle class would be a key milestone along the road to 3rd world status. Current U.S. tax policies favor the largest corporations and this is unlikely to change in the foreseeable future. Although tax increases exacerbate economic downturns, several tax options have been or are being discussed. However, none of them are likely to be put in place.

Increasing taxes on corporate profits would result in job losses in the short term and would affect dividends and share prices in the stock market. Lower dividends or share prices would affect pension funds, including government pension funds.
Increasing taxes on capital gains would impact the non-tax-exempt investments of the now retiring "baby boomer" generation and would reduce capital formation thus reducing investment in new businesses or business expansion and hampering job growth.
Increasing payroll taxes would cause companies to downsize resulting in job losses and would have a chilling effect on hiring.
A Value Added Tax (VAT) is impractical in the United States because countless special taxes already exist at all levels of the supply chain. To prevent unpredictable, disruptive consequences, implementing a VAT would require years of study and comprehensive tax reform.
A national sales tax is undesirable because it would overlap and interfere with already existing state sales taxes, which are highly inconsistent across states.
Carbon taxes remain possible but they would encumber businesses and result in job losses or reduce hiring.

Chief among the remaining possibilities is the income tax but, according to the Tax Policy center at the Urban Institute, Brookings Institution, 46% of American households will pay no federal income tax in 2011. The reasons include income tax exemptions for subsistence level income, dependents and nontaxable tax expenditures for senior citizens and low-income working families with children.

Assuming that big banks, multinational corporations and the wealthiest 1% of Americans remain off limits in terms of tax policy, the range of income taxed is likely to widen from the current tax on households earning more than $250,000 per year to progressively lower income levels. In fact, the government's intended revenue source is precisely what remains of the once much larger middle class: professionals, small business owners and dual income families in urban areas, etc. These are the households that have managed to stay ahead of inflation, declining real wages and falling household incomes.

Among other things, U.S. tax policies will erode capital formation within the remnants of the middle class, which is the engine of small business creation and the source of most American jobs. The eventual result will be a three-tier socioeconomic structure consisting of a super rich wealthy class, a much poorer working class and a massive, politically and financially disenfranchised underclass, similar to that of a 3rd world country.

Via Dolorosa

The United States increasingly resembles a 3rd world country in terms of unemployment, lack of economic opportunity, falling wages, growing poverty and concentration of wealth, government debt, corporate influence over government and weakening rule of law. Federal Reserve monetary policies and federal government economic, regulatory and tax policies seem to favor the largest banks and corporations over the interests of small businesses or of the general population. The potential elimination of the middle class could reshape the socioeconomic strata of American society in the image of a 3rd world country. It seems only a matter of time before the devolution of the United States becomes more visible. As the U.S. economy continues to decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate. There is little evidence of political will or leadership for fundamental reforms. All other things being equal, the U.S. will become a post industrial neo-3rd-world country by 2032.

How the U.S. Will Become a 3rd World Country (Part 1)

Ron Hera — Sun, 01 Jul 2012 19:44:00 GMT

The United States is increasingly similar to a 3rd world county in several ways and is accelerating towards 3rd world status. Economic data indicate a harsh reality that obviates mainstream political debate. The evidence suggests that, without fundamental reforms, the U.S. will become a post industrial neo-3rd-world country by 2032.

Fundamental characteristics that define a 3rd world country include high unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive government policies. All of these characteristics are evident in the U.S. today.

Other factors include poor public health, nutrition and education, as well as lack of infrastructure. Public health and nutrition in the U.S., while below European standards, stand well above those of 3rd world countries. American public education now ranks behind poorer countries, like Estonia, but remains superior to that of 3rd world countries. While crumbling infrastructure can be seen in cities across America, the vast infrastructure of the United States cannot be compared to a 3rd world country. However, all of these factors will rapidly deteriorate in a declining economy.

Unemployment and Lack of Economic Opportunity

Unemployment, which is a deep, structural problem in the U.S., is a fundamental challenge to economic opportunity. The U.S. labor market is in a long-term downward trend linked to globalization, i.e., offshoring of manufacturing, outsourcing of jobs and deindustrialization.

The U.S. workforce has declined by approximately 6.5% since its year 2000 peak to roughly 58.2% of working age adults and the U.S. now suffers chronic unemployment of 9.1%. Although the workforce grew in the 1980s and 1990s, as dual income families became the norm, the size of the workforce is shrinking due to a lack of economic opportunity.

Officially, long-term unemployment is 16.5% and the ranks of the long-term unemployed (those jobless for 27 weeks and over) include 5.9 million, 42.4% of those unemployed. However, prior to the Clinton administration, unemployment measures included workers who are now no longer counted as part of the workforce. Using the more accurate pre-Clinton criteria, unemployment exceeds 22%, only 3% below the worst point (24.9%) of the Great Depression. For countries with populations greater than 2 million, Macedonia leads the world with 33.8% unemployment, followed by Armenia at 28.6%, Algeria at 27.3% and the West Bank and the Gaza Strip both at 25.7%.

Compounding the unemployment problem is the fact that an entire generation of young Americans is being left behind in terms of economic opportunity. Student loans exceed $1 trillion while the labor force participation rate for those aged 16 to 29 who are working or looking for work fell to 48.8% in 2011, the lowest level ever recorded. Lack of economic opportunity among the youth, including millions of unemployed college graduates, is a political wildcard reminiscent of countries like Tunisia.

The structural decline of the U.S. labor market will continue as American workers are merged into a global labor pool in which they cannot yet directly compete for jobs with workers in countries like China and India. In China, for example, gross pay, in terms of purchasing power parity, is equivalent to approximately $514 per month, 57% below the U.S. poverty line. According to the Economic Policy Institute, the U.S. trade deficit with China alone caused a loss of 2.8 million U.S. jobs since 2001.

Falling Real Wages and Household Incomes

Workers earning more dollars are actually poorer in terms of purchasing power when the cost of living rises faster than wages,. In fact, if household income is adjusted for inflation, most American families have grown significantly poorer over the past ten years. In 2010, for example, real median household income fell 2.3%. Although the average wage has risen steadily in nominal terms, dwindling purchasing power is a reality for most Americans. When adjusted for inflation, the wages of most Americans have not kept up with the Consumer Price Index (CPI).

According to famed economist Milton Friedman, "inflation is always and everywhere a monetary phenomenon." In other words, prices rise when the money supply is increased faster than population or sustainable economic activity. Apparent economic growth created through credit expansion, i.e., by increasing the money supply, has a temporary stimulative effect but also causes prices to rise. True Money Supply is an accurate measure of inflation.

Although CPI is sufficient to illustrate declining real wages, CPI does not measure the cost of living in a realistic way. According to economist John Williams of Shadow Government Statistics, CPI systematically understates inflation.

