Eric Sprott: The Solution…Is The Problem, Part II

Tyler Durden's picture

From Eric Sprott & Etienne Bordeleau

The Solution…is the Problem, Part II

When we wrote Part I of this paper in June 2009, the total U.S. public debt was just north of $10 trillion. Since then, that figure has increased by more than 50% to almost $16 trillion, thanks largely to unprecedented levels of government intervention.

Once the exclusive domain of central bankers and policy makers, acronyms such as QE, LTRO, SMP, TWIST, TARP, TALF have found their way into the mainstream. With the aim of providing stimulus to the economy, central planners of all stripes have both increased spending and reduced taxes in most rich countries. But do these fiscal and monetary measures really increase economic activity or do they have other perverse effects?

In today’s overleveraged world, greater deficits and government spending, financed by an expansion of public debt and the monetary base (“the printing press”), are not the answer to our economic woes. In fact, these policies have been proven to have a negative impact on growth.

While it hasn’t received much attention in recent years, a wide body of economic theory suggests that government policies and their size relative to the total economy can have a significant detrimental impact on economic growth. A recent paper from the Stockholm Research Institute of Industrial Economics compiles evidence from numerous empirical studies and finds that, for rich countries, there is overwhelming evidence of a negative relationship between a large government (either through taxes and/or spending as a share of GDP) and economic growth.1 All else being equal, countries where government plays a large role in the economy tend to experience lower GDP growth.

Of course, correlation does not imply causation. While the literature is not definitive on causation, it still provides strong evidence that more taxes and government spending as a share of GDP (except for productive investments such as education) is associated with lower growth.

One exception to these findings is the experience of Scandinavian countries. They have both high taxes and high government spending as a share of GDP but have experienced relatively rapid growth over the past 20 years. However, a significant share of their spending goes to education, which has been found to foster growth. They also counterbalance the large role of the state with very liberal, pro-market reforms and low levels of public debt.2

Debt overhang and economic growth

Even if one believes that temporary Keynesian-type fiscal stimulus, in the form of tax breaks and increased government spending, can spur growth in the short-term, these actions inevitably lead to larger deficits and higher government debt (see July 2010 Markets at a Glance, “Fooled By Stimulus”). As Figures 1 and 2 below show, the U.S. Federal Government deficit and debt levels are already at their highest levels since the end of World War II and the scope of future stimulus appears to be rather limited. According to our projections (which assume there will be no fiscal cliff), the U.S. federal debt will increase significantly as the deficit remains sustained and elevated. For many European countries the situation is even worse.

FIGURE 1: U.S. DEFICIT AS A SHARE OF GDP
US-deficit-GDP-E.gif

FIGURE 2: U.S. DEBT-TO-GDP*
US-debt-GDP-E.gif

Source: The White House: Office of Management and Budget (OMB) and Sprott Calculations
*For reasons discussed in May 2009 Markets at a Glance The Solution … is the Problem, Part 1, we show total federal debt subject to the debt ceiling.

 

High levels of debt, or debt overhangs, cause more problems. Recent work by Carmen Reinhart and Kenneth Rogoff (Harvard University) demonstrates that banking crises are strongly associated with large increases in government indebtedness, long periods of unemployment and, ultimately, some form of default. They identify a threshold of 90% debt-to-GDP as the trigger to a debt crisis.3 As shown in Figure 2, the U.S. has already passed that threshold.

The historical evidence shows that countries with large governments and high levels of debt have on average, achieved lower economic growth. Given the already high level of debt and deficits in most developed countries, it is doubtful that increased fiscal stimulus will really help the recovery. It’s clear that debt is the problem and the solution does not lie in piling on even more of it. The current debt situation, coupled with the increasing lack of transparency of politically motivated regulations and interventions, leaves little room for a healthy deleveraging of our economies. Here is what central planners have in mind.

