Tag: economics

Mailvox: take another look

HR asks an unexpected question:

I am reading your book and find it fascinating. I really appreciate your laying out the several possible scenarios and the arguments pro and con as well as identifying their supporters. The chart on your blog of “Debt Outstanding 2004-2009” I find quite convincing for your position on the key question of inflation vs deflation. However I also find that the Fed Statistics (see page 9 of this link) seem to show quite different trends and support the opposite conclusion. What is the source for your chart?

I’m glad HR finds it worthwhile reading. My source for the sector debt is the Federal Reserve flow of funds account. Notice how the red line for Federal debt on the chart ends a little below the $8,000 billion line. If you look a little more carefully at the linked PDF, you’ll see that this corresponds rather neatly with the $7,805 billion reported in 2009-Q4 for the Federal Government. The reason for this is that the Federal Reserve flow of funds account is, in fact, the very Z1 report that HR cited.

In other words, you have to look at the bottom of the page, not the top, since those are the 1978 numbers. It’s a bit easier to see this in the online version, in which the years run from left to right.

RGD: a rather good review

An academic economist reviews RGD:

The book is simply a brilliant masterpiece. It is written remarkably well and gets you to read more and more. It provides a balanced mix between telling a story and zooming in on the economic fundamentals. Right from the very beginning, it becomes perfectly clear to the cognoscenti that Vox is a member of a small, ultra-elite club that has figured out the fundamental flaws of our modern-day Keynesian economic dogma, as well as the finest points of the Austrian school that only few people in the world are familiar with and understand. As an Austrian myself, it is easy to see how sophisticated Vox is in the area.

I am a professor in Economics who has been trained in and disillusioned from the mainstream economics. As an economist, I was completely reborn when I became an Austrian 7-8 years ago. Ever since, I have been teaching economics and finance mostly as an Austrian. During the Spring semester of 2008, I was teaching a course on the Financial Crisis at the American University in Bulgaria. My biggest regret is that I did not have at that time available to use Vox’s book for my course. It would have been perfect. The book may be somewhat difficult for first year Econ 101, but it is absolutely perfect for juniors and seniors – it could well be the book that will make them rethink their mainstream economics foundations. For my course, I had to use Peter Schiff’s “Crash Proof” as the very best available at the time. If I had to do it today again, I would use “The Return of the Great Depression” as my primary book. When combined with “Crash Proof”, it provides a killer combination that would open the eyes to any student willing to read. My third choice would be, without doubt, “Meltdown” by Thomas Woods.

Enough praising Vox and his book. Do not hesitate to get your copy and read it – I guarantee that you would be glad you did it.

This is without a doubt the best book review I have ever received from Bulgaria. Possibly the most interesting thing about Dr. Petrov’s review is that I happen to know he does not agree with me on the most important question of the day, inflation vs deflation. But, as I have said many times in writing about the issue, including in RGD, there are very smart and informed individuals on both sides of the issue and it is only the less sophisticated observers who think that the issue is simple enough to be critical of the other side for the way they interpret the available evidence. While I think that evidence of the last fifteen months has tended to favor the deflationary scenario, I don’t regard the matter as settled. And I certainly don’t think any less of excellent economic observers such as Marc Faber, Jim Rogers, Peter Schiff, the Mogambo Guru, or Dr. Petrov due to their expectation of a Whiskey Zulu situation.

Economics is a complex science wherein the timing remains an art. This means everyone gets something wrong sooner or later; even when you have interpreted all the evidence correctly you can still get the timing fatally wrong. I very much appreciate Dr. Petrov’s review, as it is great to see academics who have opened their minds to Austrian School economic theory. But, to return to the inflation/deflation matter, this chart on the diminishing marginal utility of debt nicely illustrates why I fall on the deflationary side and why I am confident that we are still in the early stages of the Great Depression 2.0.

