Economic Thrill Rides

volatility-cartoon

The following is excerpted from an editorial in Barron’s by Thomas Donlan. (Full article Barrons. Subscription req’d)

Central planning that is intended to eliminate chaos eventually creates it. As Friedrich Hayek wrote in The Road to Serfdom, state economic planning is unavoidably arbitrary: “The more the state plans, the more difficult planning becomes for the individual.”

Among many examples of this principle: If a government tweaks money supply to hit targets for interest rates and exchange rates, it will provide stability in those things, but the economy will fluctuate. Or, if the government tries to guarantee general economic growth, as measured by employment, gross domestic product, consumer confidence, business investment, or all of them, rates of interest and exchange will fluctuate. Either way, the economy will be under control of an unstable, unpredictable thing that seeks order instead of liberty, and so can deliver neither.

We should see in the recent market chaos the economic chaos created by planning — not just in China but in the U.S. and Europe, as well. Markets are trying to follow political orders. In China, the government wanted to let markets have more influence over the value of money, until it observed the results and ordered a devaluation. In Europe, the promise to do “whatever it takes” to stabilize a rickety monetary union has perpetuated chaos.

Naturally, markets gyrate under pressure of the sort generated by the president of the New York Federal Reserve. From one side of his desk, he said he still hopes that the Fed will raise interest rates this year, while from the other side, he observed that the case for a rise “seems less compelling.”

The great danger in a market tremor is what people do about it. China, the U.S., and Europe have given too much power to their monetary authorities, relying on central bankers to sail against the winds of economic change. They believe economies respond predictably to tinkering with money markets.

Actually, economies respond to stimuli with booms and to tightening with busts, unless they don’t. As economist Ed Yardeni suggested at midweek, perhaps with tongue in cheek, “Another 2008 crisis is imminent eventually.”

All over the world, there are people who imagine themselves to be masters of the material universe. They are the greatest threat to liberty and prosperity.

I have been arguing for some time that this is how we should understand economic policy over the past 30+ years, often referred to as the Great Moderation. We’ve tried to guarantee economic growth as measured by nominal GDP, interest rates, employment, and price stability as measured by the CPI. The result has caused asset prices such as commodities, exchange rates, real estate, and precious metals to fluctuate quite widely and wildly.

Asset price fluctuations impose their own costs on people, often with arbitrary effects, like when you are forced to buy or sell a house (see chart below). Asset price support by the Fed has also greatly enriched those who own more assets, widening the economic inequality gaps. It is hardly an ideal state of affairs, nor one that can easily be justified on philosophical grounds.

Housing index

Politics, Economics, and the State of Our World

QE paradox

This is an interesting graphic that not only illustrates the futility of current monetary stimulus (the QE-ZIRP Paradox), but also the larger contradiction we’ve created in the relationship between politics and economics. I’ll explicate how this contradiction also explains Europe’s predicament with Greece and the other periphery countries in Eurozone, and also applies to emerging countries, especially China.

We can envision economics as a boundary of constraints or possibilities on the choices we can make in life. We might call these budgetary constraints, but it also pertains to constraints on growth and expansion. Relate this to personal finance:  economics constrains the choices we have on what kind of house we buy or rent, what cars we drive, what vacations we can take, what schools we attend, etc., etc. Within those constraints we often have many choices and possibilities for trade-offs. We can decide to buy a small house to afford a big car, or a tuition-free school in favor of more exotic vacations. We make these decisions everyday throughout our lifetimes.

The personal choices we make within the constraints of economics are analogous to the social choices we make through democratic politics. So, economics is like the box within which politics can allocate resources by democratic consensus. We can decide on more social welfare, or more national defense, or more leisure time. The irrationality is believing that we can somehow make choices that lie far outside the constraints of economics. Fantasies like we can all fly to the moon, all have a heart transplant, or perhaps live high on the hog without working to produce the necessary prosperity.

