A national economy is made up of many organisations and individuals. The activities of some will be profitable and the activities of others will not. The mechansim which ensures that the majority of activities in an economy are profitable (and thus the health and growth of an economy) is that the individuals and organisations concerned bear the costs involved in failure. For when a company makes a loss it means that the resources required to sustain its activities are considered more valuable (by the market place) than the goods and services that came out of it. However the goods flowing into the organisation are (or should be) paid for by shareholders whilst only the goods and services flowing out of it are paid for by consumers and thus by anyone other than the shareholders. As such, when a company begins to make a loss it is first and foremost the shareholders that should call for and bring about the dissolution of the company – for it is they who stand to lose the most.
If this fail-safe mechanism is removed and companies that make losses are allowed to persist through the use of public funds to sustain their existence then we have a problem… a big problem. For in that case there is no incentive for the individuals and organisations to make profits. These loss making entities must be sustained at the expense of profitable activities and hence hinder the ability of the economy to turn a profit, remain healthy and to grow. When the value of the resources consumed by government sustained loss making industries exceeds the value of the goods and services produced both by these and by genuinely profitable activities, the nation’s economy will begin to shrink.
The road to Tokyo
In the United States today, just as in Japan in the early 1990s, the economy is currently suffering the effects of massive losses steming from the banking sector and is in technical recession. No better example can be found of an industry which continues to exist but for the grace of government intervention. The government granted monopoly that the central bank enjoys in the creation of legal tender, the ability of banks to maintain but a fraction of their reserves without fear of a bank run because they are protected by the lender of last resort, FDIC insurance and if all else fails the ad-hoc creation of facilities such as the TARP make absolutely certain that whether you make profits or losses, in the banking industry, there is no such thing as failure. Further, the fractional reserve system ensures that the majority of the money that banks lose is not owned by the shareholders of the banks concerned but by the depositors who trusted those banks (once again as a result of government meddling, for it is government guarantees that has led depositors to think of these institutions as safe houses for money – rather than the highly leveraged investment vehicles that they really are).
However, spectacular as thy are, the losses in the banking sector are but the beginning of a slippery slope that most western nations have begun to walk down and, bizarrely, they seem to be lathering themselves up with soap and smiling in gay Keynesian confidence as they do so. Various mainstream commentators have predicted a return to growth some time in 2009 as the “stimulus plan” starts to take effect and the IEA even takes this as a given when it predicts demand for oil rising in 2009 for the same reasons. However it is hard to see the basis for such optimistic views of a return to recovery – these predictions are merely wild stabs in the dark. Sometimes the estimates for a return to growth are based on empirical evidence such as the “average length” of the last X recessions or the “average fall in house prices” in the last Y housing busts. But we are not in any of the last X recessions – we’re in this one! Surely there must be more fundamental reasons upon which we could base our expectations for the future.
At first glance, the slippery slope that the western nations are lathering themselves up for looks deceptively like the path that the Japanese walked down. I dug up an article written by Benjamin Powell back in 2002 where he described Japan’s Recession (from Keynesian, Monetarist and Austrian perspectives) and 6 years later it appears that very little has changed. Indeed why would it? Would we expect the Japanese economy to have recovered since then based on empirical evidence concerning the average length of recessions in Japan in the last 50, 100 or 1000 years? Certainly not – we’d expect the Japanese recession to end when the Japanese economy returns to profitability and that would require changes that the Japanese have not yet made. For just as it was the case back in 2002 when Powell was writing it is still the case today that Japan’s government and her major trading houses have refused to allow their unprofitable enterprises (starting with their banks) to go under.
Thus it is tempting to think that if western governments engage in policies similar to those of the Japanese, such as “quantitative easing” and keeping failed companies on life support, then we might expect much the same results. However today, as was the case in the 1990s, Japan is very different from most western nations in one crucial respect: Japan maintains a consistent trade surplus. This is a statement of the obvious, however it was not until recently that I realised why this was so important. Quite by accident I stumbled upon the answer in the Murphy vs. Schiff article that I wrote last week, which analysed an old disagreement between Robert Murphy and Peter Schiff about whether a consistent trade deficit was sustainable or not. It turns out (as I describe in that article) that the answer to that question is, “Yes – providing that both the lending and the borrowing economies are growing and that the economy doing the borrowing is able to increase its productive output by enough to pay the interest on the loan”.