The decline in real household income has set Americans back to 1996 levels, despite many households now having two incomes rather than one. Dual income families accounted for much of the increase in real median household income during the 1980s and 1990s, but, today, two incomes are barely better than one income was three decades ago. The decline in real wages was obfuscated in the 1980s and 1990s by growth in the workforce, e.g., by women entering the workforce. Real median household income rose while real wages declined because more households had two incomes. As U.S. wages and household income continue to fall in real terms, both poverty and reliance on government assistance programs will continue to rise.

Growing Poverty

According to the U.S. Census Bureau, the poverty rate in the United States rose to 15.7% in 2011, with 47.8 million Americans living in poverty (1 in 6). The official poverty line, determined by the U.S. Department of Health and Human Services, is $22,314 for a family of four. The number of families living in poverty has risen sharply since 2006 and continues to climb. The U.S. Department of Agriculture's Supplemental Nutrition Assistance Program (SNAP), commonly known as "food stamps," serves 45.8 million households as of May 2011. The program now feeds 1 in 8 Americans and nearly 1 in 4 children.

Based on the outlook for employment and wages, both poverty and reliance on government assistance programs will continue to grow. However, the negative trends in employment, wages and poverty have not affected all Americans equally. In fact, the household income and wealth of the wealthiest Americans has increased sharply, despite the overall deterioration of the U.S. economy.

Increasing Concentration of Wealth

Alan Greenspan, former Chairman of the Federal Reserve, warned that, "Ultimately, we are interested in the question of relative standards of living and ... trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume." In other words, concentration of wealth undermines the consumer base of the economy, causing GDP to decline and resulting in unemployment, which reduces living standards. Obviously, the total wealth of society is reduced when wealth is highly concentrated because there is a lower overall level of economic activity.

Economic data from several sources, including the Congressional Budget Office (CBO), show that wealth and income in the United States have become increasingly concentrated with the wealthiest 1% of Americans owning 38.2% of stock market assets, e.g., shares of businesses. For the wealthiest 1% of Americans, household income tripled between 1979 and 2007 and has continued to increase while household wealth in the United States has fallen by $7.7 trillion. The Gini Coefficient illustrates the growing disparity in income distribution. In terms of the Gini Coefficient, the United States is now at parity with China and will soon overtake Mexico, a still developing country. It should be noted, of course, that the U.S. remains a far wealthier country overall. If the current trend continues, however, the U.S. will resemble a 3rd world country, in terms of the disparity in income distribution, in approximately two decades, i.e., by 2032.

Welcome to the 3rd World

The United States is quickly becoming a post industrial neo-3rd-world country. Partly as a consequence of worsening unemployment and lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth, the U.S. government faces a historic fiscal crisis. Dominant corporate influence over the U.S. government, particularly by large banks, weakening rule of law at the federal level and destructive tax policies are compounding the economic problems facing the United States. Barring fundamental reforms or a hyperinflationary collapse of the U.S. dollar (due to the fiscal problems of the U.S. government), the deterioration of the U.S. economy will continue and accelerate. As the U.S. economy continues its decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate and the 3rd world status of the United States will become apparent.

Interview: Eric Sprott on Gold and QE2

Ron Hera — Mon, 18 Oct 2010 09:23:00 GMT

The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with Eric Sprott, Chairman, Chief Executive Officer and Chief Investment Officer of Sprott Asset Management LP and Chairman and CEO of Sprott Money, Ltd. With over 35 years of experience in the investment industry, Mr. Sprott is the Senior Portfolio Manager for numerous funds comprising several billion dollars in assets.

After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities (now called Cormark Securities Inc.), which today is one of Canada’s largest independently owned securities firms. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.

Eric’s investment abilities are well represented by his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge Fund L.P. was awarded the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. In addition, the Sprott Offshore Fund Ltd. won the 2006 MarHedge Annual Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award (Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year for Ontario. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisers. In October 2008, the Sprott Offshore Fund Ltd. won the award for the Best Long/Short Hedge Fund globally by HFM Week, a leading publication for the global hedge fund industry.

Eric’s predictions on the state of the North American financial markets have been captured throughout the last several years in a series of investment strategy articles entitled “Markets At A Glance”.

Hera Research Newsletter (HRN): Thank you for taking the time to talk to us today. You’ve commented in your articles and elsewhere that the financial problems of the United States are much more serious than one might imagine based on the official statements of the US government.

Eric Sprott: The situation goes back at least to 2000 when we saw the Nasdaq rolling over. Before it rolled over, we’d written about it, in fact, we almost to the day published an article entitled “Speculation is Rampant, Don’t be a Part of It”. From that point on, I’ve believed we’re in a secular bear market. The Nasdaq certainly has been in a secular bear market since then. Somehow they resurrected the S&P and the Dow but in order to do it they had to start a housing mania and a lending mania and now, a government spending mania. We still think that the situation peaked in 2000 and continues today in a secular bear market, but it’s morphing into a bigger problem.

HRN: What is the bigger problem?

Eric Sprott: The bigger problem that we have today is where the sovereign risk stands and the size of the US deficit and I think that the question today is “Does Keynesianism work?” In other words, if you spend money it’s supposed to stimulate your economy, but there have been a number of reports suggesting that the opposite happens, that you get a negative return for government spending. One study was done in Canada by the Fraser Institute and another was done by three Harvard professors and their conclusions were that government spending was not good for private enterprises, period. You can see this if you look at a chart showing the marginal value of each dollar spent by the US government from 1960 to today.

HRN: Do you mean the marginal return on a dollar of debt?

Eric Sprott: The marginal value of government expenditures, yes, debt, essentially the deficit spending. The economic effect of running deficits is now something like negative 40 cents on the dollar. I think Keynesianism is sort of being stood on its ear and it seems quite likely that there is a negative return on deficit spending. For example, if the US government extended unemployment insurance benefits yet again, what do we all think the people receiving unemployment benefits would do? Would they be rushing out to get a job or not rushing out to get a job? You see, deficit spending almost always works against the system. When I look at US GDP, which I think last year probably went up by $400 billion, but, at the end of the day, there was an extra debt of $1.5 trillion and this year it will probably go up by the same amount, any thinking person would realize that if you tack on $3 trillion of debt and you’ve got less than $1 trillion of GDP growth, that’s a formula for bankruptcy.

^{Chart courtesy of} ^{Nathan A. Martin}

HRN: Are you saying government stimulus doesn’t work because debt rises faster than GDP?

Eric Sprott: Yes, it doesn’t work. I’m not even including debt at the state and municipal levels. I’m just using federal debt. Debt at other levels of government in the US is going up too, but not at the rate the federal government debt is increasing.

HRN: What sort of outcome or endgame do you foresee?