The zero-reserve banking system

Unbelievable. They certainly didn’t teach this in our economics textbooks. From Ben Bernanke’s testimony to the House Committee on Financial Services:

Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Those who have RGD will note that this elimination of reserve requirements would theoretically permit the former fractional-reserve banks to make an infinite amount of loans regardless of what deposits they hold. This would also theoretically provide a rational basis for the hyperinflation scenario, but as I have pointed out many times before, even an infinite money multiple will require an infinity of borrowers.

If this does not make it clear to you that the financial authorities are getting desperate, I don’t know what will. The ironic thing is that most people still believe that the fractional-reserve system is based on a 10% minimum reserve requirement.

Mailvox: Eurosclerosis and collapse

Eilonwy asks about RGD:

I’m reading The Return of the Great Depression, which I bought at full-price at the Wall Street Borders. I’m only a quarter through it, since I have to call my securities-analyst brother once a day to make sure I understand the concepts. In short: it’s slow, but worthwhile, going for me.

One question I have for you, and maybe it’s answered later in RGD is: when? I get this sense from reading your blog and Mr. Denninger’s, that the center cannot hold much longer and that we are tottering on the brink of a Greek-style collapse. Then I read on Yahoo Finance that Social Security has moved permanently into the red and that the debt we will accrue paying SS benefits will hurt our AAA rating, moving us yet further into debt. As Ed Morrissey states, “the wheels have begun to fly off the entitlement bus.”

What I don’t quite understand is how the welfare states of Europe cruised along – functionally – for 60 years, with entitlement programs far more progressive than what we have here, before facing the crisis they find themselves in now. Whereas (at least when reading you and Mr. Denninger) it doesn’t seem our economy will be able to hold it together for five years, and we haven’t even socialized medicine yet!

I think my question is twofold: 1) are we really bordering collapse, or could we limp along a la Britain and France, with a soft-totalitarian welfare state, and remain semi-prosperous for a decade or three before all the bad decisions we’ve made and are making really come back and whallop us? and 2) if we are bordering collapse, why do we find ourselves here so quickly?

The main reason that Europe has been able to limp along with heavier social outlays is because the European nations have virtually no defense budget. Since 1962, U.S. defense spending plus defense-related interest on the debt has amounted to around $2,500 per year per capita. If you consider that full Social Security benefits at the average income amounts to around $12,576 per retiree, it’s not hard to see where Europe has been finding its additional social spending.

In answer to your first question, yes, we really are bordering upon collapse because our total debt level is over 500% of GDP when all of the unfunded, off-balance sheet debts are included, as they must be. This is completely unsustainable even if we ended all defense spending today. Which, of course, we’re not doing anyhow. In answer to your second question, this is a rather binary problem. You can get by one way or another right up to the moment that you can no longer do so. While some still think it’s possible to hyperinflate out of the problem – which is really just a means of buying stability a little time if you consider the eventual fate of most countries that hyperinflated – there is a very serious timing problem even if the peculiar U.S. debt-money system permits such rampant inflation.

Once the fleets of money helicopters are sent aloft, it’s game over for the global economy, for everyone with savings, and everyone holding debt. That’s assuming it even works; if it doesn’t work then it’s an instant game over for geopolitical stability. So, Washington and the Fed don’t dare to issue the order until the very last minute… which means that when the next default crisis hits, there is a very good chance that they will not react quickly enough and the financial system will collapse in a catastrophic manner beyond the ability of even hyperinflation to help it limp along.

Perhaps the financial wizards who created this situation can find a way out of it, but I do not see one nor have I read anything by anyone that offers what I consider to be an even remotely credible solution. And while it’s true that these events always take longer to develop than anyone ever thinks, when they finally come to pass they tend to unfold much faster than anyone expects.

Mailvox: Deflation vs inflation

JB inquires regarding the matter:

Congratulations, it looks like you’re right about deflation vs. inflation. I thought based on the historical example of other systems going belly up that inflation was always the final scenario. But your grand graphs of credit implosion are everything a rubbernecker could wish for in twisted limbs and crashed clunkers.

