If you Missed the U.S. Subprime Mortgage Crisis you might be able to catch one in South Korea

Posted by PITHOCRATES - February 23rd, 2013

Week in Review

Stop me if you heard this one before (see S. Korea’s Poisoned Chalice of Household Debt Restricts Park by Sangwon Yoon posted 2/21/2013 on Bloomberg).

Park [Geun Hye, Korea’s incoming president] suggested state institutions could buy stakes in mortgaged apartments that have fallen in value, such as Kwon’s. The stakes would then be used as collateral for asset-backed securities, using rent from homeowners to pay interest to investors…

South Korean regulators have been working on a “soft landing” policy since June 2011, including limits on bank lending and tax breaks for homeowners switching to fixed-rate loans. About 85.8 percent of mortgages are currently adjustable…

“The quality of household debt is worsening,” said Lee Eun Mi, senior research fellow at Samsung Economic Research Institute in Seoul. Park needs “measures to stymie the rising danger of a massive default crisis…”

Some borrowers have staved off default by taking out further loans to pay mortgage interest…

Irresponsible household borrowing began after the 1997-1998 Asian financial crisis, said Kim Mi Sun, a debt counselor at a non-profit organization called Edu Money in Seoul. In the wake of corporate defaults during the crisis, the government curbed companies’ ability to sell credit, prompting banks to expand lending to consumers, including a rapid increase in home loans.

“It became so much easier to get loans after the crisis and everyone started taking out debts and mortgages they couldn’t afford,” said Kim. “The crux of the issue is that people simply don’t know how to manage their finances.”

The credit boom early in the last decade caused house prices to soar and left many Koreans with large loan obligations.

Sound familiar?  Sounds a lot like the subprime mortgage crisis, doesn’t it?  Easy credit encouraged a lot of people to buy houses they couldn’t afford with adjustable rate mortgages (ARM).  Just like in the United States following President Clinton’s Policy Statement on Discrimination in Lending.  Where the president told lenders that they had better find a way to qualify the unqualified or else.  Which they did.  With subprime lending.  And the ARM.  And when the interest rates reset at higher rates there was a massive default crisis.

Interestingly Park Geun Hye is suggesting a solution to help underwater mortgages that the U.S. used to spread the subprime mortgage crisis contagion around the world.  The collateralized debt obligation (CDO).  Fannie Mae and Freddie Mac bought the toxic subprime mortgages and packaged them into CDOs.  And unloaded them on unsuspecting investors.  Telling them that they were high yield.  And low risk.  Because their return came from the cash flows of homeowners making mortgage payments.  And what was less risky than mortgage payments?  Of course, what they failed to mention was that these were ARMs sold to low-income people who had no hope of paying their mortgage payments if interest rates ever rose.  Which they did.  Sending the fallout of the subprime mortgage crisis around the world.

No.  CDOs may not be the best solution to their problems.  And chances are that investors may not buy these.  For they were burned once by Fannie Mae and Freddie Mac.  And they’re probably not going to fall for the old ‘investment backed by cash flows from subprime mortgages’ trick again.

Amazing how some things never change.  Different place.  Different people.  But the same bad government policies.  Producing the same massive default crisis.  This is what you get when you interfere in the free market economy.  But some people never learn this lesson.  Despite the numerous examples of what not to do.  And if anyone taught people what NOT to do was the U.S. in the run-up to the subprime mortgage crisis.  Even the Americans can’t learn from their own lesson as President Obama is already talking about bringing back the policies that caused the subprime mortgage crisis in the first place.  Putting more people into houses that they can’t afford.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , ,

Retained Earnings

Posted by PITHOCRATES - November 12th, 2012

Economics 101

Small Business Owners often Reinvest Everything they Earn back into their Businesses

It takes money to make money.  Before a business can make any money it has to produce something that can create revenue.  That is, they have to create something of value that people will pay money for.  To do that they have to buy land, buildings, equipment, etc., first.  They have to hire people and pay wages, salaries, benefits and payroll taxes first.  They have to spend this money before they can sell anything of value.  Because there is a time delay before the money they spend can produce anything to sell they have to get money elsewhere.  To pay all the bills.  Before they can start paying their bills from their revenue.

Small business owners often use their life savings.  They may mortgage their homes.  They may borrow money from their parents.  Or from other family.  If their capital needs are small they may use their credit cards.  And work out of their homes.  But one thing is for sure.  A small business is a cash hungry beast.  And it has a voracious appetite when it’s growing.  For those who make it to this level may be able to convince a bank to loan them money.  That can fund that growth.  Others may turn to venture capital.  If they can convince a venture capitalist that they have a great idea than can really make some money.  More advanced businesses may require even greater sums of money to fund growth and turn to the capital markets.  Using stocks and bonds to fund that growth.

Of course, it takes awhile to get to that level.  Unless you have one of those great and unique ideas.  Which can accelerate a business through this growth process.  But for most it’s a longer journey to get there.  Involving a life of sacrifice.  Skipping vacations.  Eating more hamburger than steak.  And putting off the things you want (new television, smartphone, tablet, car, etc.) until you can afford them.  Which often doesn’t come for a very long time.  Instead, small business owners often reinvest everything they earn back into the business.  To help get it to the next level.  Many small business owners don’t even pay themselves.  Because their business needs that cash elsewhere.

A lot of Small Business Owners don’t pay themselves as they Establish their Businesses

So why do they do it?  It’s not for the money.  For small business owners could make more money working for someone else without all of the headaches.  No.  They don’t do it for the money.  They do it because they’re entrepreneurs.  Filled with a passion to do something better.  Or new.  Just look at what drove Steve Jobs.  It wasn’t the money.  It was all about creating great things.  Things he couldn’t stop thinking about.  Driving some of his people crazy with his relentless push for perfection.  But he couldn’t help himself.  For he felt no inner peace until he realized his vision.  Even when his engineers and designers said what he wanted couldn’t be done.  And they kept saying that until they did what they said couldn’t be done.

This is why some entrepreneurs go ‘Albert Einstein’ in pursuit of their vision.  So focused they skip meals because they forgot to eat.  Or didn’t want to waste time by stopping to eat.  Ever try to eat lunch with a small business owner?  It can be a little on the frustrating side trying to hold a conversation.  As they never shut down.  Their mind is somewhere else.  They’re thinking about something.  On the phone.  Checking email.  Scratching notes.  These are the people that keep working the phones even when sitting on the toilet.  They’re that driven.  And we’re lucky to have such people in the world.  For they make a lot of things we like.  And create a lot of jobs.  In fact, these small business owners are the engine of job growth.  For no one creates more jobs than they do.  Not even the big corporations with billions in revenue.  It’s the small business owner who does cartwheels when they break a million in revenue.  It’s the small business with 5 employees that hires a sixth.  This is where real job growth comes from.  Because there are so many more small business owners than big corporations.