Eric Sprott: A few months ago, I wrote an article entitled “Surreality Check Part Two… Dead Government Walking” where I specifically zeroed in on the US government. When I wrote Surreality Check … Dead Men Walking back in November of 2007, I predicted that some companies—I pointed out Citigroup, GM, Fannie, Freddie—were all broke. They had pretty good market caps at the time, but the reality was that they were broke and I think the reality is that the US government is broke. If you take all of the unfunded liabilities—the number is something like $60 trillion or $100 trillion—there’s absolutely no way that it can be repaid. They’re going to have to repudiate some obligation, just as other governments are doing now. For example, the UK and France and maybe even Germany all extended the number of years you have to work before you get a pension. There is a sense of repudiation of what they promised and that will have to happen in the US as well.

HRN: Is debt monetization a repudiation of debt?

Eric Sprott: All of history says we shouldn’t trust government, so why do we trust the money that the government says is worth something when the history of governments is one broken promise after another? The only thing they’ve done, over the last 90 years or so, is to keep gouging the taxpayer, while at the same time racking up increasing debt. There’s very little responsibility at the government level for the financial well being of a country in the long run. Fiat money will all go back to its intrinsic value, which is zero. You need real things to support the valuation of currencies. I find it absolutely shocking that we trust government.

HRN: Since you expect fiat currencies to fall in value, do you also expect real assets to rise in price?

Eric Sprott: I think it depends on the class of the real asset and what determines its value. For example, I always question real estate because a lot of real estate is so indebted. If people have to pay their debts back you can have real estate going down, even though you might be in QE2 or QE3 by the time, because there’s just not enough cash flow being generated. I think of things like agricultural products, oil and gas. I think of things that can be used as a medium of exchange, such as gold and probably silver, or maybe other precious metals but that’s the category I think is the most survivable in terms of holding its value.

HRN: Is that why you’ve invested in precious metals and gold in particular, to survive the bear market?

Eric Sprott: My history with gold goes back to about 2000 when things were bottoming out there and, in fact, coincided with our belief that we were going into a bear market. When you look at any bear market, you think “How do you survive it?” We’ve thought ‘you’ve got to have gold and gold stocks’ and it’s worked out so beautifully that it’s shocking. To think that the markets over the last 10 years are down and gold is up something like 500% and gold stocks are up something like 1200% from their lows. That’s been the place to be.

HRN: It seems a lot of money is flowing into the Sprott Physical Gold Trust (NYSE:PHYS).

Eric Sprott: As it applies to US residents, the tax rate on a capital gain in the Sprott Physical Gold Trust is 15% today whereas if you own the ETF, because gold is considered a collectible by the IRS, the tax rate is 28%. That’s a big reason for people to choose this vehicle versus an ETF. In addition to the tax benefits for US investors, the gold is held at the Royal Canadian Mint in Ottawa and to some people in the US that’s a good thing, because they’d like to see it out of the country. Also, the trustee is not a levered financial institution. The trustees for the gold and silver ETFs are levered financial institutions and therefore, when you have leverage there’s always potential risk. Of course, the reason we started it was that a lot of people realized there’s so much paper gold around that when you go to claim your gold it’s not going to be there.

HRN: I understand there’s a premium of between 5% and 10% for shares in PHYS over the spot price of gold.

Eric Sprott: We wanted people to be able to literally get their physical gold, so there’s a mechanism where, if you can buy a bar, which is 400 ounces, we will deliver it. The physical quality of it—the knowledge that the gold is there—in addition to the tax advantages, creates the premium. I think it’s justified. There are certainly no other North American vehicles where you can get physical gold. That’s why we created this vehicle.

HRN: So, there’s a level of insurance that’s just not there with ETFs like GLD. Do you view gold purely as insurance or do you also view gold as currency?

Eric Sprott: When I first got involved in gold, I came to the conclusion, based on Frank Veneroso’s book, The Gold Book Annual 1998 (Jefferson Financial, 1998), that the gold market was being suppressed by central banks and that that logjam had to break. Veneroso proved that there were sellers of about 400 tons a year. Given enough time, their willingness to sell gold had to run out. Now we are in a situation where central banks, which used to be sellers of gold, have become buyers of gold. The gold market is very small. The mines produce, let’s say, 2,600 tons per year and the central banks used to sell 400 tons. That’s a lot of tons in a 2,600 ton a year market. Now, central banks are buyers of probably 200 tons or more. I think the World Gold Council estimated that central banks bought as much as 400 tons last year. Imagine a shift of going from a seller of 400 to a buyer of 400 in a mine supplied market of 2,600 tons. Where are all of the normal users of gold going to get gold with this huge change at the central bank level?

HRN: It’s curious that central banks would have sold gold as the price was declining and are now buying when the price is rising.

Eric Sprott: Now we have gold ETFs, that didn’t even exist 10 years ago, and they are now among the largest owners of gold in the world. There are also funds like ours and Paulson & Co. or David Einhorn’s fund, Greenlight Capital, as well as various pension funds that now own gold but that never owned gold 10 years ago. Where are these funds getting all of their gold when they weren’t even part of the supply and demand equation 10 years ago? I wonder where all of this gold is coming from. I’ve always been suspicious that it’s surreptitiously coming out of the central banks.

HRN: Central banks manage the exchange rates of currencies, which is no secret. If gold is still treated as a currency, the gold exchange rate might be managed, as it was under the London Gold Pool.

Eric Sprott: Central banks can also influence bond markets, and not just government bonds. Last year the US Federal Reserve bought $1.2 trillion worth of mortgage backed securities.

HRN: That was a huge injection of liquidity.

Eric Sprott: We’ve had a huge shot in the arm both in the financial markets and in the fiscal markets, but we took on huge debts as well. The hand of government in everything has been unbelievable and what do we have to show for it as we sit here today? We’ve seen the economic data fall off a cliff: retail sales, new home sales, consumer confidence, the Baltic Dry Index, the Chinese stock market index. I mean, the things that have fallen off the table have been so dramatic and over such a short time.

^{Chart courtesy of} ^{InvestmentTools.com}

HRN: We’re not seeing much of a recovery in the US.

Eric Sprott: In some of the data you’re seeing, no recovery. Housing, for example, is at a dead, flat bottom. I expect that car sales are going to start doing the same thing. In fact, we’re going negative right now: the leading economic indicators, the ECRI Index, I mean everything. You’ve got to think we’re just going straight down, not even slowly.

HRN: You mentioned the heavy hand of government in these massive interventions.