I’m still not clear on what’s going on, and I’d like to run a few questions by you. Credit contraction is ~ to GDP contraction, yes? So if deflation is keeping pace with reduction of goods and services, then prices should remain constant, right? Consumer goods are a subset of that. Are you predicting deflation from the consumer’s perspective, and if so, why? What I’m getting at is that even though the credit bubble’s magnitude dwarfs all other considerations, its implosion doesn’t logically necessitate consumer deflation, as far as I can understand. I guess your main reason there won’t be inflation, besides the impossible magnitude of the credit bubble, is that the Fed is private and won’t order the whirlybirds aloft. Why do you think a legal technicality like that is going to stop the Fed’s big brother, the US Federal Government? Given the trend, shouldn’t we be more surprised if any banks at all manage to remain private?

First of all, let me say that the question is far from settled. I understand the inflationary case and it is a perfectly reasonable one, albeit based on general principles that I do not believe apply in the specific case of the peculiar U.S. monetary system. I’m going to address the matter in more detail in a column and explain why I expect the debt-money supply to decrease to a certain, specific level at a minimum. However, the easiest way to achieve a basic understanding of the issue is to look at this chart which incorporates the latest Federal Reserve flow of funds account of total debt outstanding.

The red line amounts to the case for inflation. This is the Federal spending that the inflationistas assume can grow indefinitely and has, in fact, increased by $2 trillion since the third quarter of 2008. However, even this 35% increase in 18 months has not been sufficient to counterbalance the ongoing credit contraction in the household, financial, and state & local government sectors. Moreover, that Federal spending increase is now coming to an end even as the contraction in the financial sector doubles its speed and state & local spending hits the insolvency wall.

In answer to your questions, GDP contraction is not equal to debt contraction even though debt is a primary factor in sustaining GDP growth. Because GDP is disproportionately weighted towards government spending and because the G component of GDP is dependent solely upon the growth in government debt rather than overall debt, GDP can increase even in the face of overall debt contraction. But it cannot do so for long, as the chart above indicates. As far as the banks go, because they are insolvent by every meaningful accounting measure, they have already been quasi-nationalized because although their profits remain private, their losses are charged to the public.

The end of entitlements and the occupations

After looking at the books, do you still think democracy in Iraq and Afghanistan is a priority?

50% of the federal budget right now goes to entitlements.

This last month we posted a record $220.9 billion budget deficit. We took in $107 billion but spent $328 billion.

Isn’t that special. We only funded 32% of expenditures?

Remember – entitlements were half of that $328 billion.

So let’s see if we can do the math here.

Entitlements were about $164 billion last month in spending. The rest was, of course, the rest.

But we only took in $107 billion.

So even if we eliminated all entitlement spending we still did not have enough money to cover the rest.

The insane thing is that the only pressure from the American people to date is to fight entitlement reduction even though eliminating all entitlements isn’t enough to stem the financial bleeding. One certainly can’t say they aren’t going to get what they deserve. Correct me if I’m wrong, but my impression is that even the Tea Partiers don’t want to cut back on military spending.

Mailvox: Smith vs Ricardo

LS emails a 2003 essay by R.B. Calco published in the American Conservative. Here’s an excerpt:

The Father of free trade was no globalist.

Adam Smith is commonly regarded as the father of modern economics. Free traders claim he is also the father of free trade and credit him with the first systematic attack on government regulation of trade ever written. This is true as far as it goes. This is not to say, however, that Adam Smith was a free trader in the same sense that the term is promoted today. Since David Ricardo and the Austrians took hold of it, the term has acquired a dimension and a purpose that was, to paraphrase Smith, no part of his intention. Or, in any event, it was no part of his definition. Smith’s argument for trade was rooted in what economists today refer to as “Absolute Advantage”; it was left to the crafty mind of David Ricardo half a century later to invent a justification for trade on the basis of the far more subjective “Comparative Advantage” that today the economists tell us we need to consider instead.

