Hera : debt, GDP

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.

Bernanke’s Dilemma: Hyperinflation and the US Dollar

Ron Hera — Wed, 10 Mar 2010 13:13:00 GMT

Ben Bernanke, Chairman of the US Federal Reserve, faces a Sisyphean task because US banks are experiencing debt deflation and, because lending is now at much lower levels, monetary deflation is encumbering the domestic US economy as existing debts continue to be serviced. Government deficit spending can only offset lower consumer spending to a degree, and the mushrooming debt of the US government raises the question of whether the US can repay or roll over its debt obligations, given that tax receipts are likely to fall. Despite deflationary pressure, the value of the US dollar is in a downtrend pointing to higher prices for imported goods and energy. Devaluing the US dollar will reduce the value of debts in real terms, thus it can make debt levels sustainable, but higher prices will exacerbate debt defaults, worsening the condition of US banks. Mr. Bernanke's dilemma is how to salvage the balance sheets of US banks without sparking high inflation or unleashing hyperinflation.

Where the US dollar is concerned, opinions on hyperinflation range from the view that hyperinflation of the world reserve currency is impossible in principle (because, for example, the values of other currencies are linked to that of the US dollar), to the view that hyperinflation of the US dollar has already happened and that all that remains are the consequences. The two most widely accepted theories of hyperinflation are the monetary model, where a positive feedback cycle is caused by a disproportionate increase in the velocity of money as a consequence of increasing the money supply too quickly, and the confidence model, where the monetary authority issuing a given currency is perceived to be insolvent or no longer legitimate.

The view that hyperinflation is the inevitable result of a central bank issuing too much money or of a government taking on too much debt, while correct, both states the obvious and presupposes that some previously known or predictable limit is reached. The ability to service debt is one such measure, but the value of a debt in real terms depends on the value of the currency. In practice, hyperinflation is recognized only after the inexorable death spiral of a currency has begun. Detecting it in advance is another matter entirely.

Mathematical models of hyperinflation, such as predicting years between redenomination based on inflation rates or applying the quantity theory of money, describe what is happening but not why. Using the monetary model alone makes it difficult to explain apparent counterexamples where high levels of sovereign debt compared to a nation's gross domestic product (GDP) or monetization did not result in hyperinflation.

The confidence model seems to suggest that hyperinflation can be explained by crowd psychology where hyperinflation is analogous to a market mania or is an example of mass hysteria. The idea that hyperinflation is only a crisis of confidence, i.e., that it is a psychological phenomenon, not only lacks predictive value but implies that hyperinflation can be prevented by manipulating public opinion regardless of mathematical realities.

When a nation's bond market collapses, so does its currency. The view that hyperinflation is fundamentally caused by failed bond issues suggests that what is of interest are the reasons why a nation's bond market breaks down, along with indications of developing bond market distress.

One fact that is clear in every historical example of hyperinflation is the rejection of the currency of a given country either by other countries or by its own citizens. The simplest explanation of hyperinflation is that when the credibility of a government, or of its central bank, breaks down, the recognition of this fact is expressed as a race to shed the currency and to divest of the government's bonds. One way to evaluate the possibility of hyperinflation is therefore to gauge the transparency, completeness and veracity of government and central bank statements regarding their balance sheets, budgets and bond issues. Incomplete or inaccurate information and propaganda contrary to empirical evidence are proverbial red flags signaling that credibility may be lacking and that confidence is therefore misplaced.

Between Scylla and Charybdis

Growth in the US monetary base has been cited as evidence of incipient hyperinflation but, while a distortion in the US financial system is apparent, the currency in question is not in circulation and the effect is that of re-inflation since US banks have suffered massive losses linked to the US mortgage market.

Chart courtesy of Federal Reserve Bank of St. Louis

The growth in the US monetary base by over $1 trillion since 2008 represents currency held within the banking system on reserve, which increases the ability of US banks to absorb further losses.

Chart courtesy of Federal Reserve Bank of St. Louis

While more than doubling the US dollar monetary base in less than 2 years is viewed by some as printing too much money, high inflation or hyperinflation have yet to strike. Although money has shifted out of the broad US economy and into the banking system, the excess liquidity exists in the form of bank reserves and, despite the fact that inflation is always and everywhere a monetary phenomenon, if bank reserves are considered separately from interest rates and lending activity they have little direct impact on prices in the broad US economy. In fact, the widest measure of the US money supply is contracting and the broad US economy is in the grip of debt and monetary deflation.