Eric Sprott: The conclusive evidence is that when governments get involved with things, the impact is negative because you get a misuse of funds. It’s like the Fed goes in and buys a bunch of mortgage-backed securities (MBS) so the housing market stays together but if they stop, the housing market collapses because it was a misallocation of resources. We should not have been encouraging people to be buying houses. We should have been doing the opposite: saving money. We have to learn to save here both at the individual level, the corporate level and at the government level. The government is giving all the wrong signals, they’re getting the wrong people to do exactly the wrong things and it makes the problem that much bigger.

HRN: Would it be fair to say that, in your view, central planning and the economy is just sort of an ineffective strategy?

Eric Sprott: You know, I think we’d all agree when we hear that statement. Central planning doesn’t work, but then when it comes to our own government, all they want to do is centrally plan even though they don’t think they’re centrally planning, but, by god, they are. The US government is saying that to make the economy go they’re going to run a trillion and a half dollar deficit. If that’s not central planning, I don’t know what it is.

HRN: I think the US national debt is expected to reach $20 trillion. Do you think the US is going to be able to borrow and roll over debt at those levels?

Eric Sprott: Where does the money come from? Theoretically, the money has to come from companies or individuals. If we just took one country and said that they should fund themselves from the earnings of companies and savings of individuals and if there were no way, between the individuals and the companies, that they had the money every year to throw into government, it wouldn’t work. The US government funded itself with debt all of last year and certainly into March of this year. The thinking is that between the Fed buying financial assets in the market and the banks buying government debt and not lending, that they’ve been able to fund the government, but we’re going to find that it’s not sustainable. The process of asking people to be indebted to the tune of a trillion and a half dollars per year just at the federal level is impossible; and to do it several years in a row with the growing legacy of the debt is not sustainable. What if interest rates were where they really should be?

HRN: Do you think that, with a weakening dollar, the real interest rate could be negative right now?

Eric Sprott: This 0% interest rate policy, 20 years from now, will be looked at as one of the biggest financial jokes of all time. Of course, the primary beneficiaries are the banks and the government. Banks can borrow for nothing and the government can borrow for next to nothing, but the true interest rate should be much higher. I mean, what’s the point of saving? You’re asking somebody to save to fund the deficit and then you pay them nothing to save. What’s the point? You get nothing for your savings. Why would people save?

HRN: With a second round of quantitative easing, QE2, do you think there could be a loss of confidence in US government debt or in the US dollar?

Eric Sprott: We have a dilemma staring us in the face and I don’t see an easy way out of it. People will start questioning sovereign risk. It started with Ireland; it went to Iceland; it went to Greece; it’s maybe now with Portugal or Spain and it might be washing up on the shores of North America. As you know, the dollar has been quite weak recently and I think, as more and more people assess the problem, they’ll find that there aren’t many safe sovereign places to go. There just aren’t many. They’re very, very rare. Either there will be no QE2 and interest rates will go higher, or, if there is a QE2, interest rates can stay low, but ultimately, if we then go on to QE3 or QE4, the gig will be up because everyone will realize we’re just printing money and we’re not getting out of this problem. If we’re just printing and printing and printing, people will want to convert their bank deposits to something real because they’ll realize that fiat money is not going to hold its value.

HRN: What do you see as a solution here? What’s the path forward for the world?

Eric Sprott: I don’t think there’s a solution. People always say to me, “When would you not be bearish?” I say, “Well, I won’t be bearish when I see people in the central banking community and in the sovereign area start to take responsibility.” One might argue that maybe we’ve seen the first signs of that over in Europe and the UK and Greece with austerity. What’s interesting is that most of these programs start a year later. They don’t start today. It will be interesting to see when we get there, how powerful those programs will be.

HRN: Are the European austerity measures indirect bailouts, preserving sovereign debt?

Eric Sprott: That’s why they announce them. We saw QE with the ECB when they put a trillion dollars in for the Greek bailout. If they hadn’t announced austerity programs what would we all be thinking? You can’t get the bailout and not at least say you’re going to try to stop spending money. It was almost mandatory for people to say at the time. They all had to chime in because the Euro and the European banking system were under immense pressure. Deposits were leaving those countries, so they had to do something.

HRN: How do you foresee the sovereign debt situation unwinding?

Eric Sprott: I think we’re too far gone. There’s way too much debt. Just the federal debt is something like $40,000 for every American, so a family of four has got $160,000 in debt they’ve got to lug around; and that’s forgetting the states. I don’t think we can work our way out of it. We’ve gone for 60 years by expanding debt and, all of a sudden, that era ends and you have a contraction and the contraction will be rather elongated.

HRN: Thank you for sharing your views with us.

Eric Sprott: Thanks a lot.

After Words

Eric Sprott’s track record as a Portfolio Manager and as an entrepreneur in the natural resource sector speaks for itself. Whether one agrees with Eric Sprott’s skepticism regarding the fiscal responsibility of governments, the soundness of fiat currencies, or the stability of debt-laden companies and sovereigns, his contrarian analysis has enabled him to capitalize on the trade of the decade: gold. Between the anemic US economy, the Federal Reserve’s low interest rates and purchases of financial assets, as well as the US federal government’s deficits, and a second round of quantitative easing (QE2), the US dollar will certainly weaken further, fueling demand for gold.

Rent Seeking and the Flight of Capital

Ron Hera — Tue, 20 Jul 2010 01:00:00 GMT

The productive elements of the US economy are caught between powerful financial interests, e.g., banks seeking speculative gains, political constituencies seeking entitlements and government entities at all levels whose budgets and deficits are too large compared to their revenues. All three factions are competing for the same economic resources and all three are net consumers of wealth. The triumph of any one faction or of any combination thereof, promises to erode capital and to encumber production and economic growth in the future. As a consequence, capital can be expected to flow away from the United States to other parts of the world.

If banks dominate over government, for example, ever larger shares of tax revenues will likely flow to banks as a consequence of interest payments and taxes will certainly rise despite inevitable austerity measures. If government triumphs at the expense of banks, setting aside questions related to bank failures, bailouts or sovereign defaults, there is no reason to believe that government entities will become fiscally responsible or that the pattern of government expansion, as a percent of GDP, will reverse in the foreseeable future. The banking and financial services industries also represent a disproportionate share of US GDP. Political constituencies seeking entitlements are, in part, a reaction against and a consequence of disproportionate growth of government and of the banking and financial services industries. In advocating for or against any of the above factions, what seems to be ignored is where sustainable economic growth will come from in the future.

Surrounded on all sides are entrepreneurs and private capital, which are the historical engines of US economic growth. As the nation struggles to recover from the unprecedented global recession and the financial crisis that began in 2008, the competition between banks, government entities and political constituencies seeking entitlements represents a diversion of wealth and future production into economically unsustainable pursuits, such as bank profits, government stimulus or social welfare programs. In economic terms, the relationship of banks, government entities and political constituencies seeking entitlements to the productive elements of the economy can be described as one of rent seeking.