The small business owner is no stranger to sacrifice.  He or she is willing to do whatever they have to.  Even going in on the weekend and working late into the night.  While their employees are enjoying their weekend.  Spending the paychecks they earned working for the small business owner.  While the owner often doesn’t take a paycheck.  Because while he or she can sacrifice things in their personal life they need cash for their business.  For employees don’t work unless you pay them.  And if the government doesn’t get their taxes they will shut you down.  This is why a lot of small business owners don’t pay themselves as they establish their businesses.  For money they take from their businesses reduces how much their businesses can grow.  And it leaves them vulnerable to large, unexpected costs that can hit their businesses.  Or to things that can cause a drop in revenue due to something beyond an owner’s control.  Like a recession.

The Higher the Regulatory Costs and Taxes are the less Small Business Owners can Retain to Grow their Business

So when it comes to cash management small business owners are conservative.  They begged, borrowed and sacrificed to start their businesses.  And incurred substantial debt to grow their businesses.  Which only provides short-term financing.  Once they burn through that money they have to replace it with money generated by business operations.  To sustain business operations.  And to pay back those loans.  For if they don’t they can lose everything they built.  Business earnings, then, are like a fire in survival conditions.  Say you’re lost, alone and cold.  The only thing keeping you from freezing to death is the warmth from that fire.   Once started (with those bank loans) the owner has to nurture and protect that fire to keep it from extinguishing.

So how does a business make money?  They sell goods and/or services for money.  Which gives them revenue.  Then they subtract all of their costs from that revenue.  Any money left over is net profits.  Or earnings.  If they leave this money in the business these earnings become retained earnings.  That they can use to pay back those loans.  Repair old equipment.  Buy new equipment.  Pay for some advertising to expand the business.  Or even hire new employees.  If those earnings are large enough.  And recurring enough.  To give them the confidence that they will be able to pay these new costs in the future.  Provided nothing unforeseen comes up to diminish their future earnings.

But there always are.  And they’re something small business owners have to think about.  All of the time.  Especially when they think about expanding their businesses.  And hiring people.  Because that adds recurring costs.  Which is why few business owners are hiring people now.  Because of the added costs of new regulations.  The big one being Obamacare.  And higher taxes.  Especially the talk of new higher tax rates on high income people.  As most small business owners have their business earnings flow to their personal tax returns.  Even if they leave that money in their business they still have to pay taxes on it.  So while the government taxes them as rich people they’re not rich.  As they see little of their earnings.  Most of which they reinvest into their businesses.  Where it becomes retained earnings.  But the higher the regulatory costs and taxes are the less they can retain to grow their business.  And the fewer jobs they can create.  Worse, these new costs and taxes could reduce earnings to the point that they can’t pay their recurring costs.  Or service their debt.  Which could cause bankruptcy.  So small business owners are very sensitive to things like new regulatory costs and new taxes.  For they can be the difference between life and death.  If they rain down hard enough to extinguish those earnings.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , ,

Revolutionary War, Sovereign Debt, Report on Public Credit, Hamilton, Jefferson, Madison, Assumption and Residency Act

Posted by PITHOCRATES - August 16th, 2012

Politics 101

In 1792 the Outstanding Debt at all Levels of Government was 45% of GDP

Wars aren’t cheap.  Especially if they last awhile.  The American Revolutionary War lasted some 8 years until the British and Americans signed the Treaty of Paris (1782) officially ending all hostilities.  So the Revolutionary War was a very costly war.  The ‘national’ government (the Continental Congress) owed about $70 million.  The states owed another $25 million or so.  And the Continental Army had issued about $7 million in IOUs during the war.  Added up that comes to $102 million the new nation owed.  About 45% of GDP.  (Or about 35% without the state debt added in.)

To put that in perspective consider that the Civil War raised the debt to about 32% of GDP.  World War I raised it to about 35%.  World War II raised it to about 122%.  Following the war the debt fell to about 32% at its lowest point until it started rising again.  And quickly.  In large part due to the cost of the Vietnam War and LBJ’s Great Society.  Government spending being so great Nixon turned to printing money.  Depreciating the dollar’s purchasing power in every commodity but one.  Gold.  Which was pegged at $35/ounce.  Losing faith in our currency foreign governments traded their U.S. dollars for gold.  Until Nixon decoupled the dollar from gold in 1971.  Ushering in the era of Keynesian economics, deficit spending and growing national debts.  Because of increased spending for social programs governments everywhere now have debts approaching 100% of GDP.  And higher.  But I digress.

So 45% of GDP was huge in 1792.  And it continued to be huge.  Taking a devastating civil war and a devastating world war to even approach it.  It took an even more devastating world war to exceed it.  And now we’ve blown by that debt level in the era of Keynesian economics.  Without the devastation of another World War II.  This debt level has grown so great that for the first time ever in U.S. history Standard and Poor’s recently lowered the United States’ impeccable sovereign debt rating.  And restoring that debt rating at today’s spending levels will be a daunting task.  But imagine trying to establish a sovereign debt rating after just becoming a nation.  Already with a massive debt of 45% of GDP.

In Hamilton’s Report on Public Credit the New Government would Assume Outstanding Debt at all Levels of Government

There was only one choice for America’s first president.  The indispensible one.  George Washington.  Some delegates at the Philadelphia Convention in 1787 who were skeptical of the new Constitution only supported it because they had someone they could trust to be America’s first president.  George Washington.  Benjamin Franklin, John Adams, Thomas Jefferson and James Madison were indispensible at times.  But not as indispensible as Washington.  For without him the Continental Army would have ceased to exist after that winter at Valley Forge.  That same army would have mutinied (for back pay and promised pensions) after the war if he didn’t step in.  Our experiment in self-government would have ended if he did not relinquish his power after the war.  We wouldn’t have ratified the Constitution without having Washington to be America’s first president.  And our experiment in self-government would have ended if he did not relinquish his power.  Again.  After his second term as president.

With the state of the government’s finances after the war there was another Founding Father that was indispensible.  Not as indispensible as Washington.  But close.  For without him the Washington presidency may have failed.  As well as the new nation.  Because of that convoluted financial mess.  The Continental Congress borrowed money.  The states borrowed money.  Some of which went to the Continental Congress.  The army took stuff they needed to survive in exchange for IOUs.  There were bonds, loans and IOUs at every level of government in every state.  Complicating the matter is that most of the instruments they sold ended up in the hands of speculators who bought them for pennies on the dollar.  As the original holders of these instruments needed money.  And did not believe the Continental Congress would honor any of these obligations.  For before the Constitution the government was weak and had no taxing authority.  And no way to raise the funds to redeem these debt obligations.

