Deficit Spending

The discussion over the GOP's gold standard proposals continues in spite of the fact that everybody surely knows the idea is not even taken seriously by its proponents – as we noted yesterday, there is every reason to believe it is mainly designed to angle for the votes of disaffected Ron Paul and Tea Party supporters, many of whom happen to believe in sound money. As we also pointed out, there has been a remarkable outpouring of opinion denouncing the gold standard. Unfortunately many people are misinformed about both economic history and economic theory and simply regurgitate the propaganda they have been exposed to all of their lives. Consider this our attempt to present countervailing evidence. The 'Atlantic' felt it also had to weigh in on the debate, and has published an article that shows, like a few other examples we have examined over recent days, how brainwashed the public is with regards to the issue and what utterly spurious arguments are often employed in the current wave of anti-gold propaganda. The piece is entitled “Why the Gold Standard Is the World's Worst Economic Idea, in 2 Charts”, and it proves not only what we assert above, it also shows clearly why empirical evidence cannot be used for deriving tenets of economic theory.

Over the weekend, we pointed out that the old mechanism for the People’s Bank of China to expand its balance sheet and create base money has been broken by new funds flow pattern, and it will sooner or later require some sort of large scale asset purchases programme a.k.a. quantitative easing to offset the impact of the broken mechanism (after other tools such as cutting RRR reach their limits). However, we also mentioned that as the private sector is currently quite overstretched and will start the deleveraging process (if they have not already started), and that would render traditional monetary tools useless, and quantitative easing ineffective. And that would necessitate deficit spending at both local and central government levels. If we have read the social mood correctly that China might be more pro-austerity than pro-Keynesian, and if policymakers indeed share that view, then the consequence in the near term could be rather grim. The delay in stimulus as well as the small size of it so far has already done damage, if you like. The economy is already on course to a hard landing.

Bridgewater's Ray Dalio is quoted in a recent Barron’s interview, describing the current phase of the U.S. deleveraging experience as “beautiful”. He goes on to explain the three options for reducing debt: austerity, restructuring and printing money. “A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.” That sounds pretty good and makes sense. Or does it?

As we await the latest developments out of the Eurozone and Washington, JPMorgan's Kenneth Landon takes a moment to look back on this very important day in history. If you want to understand current events, then you first have to understand history. How did we get here? More specifically for financial markets, how did we end up in this mess -- this economic purgatory? This being August 15, 2012, students of the history of monetary economics no doubt are aware that this is the 41th Anniversary of the breakdown of Bretton Woods. It was on this day 41 years ago that President Nixon defaulted on the promise to exchange gold for paper dollars presented for exchange by foreign central banks. The crisis in confidence that we observe today resulted from cumulative effects of those measures.

Baupost's Seth Klarman sums it all up:

"It is a strange world we inhabit. One where economies remain extremely depressed yet almost no companies go bankrupt, while low interest rates encourage holders of capital to speculate. One where global turmoil mounts while the world passively watches. One where nearly every member of Congress will insist that we need to rein in deficit spending, while collectively Congress accomplishes virtually nothing. It would be absurdly funny if it weren’t so incredibly tragic."

The lunatics are running the asylum. This is the only conclusion one can come to when considering the nonchalance with which what was once considered an extraordinary policy with a firm 'exit' in mind is now propagated as a perfectly normal 'tool' to be employed at the drop of a hat. We refer of course to so-called 'quantitative easing' (QE), which really is a euphemism for money printing. Apart from his sole focus on short term outcomes, an important point that seems not be considered by the FOMC's Rosengren this week is the question of what should happen if the 'open-ended' QE policy were to fail to achieve its stated goals. He seems to assume that it will succeed in lowering unemployment and creating 'economic growth' as a matter of course. It goes without saying that money printing cannot create a single molecule of real wealth. If it could, then Zimbabwe wouldn't be a basket case, but a Utopia of riches. We must infer from Rosengren's idea of implementing open-ended QE until  certain benchmarks in terms of unemployment and 'growth' are achieved, that in case they remain elusive, extraordinary rates of money printing would simply continue until the underlying monetary system breaks down.

A year ago, the budget “deal” concocted between Mr Obama and his Congress was ballyhooing a “plan” to cut $US 1.2 TRILLION off annual budget deficits over a DECADE. Now, the projection for the 2012 budget is that the US government will add that amount to the funded debt of the US Treasury over ONE YEAR. This would be hilariously funny if it wasn’t so tragic. What is even funnier - and more tragic - is that the entire world is “depending” on the people who concoct this stuff.