Economic constraints and political choices interact, an important dynamic since both are malleable over time. We can make choices that expand the constraints of economics, which would mean an expansion of possibilities through growth. Or we can make choices that shrink the boundaries of the economically possible, reducing our choices in the future. The interesting point to make at this stage of our exposition is that, like the boundaries we set for our children, economic constraints are a disciplinary factor that helps to keep our political choices honest.  In other words, economics disciplines our political choices by penalizing bad choices and rewarding good choices.

This has profound implications for how society works.

One can imagine that one of the major economic constraints on our personal set of choices is the amount of money we have. In other words, the fungible value of our assets and savings. Rich people have fewer economic constraints than poor people. But this supply of money is not fixed and can be augmented by borrowing through the issuance of credit and assumption of debt obligations. So, one can buy a more expensive house by borrowing the necessary funds from a mortgage lender and then paying it back over time. We soon figured out that when the supply of money is too strict, economic constraints are unnecessarily tight, so money supply should adapt to the needs of the political economy.

Thus, we can expand the economic constraints facing society by expanding the supply of money through credit. One might think, “Wow, that was easy. Now we have lots more choices!” And the next thought should be, “Well, what’s the limit on how much money we can create?”

First, we should remember that money is not wealth, it merely represents wealth. When money was backed by gold reserves, the supply of gold limited the amount of money in the system. If  Country A adopted bad policies relative to its trading partner Country B, gold reserves would flow out, threatening the underlying value of Country A’s currency. This would force Country A to correct its policies or risk impoverishment. The exchange rates between currency A and B did not reflect these changes because both were fixed to gold; but the underlying values had obviously changed demanding a revaluation of both currencies relative to gold. While workable, this was a herky-jerky way of adapting to changing economic conditions and resulted in many financial,  economic, and political crises along the way. It took WWI and WWII to finally break away from a gold standard as an economic constraint.

In 1948, the western powers that had been victorious in WWII established an international currency regime (called Bretton Woods) backed by the US$ fixed to gold and a host of institutions to help manage international relations, such as the IMF, the World Bank and the United Nations. Unfortunately, this regime depended on US policy to defend the monetary regime, even when it contradicted US domestic economic interests. With Vietnam war spending and Great Society social spending (guns and butter), too many dollars were created, causing a run on US gold redemptions by countries like France. In 1971, the Bretton Woods system finally broke down as Nixon closed the gold window to redemptions and all currencies began to float in value relative to other currencies. There was now no fixed relationship of the currency to anything of tangible value – its value was established by government fiat. The initial effect was a stagnating economy plus inflation, a decade-long slog in the 1970s that gave birth to the term stagflation.

At the time, it was thought that exchange rate movements would signal necessary policy changes to keep each countries’ political priorities aligned with economic constraints. It turns out this assumption did not hold up to political realities because volatile exchange rates do not necessarily affect domestic economic interests to the point where politicians feel the need to respond. How many of us know or care how the US$ is performing relative to the other currencies of the world? The result was that politically favorable (more for everybody!), but economically detrimental, policies could be pursued, while exchange rate volatility could be largely ignored. Thus, the economic discipline to guide political choices was lost, permitting bad policies to persist. We have seen this in the explosion of credit and debt around the world and the volatility in exchange rates and asset markets.

Now we can see the problem illustrated in the graphic above. Instead of forcing necessary fiscal reform, we end up throwing more monetary stimulus at the problem. The results have been rising inequality, asset booms and busts, and massive resource misallocations that will cost society economically for a long time. On the global stage, China is the poster child of excess. It will all end when we finally hit the wall and throwing more money at the problem no longer works.

Europe, the EU, and Greece.

We can consider another case in Europe where volatile exchange rates after 1971 inhibited trade with unnecessary currency risks and conversion costs. The idea was that a currency union under the euro would greatly expand intra-European trade by eliminating these costs. But a currency union requires consistent monetary and fiscal policy and a re-balancing mechanism. In the US this is achieved through a Federal government that taxes and redistributes resources. In the European view, economic discipline would by imposed by a set of consistent policy rules established under the European Union and Parliament. Once, again, the result was that individual country governments found ways to skirt the rules or outright deceive the EU on its government budgets. Sometimes this was necessary given the varying needs of uneven development among countries. We see the result in Greece, when it was soon discovered that Greece had borrowed and spent public funds far in excess of the 3% boundary established by the EU.