A few tried to get their arms around this financial mess.  But couldn’t.  It was too great a task.  Until America’s first secretary of the treasury came along.  Alexander Hamilton.  Who could bring order to the chaos.  As well as fund the new federal government.  He submitted his plan in his Report on Public Credit (January 1790).  And the big thing in it was assumption.  The federal government would assume outstanding debt at all levels of government.  Including those IOUs.  At face value.  One hundred pennies on the dollar.  To whoever held these instruments.  Regardless of who bought them first.  “Unfair!” some said.  But what else could they do?  This was the 1700s.  There weren’t detailed computer records of bondholders.  Besides, this was a nation that, like the British, protected property rights.  These speculators took a risk buying these instruments.  Even if at pennies on the dollar.  They bought them for a price the seller thought was fair or else they wouldn’t have sold them.  So these bonds were now the property of the speculators.

Jefferson and Madison traded Hamilton’s Assumption for the Nation’s Capital

Of course to do this you needed money.  Which Hamilton wanted to raise by issuing new bonds.  To retire the old.  And to service the new.  Thus establishing good credit.  In fact, he wanted a permanent national debt.  For he said, “A national debt, if not excessive, is a national blessing.”  Because good credit would allow a nation to borrow money for economic expansion.  And it would tie the people with the money to the government.  Where the risk of a government default would harm both the nation and their creditors.  Making their interests one and the same.

That’s not how Thomas Jefferson saw it, though.  He had just returned from France where he witnessed the beginning of the French Revolution.  Brought upon by a crushing national debt.  And he didn’t want to tie the people with the money to the government.  For when they do they tend to exert influence over the government.  But Hamilton said debt was a blessing if not excessive.  He did not believe in excessive government debt.  And he wanted to pay that debt off.  As his plan called for a sinking fund to retire that debt.  Still, the Jefferson and Hamilton feud began here.  For Hamilton’s vision of the new federal government was just too big.  And too British.  Madison would join Jefferson to lead an opposition party.  Primarily in opposition to anything Hamilton.  Who used the Constitution to support his other plan.  A national bank.  Just like the British had.  Based on the “necessary and proper” clause in Article I, Section 8.  Setting a precedent that government would use again and again to expand its powers.

At the time the nation’s capital was temporarily in New York.  A final home for it, though, was a contentious issue.  Everyone wanted it in their state so they could greatly influence the national government.  Hamilton’s struggle for assumption was getting nowhere.  Until the horse-trading at the Jefferson dinner party with Hamilton and Madison.  To get the nation’s capital close to Virginia (where it is now) Jefferson offered a deal to Hamilton.  Jefferson and Madison were Virginians.  Give them the capital and they would help pass assumption.  They all agreed to the deal (though Jefferson would later regret it).  Congress passed the Residency Act putting the capital on the Potomac.  And all the good that Hamilton promised happened.  America established good credit.  Allowing it to borrow money at home and abroad.  And a decade of prosperity followed.  Hamilton even paid down the federal debt to about 17.5% of GDP near the end of America’s second president’s (John Adams) term in office (1800).  Making Hamilton indispensible in sustaining this experiment in self-government.  Keeping government small even though it was more powerful than it was ever before.  Of course his using that “necessary and proper” argument really came back to bite him in the ass.  Figuratively, of course.  As government used it time and again to expand its role into areas even Hamilton would have fought to prevent.  While Jefferson no doubt would have said with haughty contempt, “I told you so.  This is what happens when you bring money and government together.  But would you listen to me?  No.  How I hate you, Mr. Hamilton.”

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Inflation, Prices and Wages (Real and Nominal)

Posted by PITHOCRATES - April 23rd, 2012

Economics 101

Inflation is Good for those who Owe Money but Bad for Bankers 

There is a direct correlation between the amount of money in circulation and prices.  The more money the higher the prices.  The less money in circulation the lower the prices.  During the Great Depression the Federal Reserve contracted the money supply and prices fell.  And it caused havoc in the economy.  Low prices a problem?  Yes.  For some.  It was good for anyone buying anything for their money was worth more and could buy more.  But it wasn’t good for people who owed money.  Or banks.

Farmers had borrowed a lot of money to mechanize their farms in the Twenties.  So they owed the banks a lot of money.  When prices fell so did their earnings as the crops they grew sold for less at market.  Good for the consumer.  But bad for the farmer.  For with that big ‘pay cut’ they took they could not repay their loans.  They defaulted.  And when a lot of them defaulted they left banks with a lot of bad loans on the books and little cash in their vaults.  Causing bank runs and bank failures.

This is why farmers are in favor of inflation.  Increasing the amount of money in circulation.  Instead of deflation.  Decreasing the amount of money in circulation.  For when you increase the money supply prices rise.  Meaning more money for them at market.  Making it easier for them to repay their loans.  For although the money supply increased loan balances remained unchanged.  Higher earnings.  Same old debt.  Therefore easier to pay off.  Even though the value of the dollar fell.  So inflation is good for the farmer.  But bad for the banker.  Because the dollars they get back when the farmer repays his loan now buy less than they did before the inflation.

To Fully Appreciate the Impact of Inflation we must talk about Real Prices and Real Wages

Think of a grocer.  He buys from a food distributor to stock his grocery store shelves.  His distributor buys from farmers and food processing companies.  These purchases and sales happen BEFORE a consumer buys anything from a grocery store.  Now BEFORE the consumer goes shopping let’s say the Federal Reserve doubles the amount of money in circulation.  So the consumer goes shopping with a dollar worth HALF of what it was worth when the grocer stocked his shelves.  So if the grocer doesn’t raise his prices to account for this inflation he’ll be able to replace only HALF of what he sells with the proceeds from those sales.  Because his distributors will have doubled their prices to reflect the halving of the value of the dollar.

Of course doubling prices throughout the food supply chain will ultimately lower sales.  Which no one in this chain wants.  Which creates somewhat of a problem.  Especially when consumers don’t like paying higher prices.  Food processing companies will raise their prices.  But they can do something else to make it look like they’re not raising their prices that much.  They can reduce their packaging.  So boxes of cereal and bags of chips get smaller while prices increase only a little.  This lessens the perception of inflation on both consumer and seller.  At least, for those who can do this.  We sell gasoline by the gallon.  Which means they have to pass on the full impact of inflation in the price at the pump.  Which makes it look like gasoline prices are rising faster than most other prices.  Which is why consumers hate oil companies more than food companies.

The price we pay in the grocery store and at the pump are nominal prices.  Prices noted in dollars.  Nominal prices rise to factor in inflation.  But they don’t tell us the real impact of inflation.  That is, how it reduces our purchasing power.  For prices aren’t the only thing that rise.  Our wages do, too.  And if our nominal wages rise at the same rate as nominal prices do we won’t really notice a difference in our purchasing power.  If our nominal wages rise faster than nominal prices then we gain purchasing power.  If nominal prices rise faster than our nominal wages we lose purchasing power.  So to fully appreciate the impact of inflation we must talk about real prices and real wages.  Not the dollar amount on the price tag.  But the affect on our purchasing power.  In times of increasing purchasing power a single earner may be able to meet all the financial needs of a family.  In times of declining purchasing power it may take a second income to meet the financial needs of the family.  This is what we mean when we talk about real prices and real wages. 