The United States has maintained a persistent trade deficit since the last time it went broke in 1971 and was forced to abandoned the gold standard (and thus refused to redeem certificates of deposit that had previously been exchangeable for physical gold). Remarkably, and presumably because it was the best of a bad set of options, foreign investors continued to put stock in the US dollar following that technical default and have continued to buy US bonds ever since that time. And so long as the US economy continues to grow more or less consistently, this situation is sustainable. For whilst the US economy is growing, foreign investors have reasonably good reason to believe both that the bonds they purchase are in a currency which will hold its value until the maturity of the bond and that the US financial position will remain sound enough that there is little risk of default.
However it appears that question marks are now starting to form over both of these assumptions with respect to western debt and, in the long term, with respect to the debt of the United States in particular.
Firstly, the Fed’s efforts to “stimulate” the economy through the use of traditional monetarist techniques having amounted mostly to string pushing, the Obama administration seems willing to revive Keynesian investment in shovels and overalls. For those who are unfamiliar with the analogy, Keynes argued for government expenditure in order to get money flowing through the veins of the economy even if all the government did was to pay people to dig holes and fill them in again (since this would at least create a demand for overalls and shovels and get money in consumer’s pockets so that they could demand other products). However, the quantity of available resources in the economy is finite and so if Obama and Co command an even greater percentage of those finite resources than they presently command, (in order to dig holes and fill them in again – or to build highways, as it appears they are promising), this means that there are less resources available for use by the free market – i.e. the guys that actually have to make a profit and, as a consequence, do the lion’s share of the producing. Increased government expenditure will inevitably result in lower productivity and most likely will simply lead to even greater losses… These policies are clearly focused on employment but it is not productive employment. This cannot be expected to achieve anything but keep the crew busy playing cards while the ship is sinking.
Secondly, the myriad of new schemes that have sprung into existence, such as the TARP, which allow the treasury and Fed to purchase rubbish assets from the market in order to pretend that companies and banks that made spectacular losses didn’t actually make losses (and aren’t presently bankrupt), or the use of public funds to bail out loss making entities such as GM and Chrysler, is just more of the bad medicine that the Japanese took and which will, just as was the case in Japan, delay any return to profitability.
So the Obama plan amounts to starting lots of new loss making entities to run along side the existing ones (which we’re not going to let fail)…. all of which will cost money – a lot of money. The monetary base has expanded, over recent months, at an annualised rate of around 1400% – a staggering rate. Investment analysts such as John Mauldin argue that much of this is simply to cover historic losses and will not result in the extension of new credit and thus monetary and price inflation. However Mauldin also admits that at the same time the Fed is monetising debt directly to the tune of 800 billion dollars… which most certainly is an increase in the real monetary base used to extend credit and could thus form the basis of perhaps 8 trillion in extra money in the market place.
This does not inspire confidence in the stability of the US dollar medium to long term. For the time being, the expansion of reserves has not morphed into additional lending on the part of the commercial banks and thus any significant price inflation. But if government plans to “kick start” the economy (to use their crude analogy) are actually to work then eventually they require companies and individuals to start borrowing again and for banks to start lending again. When that happens, will the Fed be able to prevent the unprecedented expansion in the monetary base above from turning into an unprecedented rise in prices? Typically there is a lag of around 18 to 24 months between Fed monetary policy and resulting inflation, so they will have to be particularly prescient indeed if they wish to avoid serious inflation coming back to bite them as a result of their aggressive monetary policy of late. Although most economists and governments are not presently very concerned about inflation, this is possibly the biggest risk for the US economy in the road that lies ahead, since it could lead to the complete collapse of the monetary unit.
So what’s new?
The US has suffered at least 3 serious recessions in the course of the last 37 years in which it has maintained a trade deficit, and yet the dollar is still intact today. However, as I have already mentioned, we are not in any of the previous recessions – we’re in this one…
In 2001 the economy was able to rise from the ashes by injecting cheap money which lead to a housing boom, putting money in the pockets of consumers – the so called “engine” of the US economy. However this was a false boom funded by the consumption of capital and could not last. Consumer spending during this time was supplemented by Mortgage Equity Withdrawals and a delusion that the economy was still running at a profit. Without these Mortgage Equity Withdrawals (not to mention expenditure funded by a false boom in the price of other asset classes) the US economy would have been in technical recession on more than one occasion in the last 7 years. Indeed many believe that the current crisis is simply the perpetuation of the troubles that first raised their head in 2001… only now the condition is, as the Austrian’s predicted would happen if the patient refused to take their medicine, much much worse.
