With every Increase of the Debt Ceiling we get Closer to Third-World Status

Posted by PITHOCRATES - February 8th, 2014

Week in Review

George W. Bush’s last deficit was $498.37 billion.  President Obama’s deficits were $1,539.22 billion, $1,386.92 billion, $1,350.31 billion, $1,120.16 billion and $680 billion, respectively.  President Obama has taken the national debt from $12,973,669,938,453 to $16,738,183,526,697.  And increase of $3,764,513,588,244 (29%).  Or the amount added to the national debt from 1791 through 1985.

So President Obama did in 5 years what his predecessors did in 194 years.  Putting the U.S. dollar in great peril.  For the only reason why the United States hasn’t become a third-world economic basket case is because the U.S. dollar is the world’s reserve currency.  But once the world loses confidence in the American dollar they may choose another reserve currency.  And if they do all of that printing and borrowing will hit the U.S. economy hard.  Making the inflation of the stagflation Seventies seem like child’s play.

We can’t keep printing and borrowing money.  For we are approaching a tipping point.  Yes, having the power to print money can forestall the inevitable.  As long as people still have confidence in your currency.  But if they don’t there is nothing to prevent the U.S. from spiraling down into third-world status just as every other nation that destroyed their economy with out of control printing and spending.  Making these debates over increasing the debt ceiling more than Kabuki Theater (see All’s Fair in Love, War and Government? by Robert Schlesinger posted 2/3/2014 on US News and World Report).

The way that the approach to the debt ceiling has changed – going from a rhetorical opportunity and classic round of Kabuki Theater where lawmakers feign outrage and denounce the debt ceiling increase they know they’re going to vote for anyway to a genuine threat to the economy – illustrates a larger trend in Washington: the movement away from certain accepted norms in our governance. As I’ve written before, there used to be unwritten rules which helped keep the governance train on its rails – they limited the use of the filibuster to rare issues, they made the notion of deliberately shutting down the government in order to extract policy concessions out of bounds and the same with the idea of intentionally harming the economy by not raising the debt ceiling.

Those norms have increasingly been replaced with an ends-justifies-the-means view that the pursuit of power makes anything OK. That’s a real problem for our democracy.

The ends-justifies-the-means in the pursuit of power?  Yes, that is a problem for our democracy.  Such as passing the Affordable Care Act on partisan lines with back room deals.  Causing people to lose the health insurance and doctors they liked and wanted to keep.  Higher insurance premiums and higher deductibles.  A cost that went from just under $1 trillion over ten years to over $1 trillion each year (if our health care is anything like Canada’s health care).  And prolonging the worst economic recovery since that following the Great Depression.  Even telling the Lie of the Year.  Horrible things for our Democracy.  All in the pursuit of power.  In the left’s quest for the holy grail of power.  National health care.

With our huge debt weighing down our democracy we are fast approaching the tipping point.  And raising the debt ceiling may not be the best thing to do.  So someone should be trying to get some spending cuts before agreeing to raise the debt ceiling.  To save our democracy.  Before it’s too late.  Thanks to the Democrats’ pursuit of power.  Where ‘the ends-justifies-the-means’.  Even if it turns the country into a third-world nation.

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Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 4th, 2014

History 101

(Originally published 2/5/2013)

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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Quantitative Easing

Posted by PITHOCRATES - June 24th, 2013

Economics 101

The Gold Standard prevented Nations from Devaluing their Currency to Keep Trade Fair

You may have heard of the great gamble the Chairman of the Federal Reserve, Ben Bernanke, has been making.  Quantitative easing (QE).  The current program being QE3.  The third round since the subprime mortgage crisis.  It’s stimulus.  Of the Keynesian variety.  And in QE3 the Federal Reserve has been ‘printing’ $85 billion each month and using it to buy financial assets on the open market.  Greatly increasing the money supply.  But why?  And how exactly is this supposed to stimulate the economy?  To understand this we need to understand monetary policy.