Government causes the Erosion of Purchasing Power Always and Everywhere

You may get a large raise at work giving you a high nominal wage.  But if nominal prices are rising (as in a higher price at the gas pump) real wages are falling.  Because you can’t buy as much as you once did.  Meaning you’ve lost purchasing power.  So even though you got a nominal raise you may have taken a real pay cut.  Pretty much everyone today earns more than their father did.  Yet today we struggle to have as much as our fathers did.  Even with a second income in the family.  This is the impact of inflation.  Which causes real prices to rise.  Real wages to fall.  And our standard of living to fall.

As real prices rise and real wages fall we have to make choices.  We can’t have the same things we once did.  If we lose too much purchasing power our spouse may have to provide a second income, spending less time with his or her children.  Or people may work more overtime.  Or take a second job.  Or simply cut back on things.  And enjoy life less.  Cut out movie night.  Or going out to dinner.  Not renew their season tickets.  Or give less to charity.  This is the true cost of inflation. 

This all goes back to the amount of money in circulation.  As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.”  Meaning that only government can create inflation.  Because government controls monetary policy.  And the amount of money in circulation.  Which means government causes the erosion of purchasing power always and everywhere.  Even the price at the pump.  As oil is a global commodity priced nominally in U.S. dollars.  So whenever the Americans inflate their money supply the oil producers raise their prices to offset the devalued U.S. dollar.  So government causes much of the pain at the pump.  Whose monetary policies decrease real wages.  And increase real prices.   

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , ,

World War I, Gold Standard, German Reparations, Hyperinflation, Credit-Anstalt, Keynesian Policies and the Great Depression

Posted by PITHOCRATES - March 13th, 2012

History 101

Nations abandoned the Gold Standard to Borrow and Print Money freely to pay for World War I 

Banks loan to each other.  They participate in a banking system that moves capital from those who have it to those who need it.  It’s a good system.  And a system that works.  Providing businesses and entrepreneurs with the capital to expand their businesses.  And create jobs.  As long as all the banks in the system go about their business responsibly.  And their governments go about their business responsibly.  Sadly, neither always does.

World War I changed the world in so many ways for the worse.  It killed a generation of Europeans.  Bankrupted nations.  Redrew the borders in Europe as the victors divvied up the spoils of war.  Setting the stage for future political unrest.  Gave us Keynesian economics.  Saw the beginning of the decline of the gold standard.  A deterioration of international trade.  A rise of protectionism and nationalism.  Punishing German reparations.  To pay for a war that they didn’t necessarily start.  Nor did they necessarily lose.  Which created a lot of anger in Germany.  And provided the seed for the Great Depression.

A set of entangling treaties brought nations eagerly into World War I.  There was great patriotic fervor.  And a belief that this war would be Napoleonic.  Some glorious battles.  With the victors negotiating a favorable peace.  Sadly, no one learned the lessons of the Crimean War (1853-1856).  Which killed approximately 600,000 (about 35% of those in uniform).  Or the American Civil War (1861-1865).  Which killed approximately 600,000 (about 20% of those in uniform).  The first modern wars.  Where the technology was ahead of the Napoleonic tactics of the day.  Modern rifled weapons made accurate killing weapons.  And the telegraph and the railroads allowed the combatants to rush ever more men into the fire of those accurate killing weapons.  These are the lessons they didn’t learn.  Which was a pity.  Because the weapons were much more lethal in World War I (1914-1918).  And far more advanced than the tactics of the day.  Which were still largely Napoleonic.  Mass men on the field of battle.  Fire and advance.  And close with the bayonet.  Which they did in World War I.  And these soldiers advanced into the withering fire of the new machine gun.  While artillery rounds fell around them.  Making big holes and throwing shredded shrapnel through flesh and bone.  WWI killed approximately 10,000,000 (about 15% of those in uniform).  And wounded another 20 million.  To do that kind of damage costs a lot of money.  Big money.  For bullets, shells, rifles, artillery, machine guns, warships, planes, etc., don’t grow on trees.  Which is why all nations (except the U.S.) went off of the gold standard to pay for this war.  To shake off any constraints to their ability to raise the money to wage war.  To let them borrow and print as much as they wanted.  Despite the effect that would have on their currency.  Or on foreign exchange rates.

As Countries abandoned the Gold Standard they depreciated their Currencies and wiped out People’s Life Savings

Well, the war had all but bankrupted the combatants.  They had huge debts and inflated currencies.  Large trade deficits.  And surpluses.  A great imbalance of trade.  And it was in this environment that they restored some measure of a gold standard.  Which wasn’t quite standard.  As the different nations adopted different exchange rates.  But they moved to get their financial houses back in order.  And the first order of business was to address those large debts.  And the ‘victors’ decided to squeeze Germany to pay some of that debt off.  Hence those punishing reparations.  Which the victors wanted in gold.  Or foreign currency.  Which made it difficult for Germany to return to the gold standard.  As the victors had taken most of her gold.  And so began the hyperinflation.  As the Germans printed Marks to trade for foreign currency.  Of course we know what happened next.  They devalued the Mark so much that it took wheelbarrows full of them to buy their groceries.  And to exchange for foreign currency.

Elsewhere, in the new Europe that emerged from WWI, there was a growth in regional banking.  Savvy bankers who were pretty good at risk evaluation.  Who were close to the borrowers.  And informed.  Allowing them to write good loans.  Meanwhile, the old institutions were carrying on as if it was still 1914.  Not quite as savvy.  And making bad loans.  The ones the more savvy bankers refused to write.  Weak banking regulation helped facilitate these bad lending practices.  Leaving a lot of banks with weak balance sheets.  Add in the hyperinflation.  Heavy debts.  Higher taxes (to reduce those debts).  Trade imbalances.  And you get a bad economy.  Where businesses were struggling to service their debt.  With many defaulting.  As a smaller bank failed a bigger bank would absorb it.  Bad loans and all.  Including an Austrian bank.  A pretty big one at that.  The largest in Austria.  Credit-Anstalt.  Which was ‘too big to fail’.  But failed anyway.  And when it did the collapse was heard around the world. 

As banks failed the money supply contracted.  Causing a liquidity crisis.  And deflation (less money chasing the same amount of goods).  Currency appreciation (further hurting a country’s balance of trade).  And low prices.  Which made it harder for borrowers to service their debt with the lower revenue they earned on those lower prices.  So there were more loan defaults.  Bank runs.  And bank failures.  Spreading the contagion to Amsterdam.  To Warsaw.  Germany.  Latvia.  Turkey.  Egypt.  Britain.  Even the U.S.  Soon countries abandoned the gold standard.  So they could print money to save the banks.  Lower interest rates.  Depreciate their currencies.  And wipe out large swathes of wealth denominated in that now depreciated currency.  What we call Keynesian policies.  People’s life savings became a fraction of what they were.  Making for a longer working life.  And a more Spartan retirement. 