Debt overhang resolution and implications for the future

Througout history, high debt-to-GDP ratios have been resolved through five channels:4

  1. Economic growth
  2. Austerity
  3. Defaults
  4. Sudden bursts of inflation
  5. Steady financial repression and inflation

 

Clearly, number one and two are not working right now and, in some European countries, are actually negatively reinforcing each other. The U.S. is facing its homegrown fiscal cliff and political polarization makes its resolution doubtful. Number three seems politically unacceptable for rich, developed nations, which see default as the realm of developing countries. Sudden bursts of inflation are hard to contain and work only so many times as investors, assuming a normal bond market, demand higher interest rates to compensate for inflation risk. Moreover, with interest rates already, at zero it seems that we are left with number five: steady financial repression and inflation. This terminology was first introduced in the early 1970s by Edward Shaw and Ronald McKinnon, both from Stanford University.5

They define financial repression as:

  • Explicit or indirect caps or ceilings on interest rates
  • The creation and maintenance of a captive domestic audience (i.e.: forced holdings of government debt by financial institutions and pension funds)
  • Direct ownership of financial institutions and/or entry restriction in the financial industry (i.e.: China, India)

We are clearly living through a period of financial repression. The symptoms include:

  • Artificially low interest rates in most of the G20 countries and commitments to keep them low for long periods of time combined with inflation, which results in negative real interest rates
  • Large expansion of central banks’ balance sheets through the purchase of government bonds
  • Basel III liquidity rules which force banks to hold more government debt on their balance sheets6,
  • Newly nationalized banks in many countries (UK, Ireland, Spain, etc.), which have drastically increased their holdings of government debt
  • and it will bet worse...

Figure 3 below shows that financial repression can be observed within the holdings of U.S. financial institutions and pension funds, which have steadily increased their holdings of U.S. Treasuries since 2009.

FIGURE 3: HOLDINGS OF U.S. TREASURY SECURITIES BY DOMESTIC FINANCIAL INSTITUTIONSholdings-US-treasury-E.gif
Source: Federal Reserve Flow of Funds

It’s clear that governments are preparing for more. A key component to erasing government debt through inflation is extending the duration (maturity) of one’s outstanding bonds. In a normal bond market, negative real interest rates make it difficult to roll over short-term debt at low borrowing rates (although financial repression and captive financial institutions certainly help to keep rates lower than they normally would be). Due to this tendency for short-term rates to rise with inflation, however, it is in the best interests of highly-indebted countries to issue the majority of their bonds at the long end of the yield curve. As Figure 4 shows, the US Treasury is proactively planning to increase the maturity of its outstanding debt (green line) in order to maximize its benefit from inflation erosion. In other words, they are capitalizing on the current flight to safety to set the stage for further financial repression down the road. The same is true for the U.K., which benefits from one of the longest weighted-average maturity of debt in the developed world. For Eurozone countries to do away with their current debt overhang they will either have to default (the least preferred option for political reasons) or use the good old combination of steady inflation and financial repression (feared by the Germans and the ECB central planners).

FIGURE 4: U.S. TREASURY WEIGHTED AVERAGE MATURITY OF MARKETABLE DEBTweighted-average-maturity-debt-E.gif
Source: U.S. Treasury Office of Debt Management, Fiscal Year 2012 Q1 Report

Conclusion

On both sides of the Atlantic, the largest contributors to the current crisis are excessive debt and spending. We are now at a point where additional government stimulus measures will have negligible, if not detrimental effects on the economy and long-term growth. Debt has to be reduced, not increased by more deficits. Central planners have demonstrated that they don’t have the discipline to implement the Keynesian model of surplus in good times in order to finance deficits in bad times. We have now reached the limit of indebtedness and need to muddle through a painful but necessary deleveraging.

The politically favoured option of financial repression and negative real interest rates has important implications. Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings. Also, financial institutions, which are traditionally supposed to funnel savings towards productive investments, are restrained from doing so because a large share of their balance sheets is encumbered by government securities. The same is true for pension funds, which instead of holding corporate paper or shares, now hold an ever growing share of public debt. Pensioners, who are also savers, get hurt in the process.

The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.

 

1 Bergh, A., Henrekson, M. (2011): “Government Size and Growth: A Survey and Interpretation of the Evidence”, Research Institute of Industrial Economics, IFN Working Paper No. 858, April 2011.
2 Bergh, A., Karlsson, M., (2010): “Government Size and Growth: Accounting for Economic Freedom and Globalization”, Public Choice 142 (1–2): 195–213.
Reinhart, C., Rogoff, K. (2010): “From Financial Crash to Debt Crisis”, National Bureau of Economic Research, NBER Working Paper #15795, March 2010. Reinhart, C., Rogoff, K. (2011): “A Decade of Debt”, National Bureau of Economic Research, NBER Working Paper #16827, February 2011. Reinhart, C., (2012): “A Series of Unfortunate Events: Common Sequencing Patterns in Financial Crises”, National Bureau of Economic Research ,NBER Working Paper #17941, March 2012.
4 Reinhart, C., Sbrancia, B. (2011): “The Liquidation of Government Debt”, Bank of International Settlements – Monetary and Economic Department, BIS Working Paper #363, November 2011. Reinhart, C., Reinhart, V., Rogoff, K. (2012): “Debt Overhangs: Past and Present”, National Bureau of Economic Research ,NBER Working Paper #18015, April 2012.
5 McKinnon, R., (1973): “Money and Capital in Economic Development”, Washington DC: Brookings Institute. Shaw, E., (1973): “Financial Deepening in Economic Development”, New York: Oxford University Press.
6 Bordeleau, E., Graham, C., (2010): “The Impact of Liquidity on Bank Profitability”, Bank of Canada Working Paper, WP#2010-38, December 2010.