Keynesians hate the gold standard.  They do not like any restrictions on the government’s central bank’s ability to print money.  Which the gold standard did.  The gold standard pegged the U.S. dollar to gold.  Other central banks could exchange their dollars for gold at the exchange rate of $40/ounce.  This made international trade fair by keeping countries from devaluing their currency to gain a trade advantage.  A devalued U.S. dollar gives the purchaser a lot more weaker dollars when they exchange their stronger currency for them.  Allowing them to buy more U.S. goods than they can when they exchange their currency with a nation that has a stronger currency.  So a nation with a strong export economy would like to weaken their currency to entice the buyers of exports to their export market.  Giving them a trade advantage over countries that have stronger currencies.

The gold standard prevented nations from devaluing their currency and kept trade fair.  In the 20th century the U.S. was the world’s reserve currency.  And it was pegged to gold.  Making the U.S. dollar as good as gold.  But due to excessive government spending through the Sixties and into the Seventies the American central bank, the Federal Reserve, began to print money to pay for their ever growing spending obligations.  Thus devaluing their currency.  Giving them a trade advantage.  But because of that convertibility of dollars into gold nations began to do just that.  Exchange their U.S. dollars for gold.  Because the dollar was no longer as good as gold.  So nations opted to hold gold instead.  Instead of the U.S. dollar as their reserve currency.  Causing a great outflow of gold from the U.S. central bank.

Going off of the Gold Standard made the Seventies the Golden Age of Keynesian Economics

This gave President Richard Nixon quite the contrary.  For no nation wants to lose all of their gold reserves.  So what to do?  Make the dollar stronger?  By not only stopping the printing of new money but pulling existing money out of circulation.  Raising interest rates.  And forcing the government to make REAL spending cuts.  Not cuts in future increases in spending.  But REAL cuts in current spending.  Something anathema to Big Government.  So President Nixon chose another option.  He slammed the gold window shut.  Decoupling the dollar from gold.  No longer exchanging gold for dollars.  Known forever after as the Nixon Shock.  Making a Keynesian dream come true.  Finally giving the central bank the ability to print money at will.

The Keynesians said they could make recessions a thing of the past with their ability to control the size of the money supply.  Because everything comes down to consumer spending.  When the consumers spend the economy does well.  When they don’t spend the economy goes into recession.  So when the consumers don’t spend the government will print money (and borrow money) to spend to replace that lost consumer spending.  And increase the amount of money in circulation to make more available to borrow.  Which will lower interest rates.  Encouraging people to borrow money to buy big ticket items.  Like cars.  And houses.  Thus stimulating the economy out of recession.

The Seventies was the golden age of Keynesian economics.  Freed from the responsible restraints of the gold standard the Keynesians could prove all their theories by creating robust economic activity with their control over the money supply.  But it didn’t work.  Their expansionary policies unleashed near hyperinflation.  Destroying consumers’ purchasing power.  As the greatly devalued dollar raised prices everywhere.  As it took more of them to buy the things they once did before that massive inflation.

The only People Borrowing that QE Money are Very Rich People making Wall Street Investments

The Seventies proved that Keynesian stimulus did not work.  But central bankers throughout the world still embrace it.  For it allows them to spend money they don’t have.  And governments, especially governments with large welfare states, love to spend money.  So they keep playing their monetary policy games.  And when recessions come they expand the money supply.  Making it easy to borrow.  Thus lowering interest rates.  To stimulate those big ticket purchases.  But following the subprime
mortgage crisis those near-zero interest rates did not spur the economic activity the Keynesians thought it would.  People weren’t borrowing that money to buy new houses.  Because of the collapse of the housing market leaving more houses on the market than people wanted to buy.  So there was no need to build new houses.  And, therefore, no need to borrow money.

So this is the problem Ben Bernanke faced.  His expansionary monetary policy (increasing the money supply to lower interest rates) was not stimulating any economic activity.  And with interest rates virtually at 0% there was little liquidity Bernanke could add to the economy.  Resulting in a Keynesian liquidity trap.  Interest rates so close to zero that they could not lower them any more to create economic activity.  So they had to find another way.  Some other way to stimulate economic activity.  And that something else was quantitative easing.  The buying of financial assets in the market place by the Federal Reserve.  Pumping enormous amounts of money into the economy.  In the hopes someone would use that money to buy something.  To create that ever elusive economic activity that their previous monetary efforts failed to produce.