Abandoning the Gold Standard didn’t fix the U.S. Economy in 1971

Meanwhile in the U.S. the government was destroying the U.S. economy.  Trying to protect domestic prices they passed the Smoot-Hawley Tariff.  Raising the price for businesses and consumers alike.  And kicking off a trade war.  Both of which greatly reduced U.S. exports.  New labor legislation keeping wages above market prices while all other prices were falling.  And higher taxes to pay for New Deal social programs.  Wiping out business profits and causing massive unemployment.  Then came the fall in farm prices due to increased farm productivity.  Thanks to farmers mechanizing their farms and greatly increasing their harvests.  Thus lowering prices.  Making it hard to service the bank loans they got to pay for that mechanization.  Thus leading to bank failures in the farming regions.  That spread to the cities.  Causing a liquidity crisis.  And deflation.

Then came Credit-Anstalt.  And all the woe that followed.  Which caused a speculative run in Britain.  Which made the British decide to leave the gold standard.  To stem the flow of gold out of their country.  Which destroyed whatever confidence was still remaining in their banking system.  People thought that the U.S. would be next.  But the Americans defended the dollar.  And instead raised interest rates (by reducing the money supply).  To keep the dollar valuable.  And to protect the exchange rate.  Making it less attractive to exchange cash for gold.  And to restore confidence in the banking system.  Of course, this didn’t help the liquidity crisis.  Which Keynesians blame for the length and the severity of the Great Depression.

Of course, it wasn’t the gold standard that caused the fall of Credit-Anstalt.  It was poor lending practices.  A weak banking regulation that allowed those poor lending practices.  And a lot of bad government policy throughout Europe.  Especially those punishing German reparations.  And the gold standard didn’t cause the economic collapse in the United States.  For it worked well the previous decade.  Providing all the capital required to produce the Roaring Twenties that modernized the world.  It was government and their intrusive policies into the free market that caused the economic collapse.  And abandoning the gold standard wouldn’t have changed that.  Or made the economy better.  And we know this because leaving the gold standard didn’t solve all of the countries woes in 1971.  Because the government was still implementing bad Keynesian policies.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Versailles Treaty, Marshall Plan, Post-War Japan, MITI, Asian Tigers, Japan Inc., Asset Bubbles, Deflationary Spiral and Lost Decade

Posted by PITHOCRATES - February 21st, 2012

History 101

Douglas MacArthur brought some American Institutions into Japan and unleashed a lot of Human Capital

At the end of World War I the allies really screwed the Germans.  The Treaty of Versailles made for an impossible peace.  In a war that had no innocents the Allies heaped all blame onto Germany in the end.  And the bankrupt Allies wanted Germany to pay.  Placing impossible demands on the Germans.  Which could do nothing but bankrupt Germany.  Because, of course, to the victors go the spoils.  But such a policy doesn’t necessarily lead to a lasting peace.  And the peace following the war to end all wars wasn’t all that long lasting.  Worse, the peace was ended by a war that was worse than the war to end all wars.  World War II.  All because some corporal with delusions of grandeur held a grudge.

The Americans wouldn’t repeat the same mistake the Allies made after World War II.  Instead of another Versailles Treaty there was the Marshal Plan.  Instead of punishing the vanquished the Americans helped rebuild them.  The peace was so easy in Japan that the Japanese grew to admire their conqueror.  General Douglas MacArthur.  The easy peace proved to be a long lasting peace.  In fact the two big enemies of World War II became good friends and allies of the United States.  And strong industrial powers.  Their resulting economic prosperity fostered peace and stability in their countries.  And their surrounding regions.

MacArthur changed Japan.  Where once the people served the military the nation now served the people.  With a strong emphasis on education.  And not just for the boys.  For girls, too.  And men AND women got the right to vote in a representative government.   This was new.  It unleashed a lot of human capital.  Throw in a disciplined work force, low wages and a high domestic savings rate and this country was going places.  It quickly rebuilt its war-torn industries.  And produced a booming export market.  Helped in part by some protectionist policies.  And a lot of U.S. investment.  Especially during the Korean War.  Japan was back.  The Fifties were good.  And the Sixties were even better. 

By the End of the Seventies the Miracle was Over and Japan was just another First World Economy 

Helping along the way was the Ministry of International Trade and Industry (MITI).  The government agency that partnered with business.  Shut out imports.  Except the high-tech stuff.  Played with exchange rates.  Built up the old heavy industries (shipbuilding, electric power, coal, steel, chemicals, etc.).  And built a lot of infrastructure.  Sound familiar?  It’s very similar to the Chinese economic explosion.  All made possible by, of course, a disciplined workforce and low wages.

Things went very well in Japan (and in China) during this emerging-economy phase.  But it is always easy to play catch-up.  For crony capitalism can work when playing catch-up.  When you’re not trying to reinvent the wheel.  But just trying to duplicate what others have already proven to work.  You can post remarkable GDP growth.  Especially when you have low wages for a strong export market.  But wages don’t always stay low, do they?  Because there is always another economy to emerge.  First it was the Japanese who worked for less than American workers.  Then it was the Mexicans.  Then the South Koreans.  The three other Asian Tigers (Hong Kong, Singapore and Taiwan).  China.  India.  Brazil.  Vietnam.  It just doesn’t end.  Which proves to be a problem for crony capitalism.  Which can work when economic systems are frozen in time.  But fails miserably in a dynamic economy.

But, alas, all emerging economies eventually emerge.  And mature.  By the end of the Seventies Japan had added automobiles and electronics to the mix.  But it couldn’t prevent the inevitable.  The miracle was over.  It was just another first world economy.  Competing with other first world economies.  Number two behind the Americans.  Very impressive.  But being more like the Americans meant the record growth days were over.  And it was time to settle for okay growth instead of fantastic growth.  But the Japanese government was tighter with business than it ever was.  In fact, corporate Japan was rather incestuous.  Corporations invested in other corporations.  Creating large vertical and horizontal conglomerates.  And the banks were right there, too.  Making questionable loans to corporations.  To feed Japan Inc.  To prop up this vast government/business machine.  With the government right behind the banks to bail them out if anyone got in trouble.    

Low Interest Rates caused Irrational Exuberance in the Stock and Real Estate Markets

As the Eighties dawned the service-oriented sector (wholesaling, retailing, finance, insurance, real estate, transportation, communications, etc.) grew.  As did government.  With a mature economy and loads of new jobs for highly educated college graduates consumption took off.  And led the economy in the Eighties.  Everyone was buying.  And investing.  Businesses were borrowing money at cheap rates and expanding capacity.  And buying stocks.  As was everyone.  Banks were approving just about any loan regardless of risk.  All that cheap money led to a boom in housing.  Stock and house prices soared.  As did debt.  It was Keynesian economics at its best.  Low interest rates encouraged massive consumption (which Keynesians absolutely love) and high investment.  Government was partnering with business and produced the best of all possible worlds.