Rent seeking is a relationship where an individual, company or other organization seeks income by capturing the production of others through manipulation or exploitation of the financial, legal or political environment, rather than through ordinary market participation or the production of wealth. Analogous to parasitism in biology, rent seeking means obtaining an economic gain at the expense of others without any reciprocal benefit. Common examples of rent seeking include tariffs sought by industries for no purpose other than to boost profit margins and efforts by special interest groups to redistribute wealth in their favor by shifting tax burdens or government spending where there is no reciprocal benefit to any other group in society.

Businesses that produce physical goods, i.e., real production, along with labor and existing capital derived from past production surpluses are the targets of rent seeking strategies. The central question for economists is whether rent seeking is sustainable as an economic paradigm, i.e., as the dominant form of economic relationship in an economy. If so, spending by those who successfully gain control of wealth will stimulate economic activity in a sustainable way and the economy will return to genuine growth. For example, economic growth might return as bank profits trickle down through the economy; or as government borrowing and spending or expansion stimulate the economy and create jobs, e.g., government jobs; or as social entitlements, such as guaranteed retirement incomes or medical care, prove to be more efficient and less costly to society when provided by government and funded by tax revenues rather than by private industry. If it turns out, however, that rent seeking is not a sustainable economic paradigm, then the future of the US economy will be characterized by an erosion of capital and an absence of sustainable economic growth. One question that might arise in the latter scenario is whether capital will stay in the US or migrate to other parts of the world. The answer to this question lies in the nature of capitalism, as well as in the historical origins of American capitalism.

Property and Liberty
In terms of both economics and political philosophy, there are links between rent seeking where government is involved, the fundamental relation of individual citizens to the institution of the state, and macroeconomic developments in the US particularly since 1971. These links became increasingly clear since the start of the global financial crisis that began in 2008.

History bears out that capitalism, compared to other economic systems, has created more wealth, raised the living standards of more people, and has increased individual liberty to a greater extent. The reasons for the success of capitalism lie not only in economics but also in philosophy. The historical innovation and entrepreneurship and the immense industrial production of the United States in the past occurred both in the context of capitalism and in a social and legal framework established by the US Constitution. Going back to the American Revolution and before, the ownership of an individual person of their own body and of the labor that it can produce literally distinguished a free person from a slave. This concept is the common root of private property and of capitalism. The natural right of a person to the fruits of their labor, i.e., to own property, is, therefore prerequisite to other rights. In his seminal book, The Road to Serfdom, F. A. Hayek explained the interdependence of private property, the division of labor and freedom.

“... [T]he system of private property is the most important guaranty of freedom. It is only because the control of the means of production is divided among many people acting independently that we as individuals can decide what to do with ourselves. When all the means of production are vested in a single hand, whether it be nominally that of "society" as a whole or that of a dictator, whoever exercises this control has complete power over us. In the hands of private individuals, what is called economic power can be an instrument of coercion, but it is never control over the whole life of a person. But when economic power is centralized as an instrument of political power it creates a degree of dependence scarcely distinguishable from slavery. It has been well said that, in a country where the sole employer is the state, opposition means death by slow starvation.” – F. A. Hayek, The Road to Serfdom (1944)

Of course, a human being is much more than an economic unit and the natural rights of individuals do not end with the absence of slavery, thus private property can be viewed as the keystone of all human rights. In fact, provisions of the American Bill of Rights, such as the prohibition against unreasonable search and seizure are an elaboration and enumeration of private property rights vis-à-vis the rights of government. Interestingly, the American Bill of Rights contains broad prohibitions against actions by government, rather than positive rights, such as the right of an individual to a particular social benefit. In the modern world, private property and, therefore, other rights are not threatened directly by violence and coercion as they were prior to the American Revolution, but they are threatened today by excessive growth of government, by private concerns pursuing rent seeking profit strategies and by political constituencies seeking entitlements.

Taxes levied on privately owned businesses or on private individuals for the purposes of social welfare programs function as a proxy for rent seeking in that they affirm a positive right to an economic benefit for one group at the expense of another group that receives no reciprocal benefit. For example, the establishment of a legal right of a person with no means to pay for it, to obtain medical care, takes precedence over the property rights of individuals who have the means to pay for medical care on their own behalf. In the example of medical care, it is likely that those upon whom the financial burden falls have little or no objection to the arrangement because a majority of individuals probably believe that their contribution is for a worthy cause, but the precedent of government intervention over volunteerism is a dangerous one from the standpoint of individual rights.
While one group bears the economic cost, even if the only cost is reduced access to medical care or reduced quality of care, there is a more broad cost to society in terms of the erosion of individual rights. In a rent seeking economic relationship where government is the agent of wealth transfers, it is not only exploited groups that loose rights but, in fact, all citizens. When wealth is transferred or redistributed by government, rights removed from exploited groups are not transferred to groups that receive the resultant economic benefits but rather accrue to the government itself, thus diminishing the rights of all and expanding the power of government, i.e., the power to claim the wealth of it’s citizens for whatever purposes are deemed worthy.

“The preservation of freedom is the protective reason for limiting and decentralizing governmental power. But there is also a constructive reason. The great advances of civilization, whether in architecture or painting, in science or in literature, in industry or agriculture, have never come from centralized government.” – Milton Friedman, Capitalism and Freedom (1962)

While wealth transfers may be undertaken with the best intentions, over time, the eventual consequence is an aggregation and concentration of power in government at the expense of individuals. Among other things, a precedent is established whereby rights are granted by government to citizens and not the reverse. Wealth transfers by government, therefore, result in the expansion and centralization of economic and legal power in the government at the expense of the rights of individual citizens.

In the extreme, the flow of rights from individuals to government may eventually result in a totalitarian state structure where rights per se no longer exist, or exist in name only, replaced, in practice, by privileges granted by government at its sole discretion. In terms of political philosophy, a constitutional republic aims to prevent totalitarianism (historically referred to as tyranny) by establishing that the people are sovereign and that the limited rights of government are granted to it at the sole discretion of the people. In contrast, an economic system, based on government redistribution of wealth, is ultimately incompatible with a structure where the people are sovereign, i.e., a constitutional republic, simply because wealth redistribution requires that the rights of government take precedence over the property rights of individuals.

There’s been one underlying basic fallacy in this whole set of social security and welfare measures, and that is the fallacy - this is at the bottom of it - the fallacy that it is feasible and possible to do good with other people’s money. That view has two flaws. If I want to do good with other people’s money, I first have to take it away from them. That means that the welfare state philosophy of doing good with other people’s money, at its very bottom, is a philosophy of violence and coercion. It’s against freedom, because I have to use force to get the money. In the second place, very few people spend other people’s money as carefully as they spend their own. The real problem with government is not the deficit. The real problem with government is the amount of our money that it spends. – Milton Friedman

If the basic economic rights of individuals are undermined and government power expands, becoming more centralized, then controlling government spending may be problematic, particularly if doling out entitlements is central to the political goals of the regime in power, e.g., remaining in power. As has been seen in Europe, government spending for the purposes of expanding entitlements is constrained only by the capacity to borrow and to service debt, which is a pattern that can lead to economic collapse.