But just like their previous monetary efforts failed so has QE failed.  For the only people borrowing that money were very rich people making Wall Street investments.  Making rich people richer.  While doing nothing (so far) for the working class.  Which is why when Bernanke recently said they may start throttling back on that easy money (i.e., tapering) the stock market fell.  As rich people anticipated a coming rise in interest rates.  A rise in business costs.  A fall in business profits.  And a fall in stock prices.  So they were getting out with their profits while the getting was good.  But it gets worse.

The economy is not improving because of a host of other bad policy decisions.  Higher taxes, more regulations on business, Obamacare, etc.  And a massive devaluation of the dollar (by ‘printing’ all of that new money) just hasn’t overcome the current anti-business climate.  But the potential inflation it may unleash worries some.  A lot.  For having a far greater amount of dollars chasing the same amount of goods can unleash the kind of inflation that we had in the Seventies.  Or worse.  And the way they got rid of the Seventies’ near hyperinflation was with a long, painful recession in the Eighties.  This time, though, things can be worse.  For we still haven’t really pulled out of the Great Recession.  So we’ll be pretty much going from one recession into an even worse recession.  Giving the expression ‘the worst recession since the Great Depression’ new meaning.

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The Problems in the Eurozone may Influence Scottish Voters in their Independence Referendum

Posted by PITHOCRATES - April 27th, 2013

Week in Review

During the Roaring Twenties the American economy was giving the economies of Europe a run for their money.  The Europeans, accustomed to running the world for so long, looked at the economic prowess of America with concern.  And began to talk about a United States of Europe to compete with the economic juggernaut across the pond.  But when Calvin Coolidge chose not to run for a second term the progressives got back into power.  And Herbert Hoover put an end to that surging economy.  Causing a stock market crash.  And throwing the country into recession.  Which FDR turned into the Great Depression.

So there was no United States of Europe.  But there would be a European Union one day.  And after that, a currency union.  The Eurozone.  To compete against the economic prowess of the United States.  But a currency union without a political union.  Without a single fiscal and monetary policy to support that currency union.  Which turned out to be a problem.  For without that political union the currency union was only as strong as its weakest state.  In the Eurozone that state was Greece.  Whose unrestrained government spending caused a debt crisis that threatened to bring down the entire Eurozone.  Unless the other members stepped in to bail out Greece.  Which they have.  But the crisis hasn’t gone away.  For the central governing authorities can only ask Greece to cut their spending.  Which there is a lot of opposition to in Greece.  Putting a lot of pressure on the Euro.

Greece isn’t the only problem.  There was Ireland.  Spain.  Portugal.  And Cyprus.  All sovereign nations.  Sharing a common currency.  Making it all but impossible to maintain a uniform fiscal policy throughout the Eurozone.  Like they can in the United States.  Because the United States of America is a political union.  With one central government.  One central fiscal authority.  And one central monetary authority.  Making it hard for any one state to undermine the currency.  (Though California is making a valiant effort.)  Which is the problem they’re having in the Eurozone.  Many of the states are threatening to undermine the common currency.  Making a very strong case against future currency unions without a political union.  Which is something they are considering with an upcoming referendum on Scottish independence (see UK says “no clear reason” to let independent Scotland use the pound by David Milliken posted 4/23/2013 on Reuters UK).

The euro zone’s experience of countries sharing a currency but not a government shows there is no clear case for an independent Scotland to use the pound, the Treasury said on Tuesday.

The nation of 5 million will hold a referendum on September 18 next year to decide whether to split from the United Kingdom, at the instigation of the Scottish National Party that runs the country’s devolved government.

Pro-independence campaigners want Scotland to keep sterling, at least in the early years of independence, and then to decide later whether to switch to its own currency.

But in a report on Tuesday, the Treasury said there was no clear case for the United Kingdom to agree to a formal currency union with an independent Scotland, which would have an economy of a similar size to New Zealand’s…

“The recent experience of the euro area has shown that it is extremely challenging to sustain a successful formal currency union without close fiscal integration and common arrangements for the resolution of banking sector difficulties,” it added.

