The Five-Year Fantasy Is Ending

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Since these monetary/fiscal fixes (i.e. distortions) didn't address the real issues, all they can possibly do is increase the magnitude of the next collapse.

For five long years, we have pursued the fantasy that we could return to "growth" without having to fix or change anything. The core policy of the fantasy is the consensus of "serious economists," i.e. those accepted into the priesthood of PhD economists protected by academic tenure or state positions: what we suffered in 2009 was not the collapse of leveraged crony-state financialization but a temporary decline of "aggregate demand" and productive capacity.

The solution, the economic witch doctors asserted, was simple: replace temporarily slack private demand with government-funded demand (deficit spending) and flood the impaired financial system with liquidity (i.e. free money) and increase the incentives to borrow money.

In other words, the "serious economists" solution was to transfer all the interest earned by savers to the banks and push households to buy more low-quality junk from Asia on credit. This expansion of demand (for more of anything-- "serious economists" don't differentiate between a 13th pair of shoes and a single replacement pair of shoes--and they absolutely love building McMansions in the middle of nowhere) would push businesses to borrow money from banks (that's good because banks will profit, and "serious economists" want banks to skim enormous profits to keep the financial sector healthy) and expand their production and payroll.

None of this made any sense, of course, because the "serious economists" completely misread the problem. The key characteristic of science is predictable, repeatable results. Yet "serious economists" failed to predict both the 2008 global financial meltdown and the failure of their Keynesian Cargo Cult policies: zero interest rates, limitless liquidity and pushing households and enterprises to borrow more money.

There is simply no way this track record justifies economics as a science. It is at best a pseudo-science. The number of astrologers who predicted the 2008 crash far exceeds the number of "serious economists" who did so, yet the priesthood still claims the mantle of science.

Add the fallacies of "serious economists" to the resistance of the Status Quo to any reduction in their skimming operations and you get the fantasy that the only solution needed was to print trillions of dollars and give the dough to government and financiers. Five years on, "growth" has been extremely anemic, and no honest observer can deny the reality that the "recovery" is so fragile and dependent on free money that any normalization--raising interest rates, ceasing Federal Reserve quantitative easing and reducing the Federal deficit to $200 billion from $600 billion--would instantly toss the economy into a deep recession and trigger a collapse in stocks and bonds.

Absolutely nothing was done to address the structural causes of the meltdown and the erosion of the middle class and upward mobility. Was anything done to reverse the soaring costs of higher education? No--the crisis was papered over by the Federal government taking over much of the student loan debt-serf industry. You call this a solution?

How about financial reform? What exactly did the 2,319-page monstrosity of corrupted Federal power, the “Dodd-Frank Wall Street Reform and Consumer Protection Act" actually accomplish? Did it abolish the 'too big to fail banks" or did it simply enable them to prosper at the expense of the consumer?

What If We're Beyond Mere Policy Tweaks? (February 6, 2012)

How about the 2,074-page Affordable Care Act (ACA), a.k.a. ObamaCare? Did that fix the underlying problems with sickcare? No--it simply created more regulatory distortions and a subsidy for the uninsured to join the bloated monstrosity of sickcare, speeding the bankruptcy of the entire system.

America's Hidden 8% VAT: Sickcare (May 10, 2012)

The jewel in the Keynesian Cargo Cult's crown is the "wealth effect" created by the spectacular rise in the stock market. Nothing like a doubling of stocks to make everyone feel wealthier and more likely to spend, spend, spend--oops, except only the top 5% of households own enough financial assets to even notice.

This spectacular rise is supposedly based on corporate profits, which have soared to new heights. Roughly 11% of the nation's GDP (gross domestic product) is now corporate profits.

Financial sector profits have been equally wonderful:

Compare those spikes to GDP, which has registered a much more modest increase since 2008.

How could corporate profits have soared on such anemic growth? There are several rarely addressed causes.

1. The weak U.S. dollar greatly increased profits earned overseas when stated in dollars. In 2002, 1 euro of profit earned by a U.S. global corporation equaled $1 in profit when converted to U.S. dollars. That same 1 euro profit swelled to $1.60 a few years ago and still garners $1.37 in profit today. That's a 37% premium based not on profits being higher but on currency arbitrage.
Given that most U.S. global corporations earn 50% or more of their sales and profits overseas, this is an enormous factor in rising profits.

2. The Federal Reserve's flood of free money washed over the entire global economy, sparking an orgy of investment and consumption in emerging markets. Some percentage of this flowed to U.S. corporations, which have compensated for weak domestic sales with strong growth in emerging markets.

Both of these conditions are at risk of reversal. The Fed's modest "tapering" of its liquidity flood triggered a near-collapse in the emerging markets, and the U.S. dollar's weakness is based on a rising yen and euro. Given the systemic problems in Japan and Europe, this five-year trend could reverse.

Two other factors deserve mention. Some of these corporate profits result from dodgy accounting, not actual net profit. Much of the rise in stocks can be attributed to corporate buy-backs where the companies borrow billions of dollars for next to nothing and then buy back their own shares, driving share prices higher.

In summary, the five-year fantasy that free money would fix all the distortions and systemic problems is drawing to a close. Why can't the fantasy run forever? The two-word answer: diminishing returns. Handing out subprime auto loans works at first because it pulls demand forward: anyone who wants or needs a new car buys one now, rather than put the purchase off a year or two. Eventually the marginal buyers default and demand falls off, and the distortions cause an even greater collapse in demand and auto loan quality.

This pattern of diminishing return from all the fake fixes can be found in every nook and cranny of the global economy. Papering over structural problems with free money works for a while, but since these monetary/fiscal fixes (distortions) didn't address the real issues, all they can possibly do is increase the magnitude of the next collapse.