“A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury. After that, the majority always votes for the candidate promising the most benefits with the result the democracy collapses because of the loose fiscal policy ensuing, always to be followed by a dictatorship, then a monarchy.” – Scottish historian Alexander Fraser Tytler, Lord Woodhouselee (1747-1813), unverified attribution

Totalitarianism: Public or Private?
Wealth redistribution is not the exclusive domain of government. Inflationary policies by the US Federal Reserve erode the value of money and dilute the share of wealth held by those who depend on the monetary system while transferring wealth either to banks or to those who first receive newly created money. The institution of central banking is itself a form of rent seeking where governments borrow their own currencies into existence from private banks passing the burden of repayment with interest on to taxpayers, e.g., as a value added or income tax, rather than maintaining the national currency as a public facility. Central banking is associated both with economic rent seeking insofar as private interests successfully influence the central bank in their favor, and with political philosophy where the rights of individuals are concerned, e.g., monetary inflation deprives savers of the right to spend tomorrow money obtained in exchange for labor today at a value consistent with the terms of the exchange. In the latter case, the central bank produces a de facto breach of contract that is technically legal. As John Maynard Keynes famously said, “By a continuing process of inflation, government [or private interests that control the central bank] can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” In this regard, one can see the extent of the powers abdicated by governments to central banks. Central banks have the power to redistribute wealth and can do so either at the behest of government or, more importantly, in the service of private concerns.

The advent of bank bailouts, amounting to roughly $4 trillion in the US officially, but perhaps as much as $23.7 trillion, during the global financial crisis that began in 2008 was remarkable for two reasons other than the danger of systemic collapse thus averted and the amounts of money involved. First, it became apparent that large banks, and central banks, had more influence over governments than their own citizens. In fact, a majority of Americans opposed bank bailouts. Second, the power of central banks to transfer wealth was laid bare by the Federal Reserve’s purchase of mortgage backed securities which traded newly created money for what most observers agree was little more than worthless paper in an attempt to render otherwise bankrupt financial institutions solvent again.

The independent actions of the US federal government and Federal Reserve produced record profits and bonuses in the banking sector while, at the same time, household wealth in America fell significantly, creating the popular impression that Wall Street was somehow looting Main Street. The mechanism of wealth transfer, however, was actually the Federal Reserve, which had then been in place for 94 years prior to the crisis and during which, arguably, a similar process of wealth transfer had taken place gradually on a smaller scale. The arbitrary and sweeping nature of the emergency actions taken by the federal government and Federal Reserve in response to the financial crisis revealed the extent to which the powers of both the federal government and Federal Reserve had quietly expanded and become more centralized over a period of less than 100 years to a point of near absolute control over the wealth, i.e., the property, of US citizens. The roots of these developments, however, lay not in the economic bubbles leading up to the financial crisis that began in 2008 but in the 1913 Federal Reserve Act and in the New Deal that followed the resulting Great Depression.

“Legal plunder can be committed in an infinite number of ways; hence, there are an infinite number of plans for organizing it: tariffs, protection, bonuses, subsidies, incentives, the progressive income tax, free education, the right to employment, the right to profit, the right to wages, the right to relief, the right to the tools of production, interest free credit, etc., etc. And it is the aggregate of all these plans, in respect to what they have in common, legal plunder, that goes under the name of socialism.” – Frederic Bastiat, The Law (1848)

After World War II, the United States had embraced labor unions and social programs partly in response to the ideological struggle between the US and the Soviet Union, which was a totalitarian state, but the US, while fighting totalitarianism, planted the seeds of totalitarianism in its own backyard. Following decades during which social welfare programs expanded, and during which both the federal government and the financial sector grew dramatically as percentages of US GDP, the centralization of power revealed in 2008 indicated a largely unrecognized shift in political philosophy toward a totalitarian state structure.

A Monetary Empire in Decline
Perhaps every empire in decline witnesses a transition from surplus production to excess consumption and that is precisely what happened in the United States in the 1970s, marked first (after the establishment of the US Federal Reserve and then of a welfare state by President Franklin Delano Roosevelt) by the final abandonment of the gold standard in 1971 then by the 1975 shift from trade surplus to trade deficit. Both events were a consequence of spending in excess of real wealth production. These events ushered in the era of offshoring in the 1980s and of outsourcing to foreign firms in the 1990s. The idea was simple: exchange higher domestic costs for lower costs abroad and sell virtually the same products to the same domestic customers at higher margins, lower prices to gain market share, or simply hold prices at competitive levels by cutting costs. Under the banner of free trade, and later of globalization, the US government did virtually nothing to curtail these trends and the US economy appeared to expand as US dollars flooded the world in an unprecedented period of monetary expansion. As the accompanying deindustrialization of the United States progressed, two developments, in addition to the then accumulated capital in the US, mitigated the impact of declining US industrial production: (1) growth in service industries and (2) a combination of asset appreciation and increased consumer borrowing and spending (eventually reaching an unsustainable 70% of GDP), but both were fundamentally linked to monetary expansion and neither proved to be sustainable.

Replacing industrial production with a service economy was a flawed concept because as domestic production fell, it was, in fact, debt expansion that replaced the creation of real wealth, thus the US trade deficit soared. As factories closed and as jobs departed US shores for Taiwan, China, India and elsewhere, the selling of equivalent foreign-made goods and offshore services to Americans into a domestic market that included a growing number of displaced workers, became less and less plausible. The idea that displaced American workers would eventually embark upon new, service industry careers and, therefore, maintain their spending levels, in retrospect, was plainly wrong. While perhaps viable in a perfectly balanced global economy, it is difficult to imagine a sustainable domestic economy, in itself, comprising a majority of services since it would have to rely on material goods from abroad, i.e., it would suffer a chronic trade deficit. The answer for American businesses was to expand into global markets but this did little for the domestic economy, thus the US service economy failed to replace declining industrial production. What happened, in reality, was that the percentage of the total US population in the work force simply declined, flooding welfare roles and producing a growing political constituency favoring wealth redistribution.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

One way to characterize the sequence of events in the US is to say that a paradigm shift took place where the US economy moved from production to consumption; from an industrial economy to a (so-called) service economy; from wealth creation to wealth extraction; from increasing living standards to wealth redistribution; from a nation of citizens and workers to a nation of “consumers,” all the while transitioning from the largest lender in the world to the largest debtor nation in the entire history of the world. In terms of US government spending, unsustainable growth in entitlements and pork barrel politics became business as usual in Washington D.C., while Wall Street shifted from investing, in order to participate in dividends and capital gains resulting from production and value creation, to trading based on technical indicators; a competition where participants seek to extract wealth from investors and other traders in what amounts to a casino game, i.e., a rent seeking structure. Flash trading using automated trading systems and high-frequency trading algorithms, for example, is pure rent seeking in the garb of high technology.