Scotland and England have a long history.  Not all of it good.  But if we’ve learned anything from history it is that large economic blocs do better than smaller counties.  As the United States demonstrated.  And as the Eurozone tried to duplicate with their currency union.  But as that experiment showed us a currency union without a political union is a recipe for disaster.  If Scotland breaks from the United Kingdom they will have to go all of the way.  And leave sterling.  Which will make independence more difficult.  Having to set up a new currency with everything else they will have to do.  (Such as dealing with separating their military forces from the UK’s.  And providing for their own defense.  Or forming a military union with the UK.  Which will tie them closely to the UK.  Something many Scots no doubt will consider before voting in the referendum.)

Of course if they do and they devalue their new currency it would make their exports cheaper to those nations with a stronger currency.  But that weak currency will make anything they import more expensive.  As Scotland exports and imports a lot of stuff they won’t get a clear advantage in devaluing their new currency.  So they may peg their new currency to sterling.  The next best thing to keeping sterling.  Which will tie them closely to the UK.  Something many Scots no doubt will consider before voting in the referendum.  Perhaps choosing to stay in the UK.  As Quebec chose to stay in Canada in their past referendum.  Who had less in common with the rest of Canada than the Scots have with the UK.  For they don’t even speak the same language.

They could join the Eurozone.  But recent events in the Eurozone does not make that option as appealing as setting up a new currency.  Or staying a part of the UK.  It would probably be best for the rest of the world if Scotland remained part of the UK.  For the world will need at least one strong reserve currency.  As the Euro is making itself less attractive by the day.  The U.S. dollar may hit the wall soon with the amount of debt the Americans are racking up.  And the Chinese are likely to go the way of Japan before the decade is out.  And have their own Lost Decade with all their malinvestments.  The ultimate cause in the fall of state-capitalism.

Now the UK has its problems.  But their decision to stay out of the Eurozone was clearly sound as a pound.  And pound sterling may grow even more attractive as a reserve currency as these other countries continue to rely on easy credit and debt to pay for their burgeoning welfare states.  And/or their malinvestments.  But one thing the UK is doing that none of these other bloated states are doing is making real cuts in spending.  Even in their venerated NHS.  Giving the UK the edge in responsible governing these days.  And really making a strong argument against Scottish independence at this time.  Even for those who hate England.  For it is better to deal with the devil you know than the devil you don’t.  Especially during uncertain times.

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Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 5th, 2013

History 101

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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LESSONS LEARNED #3 “Inflation is just another name for irresponsible government.” -Old Pithy

Posted by PITHOCRATES - March 4th, 2010

PEOPLE LIKE TO hate banks.  And bankers.  Because they get rich with other people’s money.  And they don’t do anything.  People give them money.  They then loan it and charge interest.  What a scam.

Banking is a little more complex than that.  And it’s not a scam.  Countries without good banking systems are often impoverished, Third World nations.  If you have a brilliant entrepreneurial idea, a lot of good that will do if you can’t get any money to bring it to market.  That’s what banks do.  They collect small deposits from a lot of depositors and make big loans to people like brilliant entrepreneurs.

Fractional reserve banking multiplies this lending ability.  Because only a fraction of a bank’s total depositors will ask for their deposits back at any one time, only a fraction of all deposits are kept at the bank.  Banks loan the rest.  Money comes in.  They keep a running total of how much you deposited.  They then loan out your money and charge interest to the borrower.  And pay you interest on what they borrowed from you so they could make those loans to others.  Banks, then, can loan out more money than they actually have in their vaults.  This ‘creates’ money.  The more they lend the more money they create.  This increases the money supply.  The less they lend the less money they create.  If they don’t lend any money they don’t add to the money supply.  When banks fail they contract the money supply.