While the dull, pencil-headed, pocket calculator logic of Comparative Advantage works fine for the textbook laboratory example f two nations and two products, it falls apart entirely the minute real-world constraints or considerations are introduced. It becomes absurd when you attempt to factor “comparative advantage” across three nations and three products, let alone the hundreds of nations and millions of products of the real world. Try it – you will lose your mind.

All Comparative Advantage amounts to, reduced to its essential components, is a sophistic argument for international division of labor — for global economic union — without dealing with any issues of political union. It is the economic equivalent of living in sin, so to speak. For whatever intuitive sense it claims to have, this argument relies on a fundamental confusion between trade — economic activity between economic systems — and division of labor — economic activity between individuals in a single economic system.

At bottom, this argument is a bait-and-switch for a global system, not a plan for any one nation to become wealthy, least of all the United States, which, according to the law of equilibrium, would be forced under a free-trade regime to sustain massive losses of jobs and wealth to pull all other nations up in the new global wage and price structure.

There is little question that global free trade tends to raise the overall level of global wealth. But what consequence-blind Ricardians stubbornly refuse to understand is that Comparative Advantage simply does not work on a macroeconomic level. The falsity of their assumptions is easily determined both logically and empirically; in RGD, for example, I show how the historical trade statistics prove that the Smoot-Hawley tariff could not possibly have played a major role, let alone a causal one, in causing the Great Depression.

The important logical question that the Ricardians have to answer is this: Does the level of rising global wealth come at the benefit or the expense of the wealthiest nations? The important empirical question is this: What is the rate of increase in U.S. national wealth per capita compared to the rate of increase in global wealth per capita? Those who are intellectually honest enough to contemplate answering those straightforward questions of applied theory instead of retreating to the safety of the abstract will soon recognize that the Comparative Advantage is a fundamentally incorrect doctrine and the Ricardian case for free trade is strictly dependent upon circumstances that do not apply to many situations, presently including that of the United States.

Those who disagree are certainly welcome to answer those two questions so long as they provide an amount of reason and evidence in support of their answers. And it is worth keeping in mind, as Joseph Schumpeter pointed out, that David Ricardo was first and foremost a political creature and an ideologue, he was not an intellectual driven by a natural interest in the truth of the matter. This is not to argue that what is known as the Ricardian theory of Comparative Advantage is incorrect on an ad hominem basis, I am merely pointing out the historical fact that his case was a political one with a specific policy objective in mind. It is also worth noting that the this case was not even original to him, as the idea of Comparative Advantage was first introduced by Robert Torrens in An Essay on the External Corn Trade two years before Ricardo published On the Principles of Political Economy and Taxation.

Productivity and deflation

Karl Denninger reaches a conclusion:

The Labor Department reported Thursday that productivity jumped at an annual rate of 6.9 percent in the fourth quarter, even better than an initial estimate of a 6.2 percent growth rate. Unit labor costs fell at a rate of 5.9 percent, a bigger drop than the 4.4 percent decline initially estimated.

In the real world this means:

Work harder and get more done. Get paid less. Suck it up, don’t complain, or you’re fired. That’s all.

And by the way, reduced pay per unit of work spells DEFLATION.

That’s not necessarily so. Inflation and an increase in the supply of labor can lead to reduced pay per unit of work; real weekly wages haven’t increased in the USA since 1973. But in general, declining labor costs do tend to point towards deflation, especially if they are nominal as well as real. Productivity up and costs down is a good thing for corporations; whether that is good for the smaller number of workers working and the reduced pay they are receiving may not turn out to be good for an economy already facing widespread defaults. Especially if those corporations happen to be foreign corporations sending those profits overseas.