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Western's picture

stfu

 

how about saying something helpful, or nothing at all?

 

perfect example of the ADHD, dumbed down, instant gratification society.

 

as an aside (the useful part of my post) -> buy gold, buy silver, rid yourself of your ego and face the new paradigm with an open heart.

Desert Irish's picture

Don't worry Erics got your back.......90% down quarter over quarter....... as long as your buying his silver fund everything will be fine...or not. Timminco anyone....

Michael's picture

Revenge votes for Obama is the solution. Black balling Dr Ron Paul was not a smart move this time.

No self respecting Ron Paul supporter will vote for Mitt Romney since he is a wholly owned subsidiary of the Rothschild's and Rockefeller banksters just as Obama is.

Many millions of Ron Paul supporters like me will be voting directly for Obama in November in a political strategy so we can get a real Liberty candidate on the ballot in 2016.

If you don't like Obama next year, then impeach him for illegally attacking Libya, gun running fast and furious, and being disqualified for his forged birth certificate.

Fox news is an infomercial for the republicans and the GOP. MSNBC is an infomercial for the democrats, and ABC, NBC, CBS, CNN is left leaning, brainwashing, social engineering scum. Try not to get your news from them.

Desert Irish's picture

okay we went from dissing Eric Sprott and now we are meant to vote Obama? in defense of Ron Paul? so Romney can't win? So we can ultimately impeach Barry? There"s half a bottle of scotch I have yet to drink to understand the above....

Michael's picture

You forgot revenge on the MSM and the GOP?, but yeah, that's about right.

The Big Ching-aso's picture

 

 

We are reaching maximum pooch screwdom.

Pladizow's picture

Is your TV on?

Does your internet work?

Are there UN troops in your neighborhood?

Is there food at the suppermarket?

Is there gas at the station?

Are you in a FEMA camp?

Is the dollar still the global reserve currency?

indygo55's picture

Really? What brand and where do you live. I have the soda.

monad's picture

Soda with scotch? Thats like ketchup on macaroni and cheese. Do you put soda in wine?  Next time try sipping it, ice only. If its too strong wait for the ice to melt... See, this is what globalization does. You present a bunch of consumers with the finest pleasures your culture has developed over centuries, but without instructions - and would they even read them if you did - and they do things like this.

Sure you put brandy in the bong, but only if its dirt weed. A man's got to know his limitations...

Doña K's picture

To Desert Irish

Maybe the concept is hard to understand for some, but it seems that the republicans are not getting the message or they do get the message but they are also puppets.

Either way, Obummer's reelection will cause the system to malfunction and bring a reset. Mathematically speaking, there is no solution as Sprott's thesis describes without a reset.

Here is a perfect opportunity to prove once and for all that Keynesian theory does not work beyond certain point. The world at this moment is upside down. As Carlos Castaneda wrote in the book "A separate reality" which involved consuming funny mushrooms.

Put all ideologies aside and think a la "tabula rasa". All of you would realize that the events and the course of action of the central planners, the reporting by the MSM and the actions and decisions by the judicial system does not make sense no matter how you look at it.

Metaphorically speaking, let the patient die a dignified death, instead of chemotherapy until the insurance payments run out. BASTARDS!

cranky-old-geezer's picture

 

 

Obummer's reelection will cause the system to malfunction and bring a reset.

There is no "reset" coming regardless of whom is elected.

"Reset" would follow default, but there will be no default.

Sprott and others still don't see the big picture.  America is on a direct path to currency collapse from endless printing to fund more and more debt so Obama or Romney or whomever can keep the farce going a few more years.

When government spending is the only growing part of GDP, and increasing spending is funded by increasing borrowing funded with more printed money, it's an end-game situation leading to currency collapse.