Bankers are capital middlemen.  They funnel money from those who have it to those who need it.  And they do it efficiently.  We take car loans and mortgages for granted.  For we have such confidence in our banking system.  But banking is a delicate job.  The economy depends on it.  If they don’t lend enough money, businesses and entrepreneurs may not be able to borrow money when they need it.  If they lend too much, they may not be able to meet the demands of their depositors.  And if they do something wrong or act in any way that makes their depositors nervous, the depositors may run to the bank and withdraw their money.  We call this a ‘run on the bank’ when it happens.  It’s not pretty.  It’s usually associated with panic.  And when depositors withdraw more money than is in the bank, the bank fails.

DURING GOOD ECONOMIC times, businesses expand.  Often they have to borrow money to pay for the costs of meeting growing demand.  They borrow and expand.  They hire more people.  People make more money.  They deposit some of this additional money in the bank.  This creates more money to lend.  Businesses borrow more.  And so it goes.  This saving and lending increases the money supply.  We call it inflation.  A little inflation is good.  It means the economy is growing.  When it grows too fast and creates too much money, though, prices go up. 

Sustained inflation can also create a ‘bubble’ in the economy.  This is due to higher profits than normal because of artificially high prices due to inflation.  Higher selling prices are not the result of the normal laws of supply and demand.  Inflation increases prices.  Higher prices increase a company’s profit.  They grow.  Add more jobs.  Hire more people.  Who make more money.  Who buy more stuff and save more money.  Banks loan more, further increasing the money supply.  Everyone is making more money and buying more stuff.  They are ‘bidding up’ the prices (house prices or dot-com stock prices, for example) with an inflated currency.  This can lead to overvalued markets (i.e., a bubble).  Alan Greenspan called it ‘irrational exuberance’ when testifying to Congress in the 1990s.  Now, a bubble can be pretty, but it takes very little to pop and destroy it.

Hyperinflation is inflation at its worse.  Bankers don’t create it by lending too much.  People don’t create it by bidding up prices.  Governments create it by printing money.  Literally.  Sometimes following a devastating, catastrophic event like war (like Weimar Germany after World War II).  But sometimes it doesn’t need a devastating, catastrophic event.  Just unrestrained government spending.  Like in Argentina throughout much of the 20th century.

During bad economic times, businesses often have more goods and services than people are purchasing.  Their sales will fall.  They may cut their prices to try and boost their sales.  They’ll stop expanding.  Because they don’t need as much supply for the current demand, they will cut back on their output.  Lay people off.  Some may have financial problems.  Their current revenue may not cover their costs.  Some may default on their loans.  This makes bankers nervous.  They become more hesitant in lending money.  A business in trouble, then, may find they cannot borrow money.  This may force some into bankruptcy.  They may default on more loans.  As these defaults add up, it threatens a bank’s ability to repay their depositors.  They further reduce their lending.  And so it goes.  These loan defaults and lack of lending decreases the money supply.  We call it deflation.  We call deflationary periods recessions.  It means the economy isn’t growing.  The money supply decreases.  Prices go down.

We call this the business cycle.  People like the inflation part.  They have jobs.  They’re not too keen on the deflation part.  Many don’t have jobs.  But too much inflation is not good.  Prices go up making everything more expensive.  We then lose purchasing power.  So a recession can be a good thing.  It stops high inflation.  It corrects it.  That’s why we often call a small recession a correction.  Inflation and deflation are normal parts of the business cycle.  But some thought they could fix the business cycle.  Get rid of the deflation part.  So they created the Federal Reserve System (the Fed) in 1913.

The Fed is a central bank.  It loans money to Federal Reserve regional banks who in turn lend it to banks you and I go to.  They control the money supply.  They raise and lower the rate they charge banks to borrow from them.  During inflationary times, they raise their rate to decrease lending which decreases the money supply.  This is to keep good inflation from becoming bad inflation.  During deflationary times, they lower their rate to increase lending which increases the money supply.  This keeps a correction from turning into a recession.  Or so goes the theory.

The first big test of the Fed came during the 1920s.  And it failed. 

THE TWO WORLD wars were good for the American economy.  With Europe consumed by war, their agricultural and industrial output decline.  But they still needed stuff.  And with the wars fought overseas, we fulfilled that need.  For our workers and farmers weren’t in uniform. 