But those stock prices were getting way too high.  As were those real estate prices.  And it was all financed with massive amounts of debt.  Massive bubbles financed by massive debt.  A big problem.  For those high prices weren’t based on value.  It was inflation.  Too much money in the economy.  Which raised prices.  And created a lot of irrational exuberance.  Causing people to bid up prices for stocks and real estate into the stratosphere.  Something Alan Greenspan would be saying a decade later during the dot-com boom in the United States.  Bubbles are bombs just waiting to go off.  And this one was a big one.  Before it got too big the government tried to disarm it.  By increasing interest rates. But it was too late.

We call it the business cycle.  The boom-bust cycle between good times and bad.  During the good times prices go up and supply rushes in to fill that demand.  Eventually too many people rush in and supply exceeds demand.  And prices then fall.  The recession part of the business cycle.  All normal and necessary in economics.  And the quicker this happens the less painful the recession will be.  But the higher you inflate prices the farther they must fall.  And the Japanese really inflated those prices.  So they had a long way to fall.  And fall they did.  For a decade.  And counting.  What the Japanese call their Lost Decade.  A deflationary spiral that may still be continuing to this day.

As asset prices fell out of the stratosphere they became worth less than the debt used to buy them.  (Sound familiar?  This is what happened in the Subprime Mortgage Crisis.)  Played hell with balance sheets throughout Japan Inc.  A lot of debt went bad.  And unpaid.  Causing a lot problems for banks.  As they injected capital into businesses too big to fail.  To help them service the debt used for their bad investments.  To keep them from defaulting on their loans.  Consumption fell, too.  Making all that corporate investment nothing but idle excess capacity.  The government tried to stop the deflation by lowering interest rates.  To stimulate some economic activity.  And a lot of inflation.  But the economy was in full freefall.  (Albeit a slow freefall.  Taking two decades and counting.)  Bringing supply and prices back in line with real demand.  Which no amount of cheap money was going to change.  Even loans at zero percent.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Monetary Policy

Posted by PITHOCRATES - January 30th, 2012

Economics 101

Monetary Policy created the Housing Bubble and the Subprime Mortgage Crisis

Those suffering in the fallout of the Subprime Mortgage Crisis can thank monetary policy.  That tool used by the federal government that kept interest rates so low for so long.  Following the old Milton Friedman idea of a permanent level of inflation (but small and manageable) to stimulate constant economic growth.  Why?  Because when people are buying houses the economy is booming.  Because it takes a lot of economic activity to build them.  And even more to furnish them.  Which means jobs.  Lots and lots of jobs.

But there is a danger in making money too cheap to borrow.  A lot of people will borrow that cheap money.  Creating an artificial demand for ever more housing.  And not for your parent’s house.  But bigger and bigger houses.  The McMansions.  Houses 2-3 times the size of your parent’s house.  This demand ran up the price of these houses.  Which didn’t deter buyers.  Because mortgage rates were so low.  People who weren’t even considering buying a new house, let alone a McMansion, jumped in, too.  When the jumping was good.  To take advantage of those low mortgage rates.  There was so much house buying that builders got into it, too.  House flippers.  Who took advantage of those cheap ‘no questions asked’ (no documentation) mortgages (i.e., subprime) and bought houses.  Fixed them up.  And put them back on the market.

Good times indeed.  But they couldn’t last.  Because those houses weren’t the only thing getting expensive.  Price inflation was creeping into the other things we bought.  And all those houses at such inflated prices were creating a dangerous housing bubble.  So the Federal Reserve, America’s central bank, tapped the brakes.  To cool the economy down.  To reduce the growing inflation.  By raising interest rates.  Making mortgages not cheap anymore.  So people stopped buying houses.  Leaving a glut of unsold houses on the market.  Bursting that housing bubble.  And it got worse.  The higher interest rate increased the monthly payment on adjustable rate mortgages.  A large amount of all those subprime mortgages.  Causing many people to default on these mortgages.  Which caused the Subprime Mortgage Crisis.  And the Great Recession.

The Federal Reserve System conducts Monetary Policy by Changing both the Money Supply and Interest Rates

Money is a commodity.  And subject to the laws of supply and demand.  When money is in high demand (during times of inflation) the ‘price’ of money goes up.  When money is in low demand (during times of recession) the ‘price’ of money goes down.  The ‘price’ of money is interest.  The cost of borrowing money.  The higher the demand for loans the higher the interest rate.  The less the demand for loans the lower the interest rate.

So there is a relationship between money and interest rates.  Adjusting one can affect the other.  If the money supply is increased the interest rates will decrease.  Because there is more money to loan to the same amount of borrowers.  When the money supply is decreased interest rates will increase.  Because there will be less money to loan to the same amount of borrowers.  And it works the other way.  If the interest rates are lowered people respond by borrowing more money.  Increasing the amount of money in the economy buying things.  If interest rates are raised people respond by borrowing less money.   Reducing the amount of money in the economy buying things.  We call these changes in the money supply and interest rates monetary policy.  Made by the monetary authority.  In most cases the central bank of a nation.  In the United States that central bank is the Federal Reserve System (the Fed).

The Fed changes the amount of money in the economy and the interest rates to minimize the length of recessions, combat inflation and to reduce unemployment.  At least in theory.  And they have a variety of tools at their disposal.  They can change the amount of money in the economy through open market operations.  Basically buying (increasing the money supply) or selling (decreasing the money supply) treasury bills, government bonds, company bonds, foreign currencies, etc., on the open market.  They can also buy and sell these financial instruments to change interest rates.  Such as the Federal funds rate.  The interest rate banks pay when borrowing from each other.  Moving money between their accounts at the central bank.  Or the Fed can change the discount rate.  The rate banks pay to borrow from the central bank itself.  Often called the lender of last resort.  Or they can change the reserve requirement in fractional reserve banking.  Lowering it allows banks to loan more of their deposits.  Raising it requires banks to hold more of their deposits in reserve.  Not used much these days.  Open market operations being the monetary tool of choice.

There is more to Economic Activity than Monetary Policy

Fractional reserve banking multiplies these transactions.  Where banks create money out of thin air.  When the Fed increases the money supply a little this creates a lot of lendable funds.  As buyers borrow money from some banks and pay sellers.  Then sellers deposit that money in other banks.  And these banks hold a little of these deposits in reserve.  And loan the rest.  Borrowers create depositors as buyers meet sellers.  And complete economic transactions.  When the Fed reduces the money supply a little this process works in reverse.  Fractional reserve banking pulls a lot of money out of the economy.  Some treat these economic transactions, and the way to increase or decrease them, as simple math.  Always obeying their mathematical formulas.  We call these people Keynesian economists.  Named for the economist John Maynard Keynes.