If the political tsunami underway in Maine is any indicator, the November 2012 election will be fascinating and unpredictable

In addition to the compelling evidence that more active monetary and fiscal policy involvement did not produce beneficial results over the short run, three recent academic studies, though they differ in purpose and scope, all reach the conclusion that extremely high levels of governmental indebtedness diminish economic growth. In other words, deficit spending should not be called "stimulus" as is the overwhelming tendency by the media and many economic writers. Whereas government spending may have been linked to the concept of economic stimulus in distant periods, these studies demonstrate that such an assertion is unwarranted, and blatantly wrong in present circumstances. While officials argue that governmental action is required for political reasons and public anxiety, governments would be better off to admit that traditional tools only serve to compound existing problems.

In a recent BBC News article, philosopher John Gray asks the quaint but otherwise vain question of what would John Maynard Keynes do in today’s economic slump.  We call the question vain because practically every Western government has followed Keynes’ prescribed remedy for the so-called Great Recession.  Following the financial crisis of 2008, governments around the world engaged in deficit spending while central banks pushed interest rates to unprecedented lows.  Nearly four years later, unemployment remains stubbornly high in most major countries. Even now in the face of the come-down that inevitably follows any stimulus-induced feelings of euphoria, certain central banks have taken to further monetary easing. The question of interest shouldn’t be “what would Keynes do” but rather “why even listen to someone so pompous and nihilistic to begin with?”  Just as Keynes missed the Great Depression, modern day Keynesians missed the housing bubble and financial crash.  From his contempt for moral principles to his enthusiastic support for eugenics, Keynes saw the world as something separate from the bubble of his fellow elitists. Outside of that we guess he was a great guy!

The conventional view looks at the domestic credit bubble, the trillions in derivatives and the phantom assets propping the whole mess up and concludes that the only way out is to print the U.S. dollar into oblivion, i.e. create enough dollars that the debts can be paid but in doing so, depreciate the dollar's purchasing power to near-zero. This process of extravagant creation of paper money is also called hyper-inflation. While it is compelling to see hyper-inflation as the only way out in terms of the domestic credit/leverage bubble, the dollar has an entirely different dynamic if we look at foreign exchange (FX) and foreign trade. Many analysts fixate on monetary policy as if it and the relationship of gold to the dollar are the foundation of our problems. These analysts often pinpoint the 1971 decision by President Nixon to abandon the gold standard as the start of our troubles. That decision certainly had a number of consequences, but 80% the dollar's loss of purchasing power occurred before the abandonment of dollar convertibility to gold.

So the end stage of neoliberalism threatens a Dark Age of poverty/immiseration – most characteristically, one of debt peonage. ~ Michael Hudson

One of the most widely accepted truisms of our time is that deflation is bad: bad for debtors, bad for the indebted government, and therefore bad for the economy. What all this overlooks is how wonderful mild deflation is for those who owe no debt but who own the debt and the income streams that flow from debt. What the "deflation is bad" argument ignores is who controls the financial and political systems, and what set of conditions benefits them. Everyone assuming the Federal government has the power to create inflation and that inflation is "good" should examine the interests of those who control the government's policies, i.e. those who own the debt. Put another way: here's what will be scarce: reliable income streams and liquidity.

In the U.S. economy, the driplines are debt-based spending and leverage. Thanks to endless intervention and manipulation, the economy is now totally dependent on massive debt-based spending and increased leverage for its "growth." The person or business that becomes dependent on welfare loses resiliency and resourcefulness. To the degree that economies become dependent on debt and leverage just like individuals and companies become dependent on welfare, entire economies lose their resilience and resourcefulness. A healthy forest offers another apt analogy. A healthy temperate-region forest depends on occasional forest fires to clear out deadwood and refertilize the depleted soil with ashes. In suppressing all fires--what we might call "stress" and feedback-- management virtually guaranteed that when the forest was eventually set ablaze by a random lightning strike, the resulting fire would be catastrophic because the deadwood had been allowed to pile far higher than Nature would have allowed. The "managers" of the economy have let a couple hundred billion dollars in bad debt burn, and they think the $15 trillion economy is now restored to health. Writing off a couple hundred billion is like letting a few acres of grassland around the parking lot burn and reckoning you've cleared the entire forest of deadwood. The buildup of deadwood--fraud, impaired debt, leverage, bogus accounting, malinvestments, promises that cannot possibly be met and the multiple pathologies of crony capitalism--continues apace, untouched by Federal Reserve intervention. Masking risk and suppressing feedback do not restore resiliency or vitality; they cripple the system's ability to respond to reality.

Presenting, with little comment, the ultimate arbiter of the truth - First Trust's Brian Wesbury - discussing his "Mark-to-Market accounting is to blame for it all; the economy is fine and is not reliant on Fed QE; 80,000 jobs creating; Facebook wealth-building" view of the non-zombie economy. So we presume: Forget China, ignore Europe, the fiscal-cliff is a molehill, and once the government stops spending/growing (which is his angle) then all will be well with this thoroughbred economy - as opposed to his non-zombie plough-horse (that unfortunately just leads us down a path of low/slow growth, labor force participation-lagging, deficit spending, social welfare dependent dysphoria).