The Industrial Revolution mechanized the farm.  Our farmers grew more than they ever did before.  They did well.  After the war, though, the Europeans returned to the farm.  The American farmer was still growing more than ever (due to the mechanization of the farm).  There were just a whole lot less people to sell their crops to.  Crop prices fell. 

The 1920s was a time America changed.  The Wilson administration had raised taxes due to the ‘demands of war’.  This resulted in a recession following the war.  The Harding administration cut taxes based on the recommendation of Andrew Mellon, his Secretary of the Treasury.  The economy recovered.  There was a housing boom.  Electric utilities were bringing electrical power to these houses.  Which had electrical appliances (refrigerators, washing machines, vacuum cleaners, irons, toasters, etc.) and the new radio.  People began talking on the new telephone.  Millions were driving the new automobile.  People were traveling in the new airplane.  Hollywood launched the motion picture industry and Walt Disney created Mickey Mouse.  The economy had some of the most solid growth it had ever had.  People had good jobs and were buying things.  There was ‘good’ inflation. 

This ‘good’ inflation increased prices everywhere.  Including in agriculture.  The farmers’ costs went up, then, as their incomes fell.  This stressed the farming regions.  Farmers struggled.  Some failed.  Some banks failed with them.  The money supply in these areas decreased.

Near the end of the 1920s, business tried to expand to meet rising demand.  They had trouble borrowing money, though.  The economy was booming but the money supply wasn’t growing with it.  This is where the Fed failed.  They were supposed to expand the money supply to keep pace with economic growth.  But they didn’t.  In fact, the Fed contracted the money supply during this period.  They thought investors were borrowing money to invest in the stock market.  (They were wrong).  So they raised the cost of borrowing money.  To ‘stop’ the speculators.  So the Fed took the nation from a period of ‘good’ inflation into recession.  Then came the Smoot-Hawley Tariff.

Congress passed the Smoot-Hawley Tariff in 1930.  But they were discussing it in committee in 1929.  Businesses knew about it in 1929.  And like any good business, they were looking at how it would impact them.  The bill took high tariffs higher.  That meant expensive imported things would become more expensive.  The idea is to protect your domestic industry by raising the prices of less expensive imports.  Normally, business likes surgical tariffs that raise the cost of their competitor’s imports.  But this was more of an across the board price increase that would raise the cost of every import, which was certain to increase the cost of doing business.  This made business nervous.  Add uncertainty to a tight credit market and business no doubt forecasted higher costs and lower revenues (i.e., a recession).  And to weather a recession, you need a lot of cash on hand to help pay the bills until the economy recovered.  So these businesses increased their liquidity.  They cut costs, laid off people and sold their investments (i.e., stocks) to build a huge cash cushion to weather these bad times to come.  This may have been a significant factor in the selloff in October of 1929 resulting in the stock market crash. 

HERBERT HOOVER WANTED to help the farmers.  By raising crop prices (which only made food more expensive for the unemployed).  But the Smoot-Hawley Tariff met retaliatory tariffs overseas.  Overseas agricultural and industrial markets started to close.  Sales fell.  The recession had come.  Business cut back.  Unemployment soared.  Farmers couldn’t sell their bumper crops at a profit and defaulted on their loans.  When some non-farming banks failed, panic ensued.  People rushed to get their money out of the banks before their bank, too, failed.  This caused a run on the banks.  They started to fail.  This further contracted the money supply.  Recession turned into the Great Depression. 

The Fed started the recession by not meeting its core expectation.  Maintain the money supply to meet the needs of the economy.  Then a whole series of bad government action (initiated by the Hoover administration and continued by the Roosevelt administration) drove business into the ground.  The ONLY lesson they learned from this whole period is ‘inflation good, deflation bad’.  Which was the wrong lesson to learn. 

The proper lesson to learn was that when people interfere with market forces or try to replace the market decision-making mechanisms, they often decide wrong.  It was wrong for the Fed to contract the money supply (to stop speculators that weren’t there) when there was good economic growth.  And it was wrong to increase the cost of doing business (raising interest rates, increasing regulations, raising taxes, raising tariffs, restricting imports, etc.) during a recession.  The natural market forces wouldn’t have made those wrong decisions.  The government created the recession.  Then, when they tried to ‘fix’ the recession they created, they created the Great Depression.