Chart courtesy of Shadow Government Statistic

In terms of monetary policy, Mr. Bernanke faces an impossible choice. With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults. Concurrent government borrowing and central bank QE to recapitalize banks and sustain government deficit spending (in a Keynesian attempt to compensate for declining consumer and business borrowing), would cause the value of the US dollar to decline against other currencies thus the prices of imported goods would rise. The resulting combination of rising prices for imported goods (energy in particular) and a scarcity of money in the domestic US economy is a formula for business failures and debt defaults that would ultimately worsen the condition of the US economy and US banks regardless of lower prices for domestic goods and services.

Structural Decay

In a mathematically perfect world, growth in the money supply with a constant interest rate and level of lending is a simple exponential function. In theory, this is not problematic but in practice monetary expansion (and the associated debt) tends to grow faster than population or sustainable economic activity and even periodic deflationary episodes are insufficient to maintain a stable currency value.

Chart courtesy of Wikimedia Commons

The tendency to create currency in excess of what is required to support sustainable economic activity causes unsustainable booms where debt rises out of proportion to the ability to service or eventually repay, meaning that total debt in the economy grows faster than the GDP. The result is that for every boom artificially created by monetary expansion there is a corresponding episode of debt and monetary deflation. Nonetheless, the overall pattern of monetary expansion remains clear.

Chart courtesy of Federal Reserve Bank of St. Louis

From a policy standpoint, restraining debt issuance by private, profit-oriented banks to sustainable levels is impossible in practice because sustainable growth in GDP is an unknown when the interest rates and reserve ratios that moderate lending activity are set. In fact, the goals of the US Federal Reserve, "to promote ... stable prices and moderate long-term interest rates" require the money supply to expand faster than sustainable economic activity:

Sometimes, however, upward pressures on prices are developing as output and employment are softening-especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inflation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inflation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inflation might get built into decisions about prices and wages, thereby adding to inflation inertia and making it more difficult to achieve price stability.

Deflation is anathema because debt defaults harm lenders and governments have no mechanism to tax gains in the value of currency, thus monetary policy always errs toward inflation and over time the result approximates an exponential function. Among the results is the long term devaluation of the currency, which can also be expressed as an exponential function, i.e., exponential decay.

Chart courtesy of Wikimedia Commons

Exponential decay occurs when a quantity, such as the value of a unit of currency, decreases at a rate proportional to its own value. The decay can be expressed as a differential equation where a quantity N decays at a constant rate (a positive number) (lambda) within a given interval of time t.

Central banks implicitly manage the exponential decay in value of their respective currencies while they focus on interest rates, reserve ratios and inflation targets. Although the exponential decay in the value of the US dollar since 1913 has been distorted by episodes of deflation and variations in monetary policy, the overall pattern continues to reflect the structural reality of exponential decay.

Chart courtesy of Federal Reserve Bank of St. Loui

The combination of fiat currency, where currency is created arbitrarily, and central banking, where money and credit are centrally controlled and where there is an inescapable inflationary bias, suggests that all such regimes have a limited lifespan, but this does not allow a hyperinflationary outcome to be predicted. For example, if US citizens had been asked in 1913, when the Federal Reserve was established, if they would use the Federal Reserve's legal tender knowing that $1 would be roughly $0.05 in less than 100 years they would certainly have responded in the negative, but Federal Reserve Notes have not been rejected by the American people. Similarly, there is no necessary or obvious point where the US dollar will be rejected as it continues to decline in value for the same structural reasons. The logical outcome is an eventual redenomination.

Patterns of Hyperinflation

From the perspective of sovereign debt, the commonly understood process of hyperinflation is that if a government responds to declining foreign appetite for its debt with monetization (or in a historical context direct currency debasement) rather than immediate budget cuts, its currency looses value, at first in proportion to the dilution of the money supply and then more quickly as foreign bond holders and the nation's own citizens seek shelter from inflation in other asset classes. The cost of the government's future obligations then tends to rise in nominal terms, creating an apparent need for larger bond issues while bond yields rise, i.e., the cost of borrowing increases since monetization signals greater risk to investors. Exacerbating the problem, tax receipts tend to lag behind as domestic price inflation sets in. Further monetization is the path of least resistance. Although officials certainly believe that monetization is only a temporary measure both confidence in and the credibility of the government fail. Insolvency is eventually recognized as a reality and the nation's currency then collapses entirely.