Germany may eventually say "no more" and prevent ECB from printing the Euro to worthlessness.

There is no such possibility in America. There is no one to stop the Fed from printing all the dollars the government wants to borrow.  Federal debt could grow to $30 trillion, $40 trillion, etc. 

By then the dollar will be pretty much worthless and other nations will abandon it, perhaps making the Euro the new world reserve currency, maybe some other currency not being printed to oblivion.

No, there will be no "reset".   There will be currency collapse.  Dollars and dollar-based assets will be worthless, America will sink into chaos, and that's it for America.

 

old naughty's picture

IMHO, the reset is not for one country.

TPTB has no interests in national interests. They simply want to put in place a world .gov. That in itself is the reset, planned.

Perhaps the trigger will be the collapse of usd, perhaps something else. But it will come.

francis_sawyer's picture

It's hard to deny that a "one world government" scenario is the type that the controlling banking interests would like to engineer, but riddle me this...

Assuming even the Eurocrats & whatever treasonous Viceroy that Israel decides to install in Washington are in bed together, how can "one world government" ever possibly be anything but a joke without Putin, the Chi-Coms, Iran, or even Chavez & Venezuela on board?... (I can see it now... "Yes ~ WE'RE the self described ONE WORLD GOVERNMENT, and all you others who have most of the people & sit on most of the resources are just residents on the planet"... Pretty silly if you ask me...

Why would the Russians, Chinese, or any of the above mentioned even think about abandoning what they already have in place for an arguably diminished role at the table, when all they basically have to do is play a waiting game & watch the west implode?

Visigoths II

You can't conquer by force, or proxy... You do it by starvation & destitution...

gorillaonyourback's picture

You think the inbred elite rothschilds, queen, et al are sane? They will still try

DeadFred's picture

People who are at the top of the pyramid don't have the same motivations as those further down. Having enough to make it through life is a given so all choices are based on ego issues; will this give me bragging rights at the get together, will I win the game of dominance over my competitor. When decisions are based solely on such factors it's hard more grounded people to comprehend the mindset. It's pretty tough to grow up in a familiy of sociopaths and not end up either neurotic or sociopathic yourself. Neurotic is the healthier path if you have the choice.

James-Morrison's picture

Reset is definitely a digital age concept, like alt-ctrl-del.
What is most likely with Obaaahma (the Sheeple's choice) is more like an infinite loop.

grid-b-gone's picture

The yen would probably collapse first, even before the euro.

Once that first major currency implodes, that is the dollar's fair warning. That last chance will probably be wasted because the immediate result will be that the U.S. dollar will, by default, temporarily strengthen.

Our leadership void leaves the solution to the market.

Then again, we as voters deserve it for electing those who use our own money to buy our votes with destructive, unaffordable promises.

As individuals, we need to think like the early settlers. Only those close to the power centers could depend upon federal help. If you live in today's economic equivalent of the wilderness, your fate is more closely tied to your own preparation and resourcefulness.

I'm not talking bug-out, although I don't completely dismiss the possibility, but rather personal debt elimination, living below one's means, and having large margins of safety in scenarios I never thought would be necessary to consider.

JOYFUL's picture

the notion that yur vote could have some kind of impact upon the scripted outcome of the November theatrical event is so naive as to make one wonder if yur whole thesis is written tongue in cheek?!??! ...as is the idea that there would be need of a repeat of this forthcoming curtain closer in 2016.

There's only one kind of vote that counts at this late stage, and that one is performed with the feet...not hands. Merikans seem to have retreated into a pyschological cocoon, wrapped in comforting wooly notions of what fantasy outcome awaits them other than their processing into FEMA facilities, after the collapsing of the dollar and bankrupting of personal savings. 

It's as clear as day that this is the only future which awaits the sadly befuddled denizens of the fallen Republic, and those who refuse to stand by as spectators to their own enslavement will grasp the wisdom of conducting an organized retreat in order to live and fight another day, on the ground of one's choosing.

There is no perimeter left to defend within the Euromerikan prison zone. Resistance will occur from the margins of Empire. End of transmission.

Birddog's picture

I think if your Libertarian minded, why not vote Gary Johnson.

Landrew's picture

Why not write in Ron Pual? 

Bay of Pigs's picture

Who the fuck is this stupid asshole?

shovelhead's picture

Tylers,

Can we have a Twilight Zone prize for this post?

Hyper egotist says lose ego. Extra points for open heart 'paradigm'.