So, a currency union also has failed to discipline politics, and the result has been a catastrophe for the Greek people and a severe blow to the concept and credibility of the European Union and the euro.

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The bottom line is that democratic politics needs a firm disciplinary constraint, or else a financially manipulated economy will give society just enough rope to hang itself with. Unfortunately, this has happened quite frequently in history.

The Debt Driven Economy

mtdebt

The problem is that like all Keynesians they do not know the difference between fiat credit, which is manufactured out of thin air by fractional reserve commercial banks or money-printing central banks, and honest debt that is funded out of genuine savings from current income by households and business.

Krugman’s Dopey Diatribe Deifying The Public Debt

Actually, dopey does not even begin to describe Paul Krugman’s latest spot of tommyrot. So here are his own words—–least it appear that the good professor is being unfairly caricaturized. In a world drowning in government debt what we desperately need, by golly, is more of  the same:

That is, there’s a reasonable argument to be made that part of what ails the world economy right now is that governments aren’t deep enough in debt.

Yes, indeed. There is currently about $60 trillion of public debt outstanding on a worldwide basis compared to less than $20 trillion at the turn of the century. But somehow this isn’t enough, even though the gain in public debt——-from the US to Europe, Japan, China, Brazil and the rest of the debt-saturated EM world—–actually exceeds the $35 billion growth of global GDP during the last 15 years.

But rather than explain why economic growth in most of the world is slowing to a crawl despite this unprecedented eruption of public debt, Krugman chose to smack down one of his patented strawmen. Noting that Rand Paul had lamented that 1835 was the last time the US was “debt free”, the Nobel prize winner offered up a big fat non sequitir:

Wags quickly noted that the U.S. economy has, on the whole, done pretty well these past 180 years, suggesting that having the government owe the private sector money might not be all that bad a thing. The British government, by the way, has been in debt for more than three centuries, an era spanning the Industrial Revolution, victory over Napoleon, and more.

Neither Rand Paul nor any other fiscal conservative ever said that public debt per se would freeze economic growth or technological progress hard in the horse and buggy age. The question is one of degree and of whether at today’s unprecedented public debt levels we get economic growth—–even at a tepid rate—–in spite of rather than because of soaring government debt.

A brief recounting of US fiscal history leaves little doubt about Krugman’s strawman argument.  During the eighty years after President Andrew Jackson paid off the public debt through the eve of WWI, the US economy grew like gangbusters. Yet the nation essentially had no debt, as shown in the chart below, except for temporary modest amounts owing to wars that were quickly paid down.

In fact, between 1870 and 1914, the US economy grew at an average rate of 4% per year——the highest and longest sustained growth of real output and living standards ever achieved in America either before or since. But during that entire 45 year golden age of prosperity, the ratio of US public debt relative to national income was falling like a stone.

In fact, on the eve of World War I, the US had only $1.4 billion of debt. That is the same figure that had been reached before the Battle of Gettysburg in 1863.

That’s right. During the course of four decades, the nominal level of peak Civil War debt was steadily whittled down; the Federal  budget was in balance or surplus most of the time; and at the end of the period a booming US economy had debt of less than 5% of GDP or about $11 per capita!

In short, nearly a century of robust economic growth after 1835 was accompanied by hardly any public debt at all. The facts are nearly the opposite of Krugman’s smart-alecky insinuation that today’s giant, technologically advanced economy would not have happed without all of today’s massive public debt.

Indeed, on a net basis every dime that was added to the national debt between Jackson’s mortgage burning ceremony in 1835 and 1914 was 100% war debt that never contributed to domestic economic growth and was mostly repaid during peacetime. In effect, Rand Paul was right: In a modern Keynesian sense, the US was “debt free” during the 80 years when it emerged as a great industrial powerhouse with the highest living standard in the world.

Thereafter, there were two huge surges of wartime debt, but those eruptions had nothing to do with peacetime domestic prosperity;  and they were quickly rolled back after the war-time emergencies ended. Its plain to see in the graph below.