Economists assume that consumers and businesses respond predictably based on economic incentives and disincentives, but this presupposes that the value of money is stable (at least over the short term). If users of a currency find that it looses value such that savings and wages are perceptibly eroded before they can be utilized at fair value, the rational course of action is to shed the currency as quickly as possible. This sparks a competition to shed currency in favor of real goods and, once the process begins, the rational course of action is to participate in the proverbial rush to the exits. Interestingly, a panic is not required to explain this phenomenon.

In the context of a national economy, the cycle of hyperinflation is driven not precisely by the supply of money but by its velocity because the competition to shed currency concentrates purchasing activity in successively shorter time periods. Within a given interval, more consumers and businesses seek to buy a limited supply of available goods using all available currency, including savings, thus demand is pulled forward while the velocity of money accelerates. If monetary authorities respond by increasing the money supply, the process feeds on itself.

In terms of the quantity theory of money, which is that the money supply has a direct, positive relationship to prices, the equilibrium of prices with the number of items purchased and the money supply with the velocity of money is maintained (where M is the money supply, V is the velocity of money, P is the average price level, and Q is the number of items purchased over a given interval).

The relation holds true even as the value of a currency approaches zero while prices approach infinity. However, while there is no theoretical limit to the money supply, the supply of goods is limited in various ways and shortages of goods spur prices higher, exacerbating the problem.

The competition to shed currency first interacts with prices then with the availability of currency and with the supply of goods. Rising prices result in rising demand for larger amounts and denominations of currency producing a genuine shortage, but increasing the money supply only intensifies the competition to shed currency, like pouring gasoline on a fire.

Crisis of Credibility

A gradual decline in the value of a currency is generally accepted by consumers and businesses because it has little immediate impact and can have short-term benefits, such as making money more accessible and stimulating economic activity and growth. However, when debt increases disproportionately, a deflationary bust is inevitable and if it is postponed by further credit expansion systemic instability results.

Chart courtesy of Karl Denninger

In 1949 Ludwig von Mises pointed out in Human Action (Chapter XX, section 8) 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 system involved."

Among other things, excessive monetary inflation means that the US dollar cannot function as a store of value. Mounting evidence points to systemic instability, a lower US dollar and ultimately to a hyperinflationary outcome:

US federal government debt of $12.3 trillion, unfunded liabilities of $63 trillion, deficit spending of $1.35 trillion for fiscal 2010, and the Obama administration's $3.83 trillion budget all set new records, while federal income tax revenues are expected to fall for a second consecutive year.
It has been reported that to reduce the cost of borrowing, the maturity of debt issued by the US Department of the Treasury has shifted from the long end of the spectrum toward short term debt. At the same time, episodic flights to the perceived safety of the US dollar by global investors favor short-term Treasuries. This situation creates an escalating risk that the US Treasury will be unable to roll over short term debt and that it will resort to monetization.
7 US states are worse off than the financially troubled European nations of Greece, Ireland, Portugal and Spain resulting in warnings of a US credit rating downgrade possibly indicating an eventual sovereign default.
Unemployment in the US, where more than 2/3 of GDP is consumer spending, should be viewed as a leading, rather than a trailing indicator, thus the perception of recovery based on slowing unemployment is premature. Reported unemployment data seem to exhibit unusually pronounced disparities between initial claims and later revisions and seasonally adjusted numbers.
The widely reported recovery of the US economy is anemic at best since most of the reported forth quarter 2009 GDP growth is not sustainable and preliminary government economic data remains subject to revision by the US Bureau of Economic Analysis (BEA).
The imminent retirement of the so-called baby boomer generation comes with a combined Social Security and Medicare price tag of more than $60 trillion.
US bank failures and balance sheet deterioration together with the inability of banks to mark assets to market due to a growing commercial real estate problem and ongoing residential mortgage loan problems suggest that the financial crisis that began in 2008 is not over.
The suspension of the US Financial Accounting Standards Board's mark to market rule means that the value of mortgage loan portfolios and mortgage-backed securities (MBS) reported by banks are incorrect, which obfuscates leverage and risk while magnifying apparent profits.
Toxic assets still cripple bank balance sheets since the US Department of the Treasury has been unable to successfully carry out its Public-Private Investment Program (PPIP) making taxpayer money available to select investors that can use the money to buy toxic mortgage-backed securities, retaining any profits while putting little of their own money at risk.
The largest US Banks remain the largest holders of financial derivatives, e.g., credit default swaps (CDSs), which suggests that they may hold liabilities far in excess of amounts that can be paid or that can be bailed out if significant losses occur. The CDS market, which is the single largest class of financial derivatives, represents over $600 trillion dollars, a roughly 10x multiple of world GDP.
The Federal Reserve's plans to phase out some of its emergency programs, adding up to roughly $2 trillion currently, leaves other emergency measures in place. The Term Asset-backed Securities Loan Facility (TALF) is set to expire on June 30, 2010 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral but existing loans will not be retired for some time.
Downward pressure on the US dollar caused by the Federal Reserve's near 0% interest rates and ongoing QE has caused a US dollar carry trade affecting asset prices in global markets. While the value of the US dollar has rallied in response to episodic flights to perceived safety in US Treasuries reflecting comparative weakness in the Euro and other currencies, the overall downtrend is persistent, thus the prices of imported goods can be expected to rise.