Learning to play Kumbaya on a ukelele ought to do it.

samcontrol's picture

hey , kind of tired of adhd comments as the insult a la mode.

 Do some homework on sucessfull people with adhd, name me 5 !

If / when we crash gold will dive ,, silver more , only then will they be a good investment again.  SO ,, you get rid of the ego and realize you may be wrong on alot of things and that goes for the monkeys' 24 green arrows.

 

Silver Bug's picture

Once again, ANOTHER block buster piece by Eric Sprott. This man is a shining example of a epic Gold and Silver vigilante.

 

http://ericsprott.blogspot.ca/

Eireann go Brach's picture

By the time Obama is done with us, he will leave office with $120 Trillion in debt, have EBT cards for every man woman and child in America, have money printing machines at 7-11, and will still claim "I did not do this"!

grid-b-gone's picture

Obama has never demonstrated much aptitude for personal finance. Even with two Harvard graduates in his young family, it took the windfall of book sales for him to finally succeed financially.

He just does not seem to understand that the public-sector is overhead and it's private sector activity that creates the wealth of a nation. 

Unfortunately, the Romney-Ryan ticket is so blatently pro-wealth that they would likely squeeze out the middle class as effectively as the pro-government Obama administration has.    

mick68's picture

 

It is not a debt "ceiling," it's a debt target.

Peter Pan's picture

And here I was thinking that the problem is the problem.

Western's picture

Eric Sprott knows wtf is up.

 

Deadliest pen on the internet.

Robot Traders Mom's picture

"Deadliest pen on the internet."

 

Al Gore invented the internet pen, as well as the interwebs in general. Friday Fun Fact :)

AssFire's picture

Love the Sprott.

The medicine will become the poison.

fockewulf190's picture

I like Eric, and what he writes is on the money, but Jim Grant gets the award in my opinion.

Robot Traders Mom's picture

Smile Sprott, the Feds have you under TrapWire surveillance!

Yen Cross's picture

 Can someone put together a Sprott - Trimtabs "Bingo parlor"?   I like those odds, and the Fish won't be from Fukishima!

  Invisable ink will be confiscated at the door!

Bohm Squad's picture

Good article.  It occurs to me those unwilling to reinvest in short-term fixed assets may add to inflationary pressures as their cash is put to work elsewhere.  I hadn't thought of the fixed asset market as a stimuli for such effects before.

 

Top_Kill's picture

I was expecting him to stay that the Phys and Pslv were involved in a tragic boating accident.

Yen Cross's picture

 Ok , Junkmeister?  Everything Sprott says is postfacto'. I agree 100%

 Sprott is simply using multiple references, to reinforce the market movements based on history!

disabledvet's picture

eh. in the USA the problem is easily solved by letting energy prices "reset" to dramatically higher levels as was done after WWII. the problem is not with "more stimulus" either...we have so much "stimulus" right now it's really an abortion of the English language to say what we have right now is an economy. the problem is the inability of politicians to deal with the entitlement monster they've created...although in the EZ the problem is being dealt with by simply eliminating the bulk of the benefit checks outside of Germany. Hence trying to argue "this is about getting debt down" simply brings into relief the true enormity of the task at hand. clearly for State government to survive "there needs to be a MASSIVE price increase." Oil is the easiest target since the USA still has billions of barrels of it...and in "spiking it" in effect the USA is only making itself more wealthy. won't be fair or equitable who get's "the Lion's share" of such a policy...but at least it's do-able, and if you don't like it "buy a friggin' Chevy Volt" like the Government has told us to do. if we don't go this route but instead "go all in on a Goldman Parachute" as is being done currently "the reset could be violent" as clearly when prices start moderating "that trillion dollar deficit suddenly becomes a true trillion dollar deficit." You don't expect that thing to be repaid "through the sweat of the brow" do you?

Sabibaby's picture

Surely you jest! I'm sure high energy problems will solve the USA's problems.... 

luna_man's picture

 

 

Reads like, some of the natives are getting a little-bit restless...Anyway, keep them hits a coming...MY MAIN MAN!

analyzer_66's picture

No, instead Obama will claim "I didn't build that"

buzzsaw99's picture

More inside the box thinking.

Peter Pan's picture

The problem is one that is far greater than the debt. Debt you can write off and start anew. The greater problems are the expectations of people in relation to retirement and medical funding which clearly cannot be funded even if there was no debt. This is further exacerbated by the government wanting to maintain a military budget as if it is going to take on all the aliens in the universe.