Big interventionist governments embrace monetary policy.  Because they think they can easily manipulate the economy as they wish.  So they can tax and spend (Keynesian fiscal policy).  And when economic activity declines they can simply use monetary policy to restore it.  But there is one problem.  It doesn’t work.  If it did there would not have been a Subprime Mortgage Crisis.  Or any of the recessions we’ve had since the advent of central banking.  Including the Great Depression.  As well as the Great Recession.

There is more to economic activity than monetary policy.  Such as punishing fiscal policy (high taxes and stifling regulations).  Technological innovation.  Contracts.  Property rights.  Etc.  Any one of these can influence risk takers.  Business owners.  Entrepreneurs.  The job creators.  The people who create economic activity.  And no amount of monetary policy will change this.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Classical Greece, Persian Empire, Hellenistic Period, Roman Empire, Italian Renaissance, Venice, Florence and Government Bonds

Posted by PITHOCRATES - January 17th, 2012

History 101

The High Cost of Mercenary Soldiers and a Bloated Bureaucracy brought down the Western Roman Empire

Classical Greece dates back to the 5th century BC.  Lasted about 200 years.  And was the seed for Western Civilization.  Classical Greece was a collection of Greek city-states.  There was no Greek nation-state like the nation of Greece today.  The city-states were independent.  And often waged war against each other.  Especially Sparta and Athens.  Athens is where we see the beginnings of Western Civilization.  Sparta was a city-state of warriors.  While Athens kicked off science, math and democracy, Sparta bred warriors.  And boys trained from an early age.  Or were abandoned to die in the wilderness.

Adjacent to Classical Greece was the great Achaemenid Empire.  The First Persian Empire.  The empire of Cyrus the Great.  Which extended from the eastern Mediterranean all the way to India.  Some of those Greek city-states were on the eastern coast of the Mediterranean.  Did not like Persian rule.  And the Ionians revolted.  Supported by Athens.  The Ionian Revolt (499 BC) was the first in a series of Greco-Persian Wars.  Persia’s Darius the Great was tiring of the Greek’s insolence.  And set out to conquer the Greek mainland.  Only to get turned back at the Battle of Marathon.  His son Xerxes returned to Greece to complete the work his dad started.  King Leonidas of Sparta delayed him at the Battle of Thermopylae for three days.  But he defeated the vastly outnumbered Spartans and marched on to Athens.  Where he sacked the abandoned city.  But he would lose the subsequent Battle of Salamis naval engagement.  Losing his navy.  Forcing Xerxes to retreat.

The Greek city-states united to fight their common enemy.  And won.  With the common enemy defeated, Sparta and Athens returned to fighting each other.  In the Peloponnesian War.  Where Sparta emerged the dominant power.  But the constant fighting weakened and impoverished the region.  Making it ripe for conquest.  And that’s exactly what Phillip of Macedon did.  He conquered the great Greek city-states.  And Phillip’s son, Alexander the Great, succeeded his father and went on to conquer the Persian Empire.  Creating the great Hellenistic Period.  Where the known world became Greek.  Then Alexander died.  And his empire broke up.  Then the Romans rose and pretty much conquered everyone.  And the known world became Romanized.  Built upon a Greek foundation.  Until the western part of that empire fell in 476 AD.  Due in large part to the high cost of mercenary soldiers.  And a bloated bureaucracy.  That was so costly the Romans began to debase their silver coin with lead.  To inflate their currency to help them pay their staggering bills.

In Exchange for these Forced Loans the City-States Promised to Pay Interest

The history of the world is a history of its wars.  People fought to conquer new territory so they could bring riches back to their capital.  Or to defend against someone trying to conquer their territory.  And take their riches.  Taking riches through conquest proved to be a reliable system of public finance.  For the spoils of war financed many a growing empire.  It financed the Roman Empire.  And when they stopped pushing out their borders they lost a huge source of revenue.  Which is when they turned to other means of financing.  Higher taxes.  And inflation.  Which didn’t end well for them.

With the collapse of the Western Roman Empire the world took a step backwards.  And Europe went through the Dark Ages.  To subsistence farming on small manors.  The age of feudalism.  Serfs.  Wealthy landowners.  And, of course, war.  As the Dark Ages drew to a close something happened in Italy.  At the end of the 13th century.  The Italian Renaissance.  And the rise of independent Italian city-states.  Florence.  Siena.  Venice.  Genoa.  Pisa.  Much like the Greek city-states, these Italian city-states were in a state of near constant war with each other.  Expensive wars.  That they farmed out to mercenaries.  To expand their territory.  And, of course, to collect the resulting spoils of war.  These constant wars cost a pretty penny, though.  And built mountains of debt.  Which they turned to an ingenious way of financing.

These Italian city-states could not pay for these wars with taxes alone.  For the cost of these wars was greater than their tax revenue.  Leading to some very large deficits.  Which they financed in a new way.  They forced wealthy people to loan them money.  In exchange for these loans these city-states promised to pay interest.

Renaissance Italy gave us Government Bonds and a new way for a State to Live Beyond its Means

The vehicle they used for these forced loans was the government bond.  Used first by the Italian city-states of Venice and Florence.  Which were very similar to today’s government bonds.  Other than the being forced to buy them part.  The bond had a face value.  An interest payment.  And the bondholders could then buy and sell them on a secondary market.   The market set interest rates then as they do now.  The market determined the likelihood of the city-state being able to pay the interest.  And whether they would be able to redeem their bonds.

When there was excessive outstanding debt and/or war threatening a city-state’s ability to service their debt interest rates rose.  And the face value of existing bonds fell.  Because if the state fell these bonds would become worthless.  When state coffers were full and peace rang out interest rates fell.  And bond prices rose.  Because with a stable state their existing bonds would still be good.  Just like today.  So if you’re into government bonds you can thank Renaissance Italy.  And their wars.  Which gave birth to a whole new way for a state to live beyond its means.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

FUNDAMENTAL TRUTH #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 17th, 2010

DURING UNCERTAIN ECONOMIC times, people act differently.  If business is down where you work, your company may start laying off people.  Your friends and co-workers.  Even you.  If there is a round of layoffs and you survive, you should feel good but don’t.  Because it could have been you.  And very well can be you.  Next time.  Within a year.  In the next few months.  Any time.  You just don’t know.  And it isn’t a good feeling.

So, should this be you, what do you do?  Run up those credit cards?  By a new car?  Go on a vacation?  Take out a home equity loan to pay for new windows?  To remodel the kitchen?  Buy a hot tub?  Or do you cut back on your spending and start hoarding cash?  Just in case.  Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc.  And another loan payment won’t help.  So, no.  You don’t run up those credit cards.  Buy that car.  You don’t go on vacation.  And you don’t take that home equity loan.  Instead, you hunker down.  Sacrifice.  Ride it out.  Prepare for the worse.  Hoard your cash.  Enough to carry you through a few months of unemployment.  And shred those pre-approved credit card offers.  Even at those ridiculously low, introductory interest rates.