Other advanced economies, in varying degrees, have followed the American example, resulting in the emergence of rent seeking as the dominant economic paradigm of Western countries. To make matters worse, rent seeking by private concerns has become confused with capitalism.

The Flight of Capital
In the past, capital and individual entrepreneurs flowed into the United States from around the world because it represented two related things: freedom and economic opportunity. The post bailout world is one where large banks have, to some degree, hijacked the emergent totalitarian powers of governments in a model where perpetual sovereign debt represents a virtually unlimited flow of wealth from the subjects of totalitarian states to the banks that, through the institution of central banking, exert considerable influence over each nation’s government. The post bailout economy seems to be a veritable frenzy of rent seeking activity by banks, governments and political constituencies seeking entitlements. In all three cases, individual liberty, e.g., the right to own property is an impediment and the success of any of the three factions promises to encumber or to prevent entirely future economic growth. It makes little difference to individuals if the fruits of their labor are confiscated by inflation, by taxes to fund unsustainable government expansion, or by taxes to fund social welfare programs. In all three cases, the impetus toward entrepreneurship and the incentives for putting private capital, i.e., private property, at risk in new business ventures are reduced or eliminated. Regardless of which rent seeking faction wins, capitalism, which has created more wealth, raised the living standards of more people and which, because of its intrinsic compatibility with private property, has increased individual liberty more than any other economic system in the history of the world, is set to lose.

Capitalism, rather than ceasing to exist, will obviously adapt, thus capital will migrate away from economies characterized by rent seeking, i.e., by the consumption of wealth, to parts of the world characterized by the production of wealth. Capital may also be driven into black markets as seen under the former Soviet Union. All other things being equal, the next decade is likely to see a massive flight of capital from the United States to countries where property rights are respected (or where government is simply smaller) and where the values of investments are less vulnerable to the ravages of excess monetary expansion, counterproductive taxation and sovereign debt risk or redistribution by government in the service of political constituencies seeking entitlements. Within the latter constraints, China and emerging economies that are rich in natural resources and that produce commodities or physical goods will surely become the new bastions of capitalism.

Into the Abyss: The Cycle of Debt Deflation

Ron Hera — Wed, 02 Jun 2010 12:46:00 GMT

One of the most famous quotations of Austrian economist Ludwig von Mises is that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.” In fact, the US economy is in a downward spiral of debt deflation despite the bold actions of the federal government and of the US Federal Reserve taken in response to the financial crisis that began in 2008 and the associated recession. Although the vicious circle of debt deflation is not widely recognized, precisely what von Mises described is happening before our eyes.

A variety of positive economic data has been reported in recent months. Retail sales rose 0.4% in April 2010 as consumer spending rose and the US gross domestic product (GDP) grew at a rate of 3%. In May 2010, home sales rose to a five-month high and consumer confidence rose 17% (from 57.7 to 63.3). Industrial production rose 0.8% and durable goods orders rose 2.9%, more than had been forecast. However, the modest gains reported represent the continuing adaptation of economic activity at dramatically lower levels compared to the pre-recession period and most of the reported gains have been substantially manufactured by massive government deficit spending.

Despite the widely reported green shoots, in May, the unemployment rate rose to 9.9% while paychecks in the private sector shrank to historic lows as a percentage of personal income, and personal bankruptcies rose. Roughly 14% of US mortgages are delinquent or in foreclosure, credit card defaults are rising and consumer spending hit 7 month lows. To make matters worse, the reported increase in consumer credit, in fact, points to a further deterioration because consumers appear to be borrowing to service existing debt. Outside of the federal government, which is borrowing at record levels and expanding as a percentage of GDP, and outside of the bailed out financial sector, debt deflation has continued unabated since 2008.

Money Supply vs. Debt Service

A contraction of the broad money supply is taking place because the influx of money into the US economy, i.e., lending to consumers and non financial businesses, has fallen below the rate at which money is flowing out of general circulation as a function of debt service (interest and principle payments on existing debt), thus a net drain of money from the broad US economy is taking place. As a result, additional borrowing, as consumer spending falls, appears to be servicing existing debt in a pattern that is clearly unsustainable and that signals a further rise in debt defaults in coming months.

^{Chart courtesy of}^{Shadow Government Statistics}

The estimate of the broad money supply (the Federal Reserve’s M3 monetary aggregate) is crashing and the Federal Reserve’s M1 Money Multiplier, a measure of how much new money is created through lending activity, fell off of a cliff in 2008, and remains practically flat-lined.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The contraction of the broad money supply points to a potential slowing of economic activity and indicates that consumers and non financial businesses will be less able to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain near 10% over the next year and mortgage delinquencies, are currently at a record highs, and these dismal predictions implicitly assume a stable or growing money supply.

A tsunami of eventual mortgage defaults seems to be building and loan modifications have been a failure thus far. There have been only a small number of permanent loan modifications (295,348) under the Home Affordable Modification Program (HAMP) in 2009, out of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.

^{Chart courtesy of}^{Calculated Risk}

Although it has been reported that American consumers are saving at a rate of 3.4%, the contraction of the broad money supply suggests savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the increase in non-mortgage consumer loans indicates that consumers are borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating financially as their total debt grows, thus as they approach insolvency.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The increase in non-mortgage consumer loans has not prevented an overall decline in total household debt attributed to ongoing deleveraging by consumers. While deleveraging (paying down debt) has been interpreted as caution on the part of consumers, or as low consumer confidence, the decline in outstanding credit reflects a reduced ability to borrow, i.e., to service additional debt. This suggests that the recovery of the US economy may be illusory and that the economy is likely to contract further in coming months.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Commercial borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has not been matched by debt financed expansion in the private sector.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The broad US money supply is no longer being maintained or expanded by normal lending activity. If federal government deficit spending ($1.5 trillion annually), debt monetization and emergency actions by the Federal Reserve (totaling an estimated $1.5 trillion since 2008) to recapitalize banks are considered separately, there remains a net drain effect on the broad money supply. The scarcity of money hampers economic activity, i.e., money is less available for investment, and directly exacerbates debt defaults as consumers and businesses experience cash shortfalls, while at the same time being less able to borrow. Since unemployment is a key indicator of recession, then if the US economy were contracting, it would be evident in unemployment statistics.