Rather than a crisis of confidence, hyperinflation results from a crisis of credibility. Hyperinflation results when the social, legal and political structures that create the value of paper money break down. When a government borrows excessively and its promises to repay are contradicted by mathematical realities, the value of its currency cannot be maintained. If a government so lacks credibility that it cannot issue bonds because there are no buyers other than its own central bank, the value of its currency declines faster than money is printed to cover its obligations. Perhaps the most important indicator of impending hyperinflation is whether the statements of a government or of its central bank, e.g., with respect to the government's budget or the central bank's balance sheet, are evidence based or ideological. If they are not evidence based, the credibility of the government or central bank, and its currency, will weaken and eventually fail.

Ordinarily, supply and demand factors govern the value of money and the prices of goods, but money has another, deeper level of value apart from its role as a medium of exchange and unit of account. When money is not redeemable, it is, in effect, a contract and, as such, it can instantly become more worthless than the paper it is printed on if the agreement that gives it value is null and void.

In 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper in extremis is accepted by nobody." The reason for this is that there are two fundamental kinds of value. De jure value exists because of, and is dependent upon, social, political and legal arrangements between human beings. In extremis, agreements are often broken and unenforceable. The value of fiat currency and of government bonds are examples of de jure value. Ultimately, de jure value actually exists only in the minds of human beings and does not exist in an absolute sense, in the real world, independent of human belief. De facto value, on the other hand, exists in reality, independent of human thought, e.g., lumber or farmland. The value of real, tangible things of value ultimately devolves to biological survival and to material standards of living. Possessing a physical asset that supports survival does not require human belief in order to have biological value.

When social, political and legal arrangements are strong, reliable and endure over generations de jure value may be preferable for any number of reasons. However, when social, political and legal arrangements prove to be unstable, or fail, de facto value trumps de jure value in every case.

When the balance sheets of US banks are maintained by suspending accounting rules and when banks hold financial derivatives liabilities greater than world GDP, both the stability and credibility of the banks are questionable. When US economic data consistently seems to reflect a Pollyanna bias and the US federal budget contains unrealistic projections of GDP growth and tax revenues, while public debt and government liabilities (which now include unlimited bailouts for government sponsored entities Fannie Mae and Freddie Mac) are obviously unworkable and the US government's own central bank is already a major buyer of US Treasuries, the federal government's credibility is questionable. When private financial losses and toxic financial assets are transferred to taxpayers while profits and bonuses abound on Wall Street thanks to accounting rule changes in the midst of the worst economic contraction since the Great Depression, the credibility and competency of the US Treasury and Congress, with respect to the finances of the nation, are questionable. When the US Federal Reserve defies the US Congress, resists independent auditing, engages in ongoing QE and is the lender of last resort for banks that under normal conditions would be insolvent, its credibility is questionable. When the Chairman of the Federal Reserve, who failed to detect the largest asset price bubble in the history of the world and who has been consistently wrong in his assessment of the US economy is reappointed following the worst financial and economic disaster in generations, both his credibility and that of the Obama administration are questionable. The plethora of red flags spewing from Wall Street, from the Federal Reserve and from the federal government point to a breakdown of de jure value that is already in progress, thus to a hyperinflationary outcome for the US dollar.

Faces of Death: The US Dollar in Crisis

Ron Hera — Sun, 11 Oct 2009 08:45:00 GMT

The US economy has been in crisis since 2008 and despite optimistic statements by officials and commentators there are no fundamental signs that the crisis will end in the foreseeable future. Current economic data suggests a number of diverging and unsustainable...(read more)