To help hammer home this point, you think of your friends who lost their jobs.  Who are behind on their mortgages.  Who are in foreclosure.  Whose financial hardships are stressing them out to no ends.  Suffering depression.  Harassed by collection agencies.  Feeling helpless.  Not knowing what to do because their financial problems are just so great.  About to lose everything they’ve worked for.  No.  You will not be in their position.  If you can help it.  If it’s not already too late.

AND SO IT is with businesses.  People who run businesses are, after all, people.  Just like you.  During uncertain economic times, they, too, hunker down.  When sales go down, they have less cash to pay for the cost of those sales.  As well as the overhead.  And their customers are having the same problems.  So they pay their bills slower.  Trying to hoard cash.  Receivables grow from 30 to 45 to 90 days.  So you delay paying as many of your bills as possible.  Trying to hoard cash.  But try as you might, your working capital is rapidly disappearing.  Manufacturers see their inventories swell.  And storing and protecting these inventories costs money.  Soon they must cut back on production.  Lay off people.  Idle machinery.  Most of which was financed by debt.  Which you still have to service.  Or you sell some of those now nonproductive assets.  So you can retire some of that debt.  But cost cutting can only take you so far.  And if you cut too much, what are you going to do when the economy turns around?  If it turns around?

You can borrow money.  But what good is that going to do?  Add debt, for one.  Which won’t help much.  You might be able to pay some bills, but you still have to pay back that borrowed money.  And you need sales revenue for that.  If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan.  But you don’t have the sales now.  And the future doesn’t look bright.  Your customers are all going through what you’re going through.  Not a confidence builder.  So you’re reluctant to borrow.  Unless you really, really have to.  And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble.  Just what a banker wants to see in a prospective borrower.

Well, not really.  In fact, it’s the exact opposite.  A banker will want to avoid you as if you had the plague.  Besides, the banks are in the same economy as you are.  They have their finger on the pulse of the economy.  They know how bad things really are.  Some of their customers are paying slowly.  A bad omen of things to come.  Which is making them really, really nervous.  And really, really reluctant to make new loans.  They, too, want to hoard cash.  Because in bad economic times, people default on loans.  Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors.  And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail.  And all the money they created via fractional reserve banking will disappear.  Making money even scarcer and harder to borrow.  You see, banking people are, after all, just people.  And like you, and the business people they serve, they, too, hunker down during bad economic times.  Hoping to ride out the bad times.  And to survive.  With a minimum of carnage. 

For these reasons, businesses and bankers hoard cash during uncertain economic times.  For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty.  Uncertainty about when a recession will end.  Uncertainty about the cost of healthcare.  Uncertainty about changes to the tax code.  Uncertainty about new government regulations.  Uncertainty about new government mandates.  Uncertainty about retroactive tax changes.  Uncertainty about previous tax cuts that they may repeal.  Uncertainty about monetary policy.  Uncertainty about fiscal policy.  All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future.  Or severely reduce the purchasing power of their customers.  When this uncertainty is high during bad economic times, businesses typically circle the wagons.  Hoard more cash.  Go into survival mode.  Hold the line.  And one thing they do NOT do is add additional debt.

DEBT IS A funny thing.  You can lay off people.  You can cut benefits.  You can sell assets for cash.  You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset).  You can factor your receivables (sell your receivables at a discount to a 3rd party to collect).  You can do a lot of things with your assets and costs.  But that debt is still there.  As are those interest payments.  Until you pay it off.  Or file bankruptcy.  And if you default on that debt, good luck.  Because you’ll need it.  You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.

Profitable operations.  Yes, that’s the key to success.  So how do you get it?  Profitable operations?  From sales revenue.  Sales are everything.  Have enough of them and there’s no problem you can’t solve.  Cash may be king, but sales are the life blood pumping through the king’s body.  Sales give business life.  Cash is important but it is finite.  You spend it and it’s gone.  If you don’t replenish it, you can’t spend anymore.  And that’s what sales do.  It gets you profitable operations.  Which replenishes your cash.  Which lets you pay your bills.  And service your debt.

And this is what government doesn’t understand.  When it comes to business and the economy, they think it’s all about the cash.  That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy.  The tax and spend stuff.  When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm.  Interest rates must be too high.”  Because their tax and spending sure couldn’t have crashed the economy.  That stuff is stimulative.  Because their god said so.  And that god is, of course, John Maynard Keynes.  And his demand-side Keynesian economic policies.  If it were possible, those in government would have sex with these economic policies.  Why?   Because they empower government.  It gives government control over the economy.  And us.

And that control extends to monetary policy.  Control of the money supply and interest rates.  The theory goes that you stimulate economic activity by making money easier to borrow.  So businesses borrow more.  Create more jobs.  Which creates more tax receipts.  Which the government can spend.  It’s like a magical elixir.  Interest rates.  Cheap money.  Just keep interest rates low and money cheap and plentiful and business will do what it is that they do.  They don’t understand that part.  And they don’t care.  They just know that it brings in more tax money for them to spend.  And they really like that part.  The spending.  Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’?  Especially when it gives you money and power?  And a permanent underclass who is now dependent on your spending.  Whose vote you can always count on.  And when the economy tanks a little, all you need is a little more of that magical elixir.  And it will make everything all better.  So you can spend some more.

But it doesn’t work in practice.  At least, it hasn’t yet.  Because the economy is more than monetary policy.  Yes, cash is important.  But making money cheaper to borrow doesn’t mean people will borrow money.  Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more.  Not until they feel secure in their jobs.  Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt.  But they are not going to add additional debt to expand production.  Not until they see some stability in the market and stronger sales.  A more favorable tax and regulatory environment.  That is, a favorable business climate.  And until they do, they won’t create new jobs.  No matter how cheap money is to borrow.  They’ll dig in.  Hold the line.  And try to survive until better times.

NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend.  Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans.  Instead, they’ll beef up their reserves.  Instead of lending, they’ll buy liquid financial assets.  Sit on cash.  Earn less.  Just in case.  Dig in.  Hold the line.  And try to survive until better times.

Of course, the Keynesians don’t factor these things into their little formulae and models.  They just stamp their feet and pout.  They’ve done their part.  Now it’s up to the greedy bankers and businessmen to do theirs.  To engage in lending.  To create jobs.  To build things.  That no one is buying.  Because no one is confident in keeping their job.  Because the business climate is still poor.  Despite there being cheap money to borrow.

The problem with Keynesians, of course, is that they don’t understand business.  They’re macroeconomists.  They trade in theory.  Not reality.  When their theory fails, it’s not the theory.  It’s the application of the theory.  Or a greedy businessman.  Or banker.  It’s never their own stupidity.  No matter how many times they get it wrong.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,