World War I created an economic boom that we couldn’t sustain long after the war.  The farmers because their mechanization just grew too much stuff.  Our industrial sector because of bad government policy.  World War II fixed our broken economy.  We threw away most of that bad government policy and business roared to meet the demands of war-torn Europe.  But, once again, we could not sustain our post-war economy because of bad government policy.

THE ECONOMY ROARED in the 1950s.  World War II devastated the world’s economies.  We stood all but alone to fill the void.  This changed in the 1960s.  Unions became more powerful, demanding more of the pie.  This increased the cost of doing business.  This corresponded with the reemergence of those once war-torn economies.  Export markets not only shrunk, but domestic markets had new competition.  Government spending exploded.  Kennedy poured money into NASA to beat the Soviets to the moon.  The costs of the nuclear arms race grew.  Vietnam became more and more costly with no end in sight.  And LBJ created the biggest government entitlement programs since FDR created Social Security.  The size of government swelled, adding more workers to the government payroll.  They raised taxes.  But even high taxes could not prevent huge deficits.

JFK cut taxes and the economy grew.  It was able to sustain his spending.  LBJ increased taxes and the economy contracted.  There wasn’t a chance in hell the economy would support his spending.  Unwilling to cut spending and with taxes already high, the government started to print more money to pay its bills.  Much like Weimar Germany did in the 1920s (which ultimately resulted in hyperinflation).  Inflation heated up. 

Nixon would continue the process saying “we are all Keynesians now.”  Keynesian economics believed in Big Government managing the business cycle.  It puts all faith on the demand side of the equation.  Do everything to increase the disposable money people have so they can buy stuff, thus stimulating the economy.  But most of those things (wage and price controls, government subsidies, tariffs, import restrictions, regulation, etc.) typically had the opposite effect on the supply side of the equation.  The job producing side.  Those policies increased the cost of doing business.  So businesses didn’t grow.  Higher costs and lower sales pushed them into recession.  This increased unemployment.  Which, of course, reduces tax receipts.  Falling ever shorter from meeting its costs via taxes, it printed more money.  This further stoked the fires of inflation.

When Nixon took office, the dollar was the world’s reserve currency and convertible into gold.  But our monetary policy was making the dollar weak.  As they depreciated the dollar, the cost of gold in dollars soared.  Nations were buying ‘cheap’ dollars and converting them into gold at much higher market exchange rate.  Gold was flying out of the country.  To stop the gold flight, Nixon suspended the convertibility of the dollar. 

Inflation soared.  As did interest rates.  Ford did nothing to address the core problem.  During the next presidential campaign, Carter asked the nation if they were better off than they were 4 years ago.  They weren’t.  Carter won.  By that time we had double digit inflation and interest rates.  The Carter presidency was identified by malaise and stagflation (inflation AND recession at the same time).  We measured our economic woes by the misery index (the unemployment rate plus the inflation rate).  Big Government spending was smothering the nation.  And Jimmy Carter did not address that problem.  He, too, was a Keynesian. 

During the 1980 presidential election, Reagan asked the American people if they were better off now than they were 4 years ago.  The answer was, again, ‘no’.  Reagan won the election.  He was not a Keynesian.  He cut taxes like Harding and JFK did.  He learned the proper lesson from the Great Depression.  And he didn’t repeat any of their (Hoover and FDR) mistakes.  The recession did not turn into depression.  The economy recovered.  And soared once again.

MONETARY POLICY IS crucial to a healthy and growing economy.  Businesses need to borrow to grow and create jobs.  However, monetary policy is not the be-all and end-all of economic growth.  Anti-business government policies will NOT make a business expand and add jobs no matter how cheap money is to borrow.  Three bursts of economic activity in the 20th century followed tax-cuts/deregulation (the Harding, JFK and Reagan administrations).  Tax increases/new regulation killed economic growth (the Hoover/FDR and LBJ/Nixon/Ford/Carter administrations).  Good monetary policies complimented the former.  Some of the worst monetary policies accompanied the latter.  This is historical record.  Some would do well to learn it.

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