During WWI, for example, the national debt soared from  $1.4 billion to $27 billion, but the great Andrew Mellon, as Secretary of the Treasury during three Republican administrations, paid that down to less than $17 billion, even as the national income nearly doubled during the Roaring Twenties. That meant the public debt was back under 20% by the end of the 1920s.

To be sure, for the last 70 years the Keynesian professoriate has been falsely blaming the severity and duration of the Great Depression on Herbert Hoover’s balanced budget policies during 1930-1932. But none has ever charged that paying down the WWI debt had actually caused the Great Depression. Nor have the Keynesian economic doctors ever claimed that had Mellon not paid down the peak WWI debt ratio of about 45% of GDP that the Roaring Twenties would have roared even more mightily!

Likewise, the national debt did soar from less than 50% of GDP in 1939, notwithstanding the chronic New Deal deficits, to nearly 120% at the 1945 WWII peak. But this was not your Krugman’s beneficent debt ratio, either. Nor is it proof, as per his current diatribe, that the recent surge to $18 trillion of national debt has been done before and has proven helpful to economic growth.

Instead, the 1945 ratio was a temporary and complete artifact of a command and control war economy. Indeed, the total mobilization of economic life by agencies of the state during WWII was so complete that Washington had essentially banished civilian goods including new cars, houses and most consumer durables, and had also tightly rationed everything else including sugar, butter, meat, tires, shoes, shirts, bicycles, peanut brittle and candied yams.

With retail shelves empty the household savings rate soared from 4% of disposable income in 1938-1939 to an astounding 35% by the end of the war.

Consequently, the Keynesians have never acknowledged the single most salient statistic about the war debt: namely, that the debt burden actually fell during the war, with the ratio of total credit market debt to GDP declining from 210 percent in 1938 to 190 percent at the 1945 peak!

This obviously happened because household and business debt was virtually eliminated by the wartime savings spree, dropping from 150 percent of GDP in 1938 to barely 60 percent by 1945, and thereby making vast headroom for the temporary surge of public debt.

In short, the nation did not borrow its way to victory via a Keynesian miracle.  Measured GDP did rise smartly because half of it was non-recurring war expenditure. But even then, the truth is that the American economy “regimented” and “saved” its way through the war.

Once the war mobilization was over Washington quickly reduced it massive wartime borrowing, and set upon a 35 year path of drastically reducing the government debt burden relative to national output. Looking at the chart’s veritable ski-slope from 120% of GDP in 1945 to barely 30% of GDP when Reagan took office in 1980 you would think that the US economy should have been buried in depression during that period if Professor Krugman silly syllogisms are to be given any credit.

Of course, just the opposite is true.  The greatest sustained period of post-war real GDP growth occurred between 1955 and 1973, with real output growth averaging nearly 3.8% per annum. But after that, as shown by the relative growth rates of real final sales in the chart below, the trend rate of growth steadily eroded. Thus, economic prosperity actually reached its highest level precisely when the national debt ratio was speeding down that ski-slope.

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Indeed, during the very period when the fiscal deficit got out of control during the early 1980’s owing to the Reagan Administration’s impossible budget equation of soaring defense, deep tax cuts and tepid restraint on domestic spending, young professor Krugman was toiling away in the White House as a staff member of the Council of Economic Advisors.

During the dark days of the 1981-1982 recession when the economy was collapsing and the deficit was soaring I heard some pretty whacky ideas from the White House economists on how to reverse the tide. But never once did I hear professor Krugman argue that with the GDP at about $3.5 trillion while the public debt stood at less than $1.5 trillion or about 40% of GDP that it was time to turn on the deficit spending after-burners and get the national debt up to 100% of GDP forthwith.

No, this whole case for mega-public debt has emerged since 2008. For crying out loud,  before the great financial crisis Krugman was one of the noisiest voices in the chorus denouncing George Bush’s massive tax cuts on the grounds that they would add to the national debt, which was then $6 trillion, not $18 trillion.