Structural Unemployment

Unemployment and labor force data suggest that the US labor market is in a structural decline, i.e., millions of jobs have been and are being permanently eliminated, perhaps as a long term consequence of offshoring, outsourcing to other countries and the ongoing deindustrialization of the United States. However, the immediate meaning of the term “structural” has to with the fact that jobs created or sustained during the unprecedented expansion of debt leading to the financial crisis that began in 2008, e.g., a substantial portion of service sector jobs created in the past two decades now appear not to be viable outside of a credit expansion.

Officially, the US unemployment rate rose to 9.9% in April 2010, which represents the percentage of workers claiming unemployment benefits. However, the total number of unemployed or underemployed persons, including so-called “discouraged workers” (Bureau of Labor Statistics U-6), rose to 17.1%. Using the same methods that the BLS had used prior to the Clinton administration, U-6 would be approximately 22%, rather than the official 17.1% statistic.

^{Chart courtesy of}^{Shadow Government Statistics}

With official U-6 unemployment of 17.1% and a workforce of 154.1 million there are roughly 26,197,000 people officially out of work. Using the pre-Clinton U-6 unemployment calculation of approximately 22%, there would be 33.9 million unemployed. If the average US household consists of 2.6 persons and if 33% of the unemployed are sole wage earners, then 55.5 million US citizens currently have no means of financial support (17.9% of the population).

^{Chart courtesy of}^{Calculated Risk}

While it has been reported that the labor force is shrinking, the characterization of workers permanently exiting the workforce by choice may be inaccurate. While a shrinking workforce could reflect demographic changes, the rate of change suggests that tens of millions of Americans are simply unemployed.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Setting aside the question of whether or not those “not in the workforce” are, in fact, permanently unemployed, the workforce, as a percentage of the total US population, is currently at 1970s levels. Since many more households today depend on two incomes to meet their obligations, compared to the 1970s, a marked drop in the percentage of the population in the workforce points to a decline in the labor market more significant than official unemployment statistics suggest. What is more important, however, is that structural unemployment suggests structural government deficits, e.g., unemployment benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP (roughly 70%) consists of consumer spending, a sustainable recovery from recession seems improbable if unemployment is worsening or if the labor force is in a structural decline, since that would imply unsustainable government deficits, whether or not they are masked by nominal GDP gains thanks to economic stimulus measures.

Government and GDP Growth

The US federal government is a growing portion of GDP, thus reported GDP growth is largely a byproduct of government deficit spending and stimulus measures, i.e., reported GDP growth is unsustainable. Total government spending at the local, state and federal levels accounts for as much as 45% of GDP, thus nominal gains would be expected when government deficit spending increases. According to some measures, reported gains in GDP are a byproduct of relatively new statistical methods and, using earlier methods of calculation, GDP remains negative.

^{Chart courtesy of}^{Shadow Government Statistics}

Government borrowing and spending may have offset declines in the private sector but only to a degree and only temporarily. The resulting growth in US public debt has an eventual mathematical limit: insolvency. Of course, the actual limit to US borrowing remains unknown. The continuing solvency of the US depends on the ability and willingness of governments, banks and investors around the world to lend to the US, which in turn depends on the tolerance of lenders for the US government’s profligacy and money printing by the Federal Reserve, e.g., quantitative easing and exchanging new cash for worthless bank assets. US Treasury bond auctions will fail if lenders conclude that a sufficiently large portion of their investment will be diluted into oblivion by proverbial money printing. In that event, the US dollar will surely plummet, despite deflationary pressures within the domestic US economy, and the cost of foreign goods, e.g., oil, will rise causing high inflation or triggering hyperinflation.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

According to the Bank for International Settlements (BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2% in 2010. Rather than being the result of one-time expenses, such as temporary stimulus measures, much of the deficit represents permanent increases in government spending, e.g., due to the growing number of federal employees. If increased government spending is removed, GDP appears to be declining significantly.

^{Chart courtesy of}^{Karl Denninger}

Of course, sustainability has more to do with total debt than with deficit spending because a deficit assumes that there is an underlying capacity to service additional debt.

Unsustainable Debt

While asset prices have declined, e.g., real estate and equities, debt levels have remained high due to the federal government’s policy of preserving bank balance sheets, which had ballooned prior to the financial crisis to the point that overall debt in the US economy reached unsustainable levels.

^{Chart courtesy of}^{Karl Denninger}

The absolute debt to GDP ratio of the US economy peaked in 2007 when debt levels exceeded the ability of the economy to service debt from income based on production, even at low interest rates. Although US GDP began to decline prior to the advent of the global financial crisis, debt coverage had been in decline approximately since the 1970s, coincidentally, around the time that the US dollar was decoupled from gold.

^{Chart courtesy of}^{Karl Denninger}

Government deficit spending cannot correct the situation because, for every dollar of new borrowing, the gain in GDP is negligible and some have argued that the US economy has passed the point of “debt saturation.”

^{Chart courtesy of}^{Nathan A. Martin}

In a growing economy, additional debt can result in a net gain in GDP because the money supply grows and economic activity is stimulated by transactions that flow through the economy as a result. The debt saturation hypothesis is that, as debt levels rise, additional debt has less impact on GDP until a point is reached where new debt causes GDP to decline, i.e., the capacity of the economy to service debt has been exceeded and, not only is it impossible for the economy to grow at a rate sufficient to service existing debt (since interest compounds), but economic activity actually declines further as a function of additional debt.

A Downward Spiral

The process of debt deflation is straightforward. New lending at levels that would maintain or expand the broad money supply is impossible for two reasons: (1) asset values and incomes have fallen and millions remain unemployed; and (2) debt levels remain excessive compared to GDP, i.e., real economic activity (outside of the government and financial services industry) cannot service additional debt. The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation.

Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Since the presence of excess debt (beyond what can be supported by a stable GDP, or by sustainable GDP growth) impacts the broad money supply, efforts to preserve bank balance sheets, i.e., to keep otherwise bad loans on the books of banks at full value, will ultimately cause bank balance sheets to deteriorate more than they would have otherwise. The fact that US banks issued trillions in bad loans cannot be corrected by changing accounting rules, nor can the consequences be avoided by government deficit spending or by unlimited bailouts, and the problem cannot be papered over by dropping freshly printed money from helicopters flying over Wall Street. The major problems facing the US economy today—a tsunami or debt defaults, structural unemployment, massive government budget deficits, a contraction of the broad money supply outside of the federal government and the financial system, and a lack of sustainable growth—cannot be addressed as long as excess debt levels are maintained. As von Mises clearly understood, sound economic conditions cannot be restored unless and until the excess debt, which resulted from a boom brought about by credit expansion, is purged from the system. The alternative, and the current policy of the United States, is a downward spiral into a bottomless economic abyss.