Exploding government debt

Carlton has a nice series of charts providing a graphic representation of the rapid growth of U.S. debt over at the RGD blog:

Even more striking is the annual percentage change in the debt. Between 2002 and 2006 there is a surge in growth, presumably to fund the wars in Afghanistan and Iraq, peaking in 2003 at around 9%, but the growth begins to slow down again until 2008, when it surges over 11%, and then in 2009 it jumps to almost 19%.

Needless to say, the recent post-2007 surge is in direct contradiction to the 10% contraction in private debt that has taken place over the same period.

Mailvox: broken windows and the stimulus of WWII

CH asks about a common economic misconception:

I follow your columns so I thought you’d be able to answer this question for me, if you would. As you have stated, the Democrats are Keynesians and believe they can spend their way out of recession. Benanke cites the Great Depression as evidence of this. I know that FDR’s policies of spending didn’t lift us out of the Great Depression (they made it worse), but it is often noted that WWII did lift us out of said Depression. How can this be? How did that work? It seems to me that the militarization of our industries were funded by the Government. This put people to work and sent many to war equipped with the products of our industries and therefore operated as a large Government “stimulus”. I am trying to see Bernanke’s logic, if I am correct, that the spending the Government did to fund the war was what it took to get the economy going. This in effect is what the Dems are trying to reproduce by simply dumping money in the economy, putting people to work and creating a false demand, to bring us out of this recession. The war was true demand, sure, but wasn’t the war really a big fat stimulus? Government gave money to industries who put people to work, who paid taxes and spent money, allowing industry to produce more product, etc. I’m very confused how all this worked. Please set me straight!

First, let me note that it’s not only the Democrats who are Neo-Keynesians. Most Republican politicians are too; the monetarism of the Chicago School is little more than a Keynesian heresy that focuses on monetary policy and leaves fiscal policy out of the equation. Now, it is true that WWII helped lift the USA out of the Great Depression, but not for the reasons that the economically illiterate, historically clueless, and logically challenged usually cite. The stimulus involved in producing hundreds of thousands of ships, tanks, and airplanes and employing millions of men did not bring about the post-war economic recovery, it was the effective use of those men and materials in destroying the industrial infrastructure of Italy, Germany and Japan that did. While economists such as Henry Hazlitt and Thomas Sowell rightly cite Frederic Bastiat’s Broken Window fallacy and point out that there is nothing productive or wealth-generating about turning steel into a rusting hulk on the bottom of the ocean, they forget that destroying an economic competitor’s industrial infrastructure at no cost to your own, then providing consumer goods and the means of rebuilding that infrastructure is very productive and wealth-generating indeed.

Let us call it Vox’s Addendum to Bastiat’s Broken Window Fallacy. Or, if you prefer, the Broken Window Martial Motive. Bastiat’s parable goes thusly:

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—”It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?”

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier’s trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, “Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen.”

It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.

If, however, the shopkeeper happens to live in the next town over, his window is broken, and the house belonging to his neighbor the second glazier is burned down with the second glazier inside it due to the vagaries of violent inter-village relations, the six francs the shopkeeper will spend on repairing his broken window will be six francs that did not previously circulate within the first town’s economy, and which the shopkeeper, living in the second town, was never going to spend on shoes or books produced in the first town. Therefore, it is a good thing to break windows, so long as the windows are broken in the neighboring town at a cost that is exceeded by the benefit to be gained from fixing them.

“In short, he would have employed his six francs in some way, which this accident has prevented, [unless the accident happens to take place in the neighboring town. – VD]”

This means that while most wars are economically destructive, wars that offer the likely prospect of destroying the industrial base of one or more advanced economies without putting the nation’s own industrial base at risk are economically beneficial. By way of statistical evidence in support of this conclusion, note how the annual rate of commercial bank loan growth was much higher immediately after WWII – 25% in 1947 and 21.5% in 1950 – than it ever has been since.