The fact is, the financial crisis was caused by the massive money printing campaigns of the Fed in the years after Greenspan assumed the helm in 1987. The resulting falsification of money market interest rates and distortion of prices and yields in the capital markets gave rise to serial booms and busts on Wall Street. But these financial market deformations had virtually nothing to do with fiscal policy and most certainly did not reflect an insufficiency of public debt.

These destructive busts——the dotcom crash, the 2008 mortgage bust and Wall Street meltdown and the stock market plunge just now getting underway——-are owing to the fact that Wall Street has been turned into a gambling casino by the Federal Reserve and the other major central banks.

But rather than acknowledge that obvious reality, Krugman actually manages to turn it upside-down. To wit, he argues that repairing the nation’s busted financial markets after September 2008 required the creation of  “safe assets” in the form of government debt so that investors would presumably have a place to hide from Wall Street’s toxic waste:

Beyond that, those very low interest rates are telling us something about what markets want. I’ve already mentioned that having at least some government debt outstanding helps the economy function better. How so? The answer, according to M.I.T.’s Ricardo Caballero and others, is that the debt of stable, reliable governments provides “safe assets” that help investors manage risks, make transactions easier and avoid a destructive scramble for cash.

Now that puts you squarely in mind of the young boy who killed his parents and then threw himself on the mercy of the courts on the grounds that he was an orphan. That is, having experienced a runaway financial bubble owing to excessive monetization of the public debt during the Greenspan era, the nation’s economy now needed even more public debt in order to subdue the very Wall Street gamblers that the Fed’s printing presses had unleashed.

Every phrase in the above quoted passage is nuts, even if it is attributable to an MIT rocket scientist, who is apparently handsomely paid for publishing pure drivel. After all, investors on the free market have known how to manage genuine financial risk from time immemorial; they didn’t need today’s vast emissions of public debt to help them.

In fact, treasury notes and bonds have no logical relationship to honest hedging in the first place. The most salient case of treasury based hedging was the spectacular blow-up of Long Term Capital in 1998. In that particular instance, the gamblers who ran a trillion dollar book of speculative assets including tens of billions of high yield Russian debt blew themselves up shorting the treasuring market to hedge their interest rate risk. Then, during the panicked investor flight to safety in August 1998, their giant losses on risky assets were compounded by even larger losses on their short treasury hedge.

In fact, the real point about the government debt market in today’s central bank rigged financial system is that it has become a venue for state sponsored thievery. That is to say, when the Fed pegs the front end of the curve at zero for 80 months running and then pours $3.5 trillion of fiat purchasing power into buying the rest of the treasury curve, including mortgage-backed agency securities, in order to boost bond prices and lower yields, it is creating a  virtually risk free arbitrage for Wall Street gamblers. And that serves no public purpose whatsoever, except to transfer massive windfall profits to the most adept gamblers among the 1%.

Professors Krugman and Caballero  actually think this helps?

The problem is that like all Keynesians they do not know the difference between fiat credit, which is manufactured out of thin air by fractional reserve commercial banks or money-printing central banks, and honest debt that is funded out of genuine savings from current income by households and business.

Allocating genuine savings to public versus private capital investment almost always results in a diminution of productivity and efficiency, thereby reducing society’s wealth and living standards, not raising them. That’s because governments are invariably controlled by squeaky wheel special interest groups and lobbies which succeed in gaining in the halls of Congress what they cannot justify in the private market. Amtrak, subsidized mass transit and bus services, corps of engineers water projects and export subsidies to Boeing and GE are obvious cases in point.

But our Keynesian professors have no sense of allocative efficiency. They think that any spending—-including having the unemployed dig holes with tablespoons and fill them up with teaspoons—– adds to GDP:

One answer is that issuing debt is a way to pay for useful things, and we should do more of that when the price is right. The United States suffers from obvious deficiencies in roads, rails, water systems and more; meanwhile, the federal government can borrow at historically low interest rates. So this is a very good time to be borrowing and investing in the future……..

You can’t make this stuff up. And here’s the rest of it for the purpose of any remaining doubt.