Analysts such as John Mauldin believe that we are in for a repeat of the 1980s, when US banks once again lost depositors money (to South American governments that time round). In the 80s the troubled banks were permitted (with a little bit of fudging) to pretend that they weren’t bankrupt by swapping bad assets for good, just as is happening at present, for long enough to recover all the money they lost and return to solvency. However Mauldin assumes, just as all mainstream commentators are assuming, that the recession will magically go away in 2009… leading to the profits required to pay off past debts. None of these commentators offers a convincing explanation as to how this magical recovery will come to pass however – all of them assume that the stimulus plan will somehow bring about improvements in the productive output of the economy. The fundamental principles from the first two paragraphs of this article would tend to indicate quite the opposite.
Mauldin ignores the fact that extremely tight monetary policy endured during the 1980s and there are good reasons to believe that precisely that tight monetary policy helped bring about eventual recovery. With mortgage rates in the 10-15% range during that decade, the scarce resources of the economy were not being borrowed willy nilly to build second houses by people who had no incomes. Instead these were being reserved for companies and individuals that could make a good rate of return on money that they borrowed – sufficient to pay hefty interest rates. As such, loss making activities were culled off and profitable activities took their place. This is the direct opposite of what has happened in Japan and what is currently happening in the west today.
If the Monetarist and Keynesian policies that governments are currently pursuing result in stagnation and negative growth, as we would expect, then a repeat of the 1980s does not appear to be likely. Further, although a long drawn out recession such as the one that the Japanese have experienced might take root in the West it cannot hold. The West maintains a trade deficit and the longer that nations with trade deficits take to return to growth, the greater their debts become relative to their GDP and the harder it then becomes to return to growth… a vicious circle is entered as an ever greater portion of their GDP is allocated to paying bond yields rather than investment. We can see glimpses of the possible futures for these economies in the examples of Italy, then Greece, followed by Argentina (which defaulted in 2001) and finally for the really stupid, who refuse to learn even basic economics, the end of the line is Zimbabwe… It is thus a great pity that the people of the west today (and in particular their governments) do not yet seem ready to engage themselves in Volcker style belt tightening. They seem far more inclined to dispense with the belt and indeed the pants in a return to the flower power style economics that brought about the technical default of the United States and forced it to abandon the gold standard in 1971.
If foreign bond holders stick in there through thick and thin (and negative real yields) and if the East continues to see sufficient growth to continue to lend to the West, then western economies might survive despite government intervention (not because of it). Sufficient growth could conceivably be realised by way of technological and business process improvements, in those sectors of the economy that governments keep their paws off, to offset the vast sums of money that governments will lose through their increased involvement. However the western economies will certainly be severely weakened as a result. They may have to sell capital to the East in order to dig themselves out of spiralling debt. The USA may not come out of it as the world’s number one economy any longer and the US dollar may lose its status as the reserve currency of choice (if indeed it survives).
Western nations have few options available to them. They can attempt to “make money cheap” but this will not make real savings (the real problem) any less scarce – it will simply serve to erode the ability of the economy to distinguish between profitable and non-profitable activities, ensuring that what will certainly be a painful correction will also be a long one. They can keep loss making companies on life support, but this will merely keep labour and capital trapped in non-profitable activities rather than freeing it up to move into profitable sectors of the economy. Once again this will merely serve to frustrate the ability of the economy to return to profitability and growth. If they should fail to return to growth and bond holders should slowly come to realise the folly of lending to an entity that is making consistent losses and becoming ever and ever more unlikely to pay back its loans or if those lending to the west should see their own growth (and their ability to lend) arrested, then eventually the reality is going to come home to bite.
We tread a fine line on the precipice of a very slippery slope which, in the worst case, could ultimately end in monetary collapse and which will likely simply bring us closer to the living standards of the former U.S.S.R. Government moves to assume greater control over the economy cannot take western nations further away from that precipice. On the contrary, they plunge us head first over the edge. For what the west lacks is not consumption (public or private) but production of the kind that can only result from profitable economic activity and, thus, from a free market where companies are allowed to fail – a market where neither government nor government sponsored loss making entities can command the scarce resources which are needed by entrepreneurs to run profitable companies. It is profit making individuals and companies which are the real engine of the economy – not just the US economy but the world economy.