The months following the collapse of the credit markets have brought us further confirmation that we are headed for a depression. GDP, retail sales, commodity prices and market sentiment all point to a depression. The situation we are in is much more than an average recession, because we are in the process of deleveraging (a situation where more debt is payed back than is taken out).

Having been revised from a previous -3.8%, US GDP fell 6.2% in the fourth quarter. 3.0 million jobs were lost in 2008 and around 4 million have been lost since the beginning of the recession. According to the Labor Department, the United States is 5 million jobs away from full employment. Although the commonly cited jobless rate, the U-3 is at 8.1%, the situation is much more dire when one takes a look at U-6, the total unemployment rate. Currently, the U-6 is over 14%!

As consumer confidence has been falling, the savings rate has been increasing. At least this one is a positive sign for the United States, whose savings rate dropped below zero for a few quarters just a while back. But the numbers for consumer spending and car sales are not great. In fact, it’s actually a good thing that the consumer has realized the situation the country is in and has decided to cut back on spending. It’s the only way to go and the government should do the same. The United States has been running a fiscal and trade deficit for years and the total debt of the US government now exceeds $50 trillion (social security, Medicare, Medicaid, miccelanous).

Of course, China and Japan, who are the biggest foreign creditors of the United States aren’t going to stop funding the United States anytime soon as they both are interested in the well-being of their trade partner. Matters are worse as they stand, as you can see from the graph above, no need to make it worse by dumping American debt. A further slowdown in exports would really damage the Japanese economy as it has already shrunk a mind-blowing 12.7% in Q4 (I have a feeling that the revised number is going to be even worse).

But things are not only bad in the United States, they are also bad in Europe, which lacks a central government on fiscal and monetary policy. This makes solving the crisis much more difficult. The European Central Bank, when making a decision as whether to increase or decrease interest rates has to balance the various statistics that are fed to it across the eurozone, which now consists of 15 member states. Because the local central banks still have a say in the policy, it is much more difficult for the ECB to make a decision that fits each and every one of the countries affected.

As most of us know by now, the main reason behind this credit crisis was a real estate boom and the securitization (in a less than mildly regulated environment) that followed. Because the bank managers only thought about money in their pocket before the crisis had arrived, they lent out money to Eastern European banks en masse, asking very little interest in return. ECB rates were down and the large commercial banks of West and Central Europe had to compete with each other to give away their money. Of course, now they have realized the problems they created. And, as usual, now is a bit too late to start thinking about reserves and possible risks of devaluation, since a large number of Eastern Europe’s currencies have already been devaluated. Although some American economists and financial experts like John Mauldin have been talking about panic and bank runs in Eastern Europe, the reality looks a lot different. Anyone who is interested in Eastern European economies should read European business authors.

The last three days we have had a really on the stock markets and all the major indeces are off their lows. But beware as this is not a really of investors parking their money, this is trader money (fast money), it’s out of the market as soon as the market dips down again. We are headed for new lows. The time is not right to start investing just jet, at least not on a broad base (but there are always some companies that outshine others, even during a time of crisis).

The  leaders of the world run around telling everybody that now is the time for action and the time for discussion is over. The loudest plea for action comes from the new president of the United States, Barack Obama. Of course, in a time of crisis, immediate action is necessary. When a man gets shot, there is not debate over what to do because everyone knows that you need to get the bullet out and the wound closed.

When it comes to the economy, things are far more complicated. President Obama has put forth a stimulus package, titled American Recovery and Reinvestment Act of 2009, which weighs in at around $800 billion. Mr. Obama has repeatedly emphasized the need to invest in infrastructure, education and energy projects to get the economy going again. But according to the Congressional Budget Office cost estimate, only $92 billion would be spent fiscal year 2009 (ending in September 30, 2009), with another $225 billion spent in 2010 and another $159 in 2011. Furthermore, only around $70 billion of that would be spent on infrastructure.

The Obama stimulus package is clearly about Democratic pork, not stimulating the economy. And even though there is all this talk about renewable energy, only $18.5 B of would be spent on renewable energy and energy efficiency (according to the original plan outlined in the CBO report). And only $4.5 billion would be spent on modernizing the electrical grid, which is the backbone of any developed economy. In fact, it was the high energy prices that led to high inflation and decreased spending in 2008.

Clearly, right now is the time for discussion, not “bold” and “swift” action, especially when considering the span over which the money would be spent. It is important to remember that Obama is good with words, but that doesn’t necessarily mean that he and his administration knows what’s best for the economy as demonstrated by the CBO report.

Spending like there is not tomorrow

Imagine a situation where a man has a cardiac arrest. The doctor gives him two options: either stop smoking, start exercising and eating right; or take drugs that will make him feel better. Now, the obvious choice should be the first one and this is the only viable option in the long term. Taking pills won’t cure him, it will only make the pain go away for a while. Eventually, he is going to have to change his lifestyle.

The economies of the US and many Western countries face a similar decision – they can either cut spending and eliminate inefficient and unsuccessful state programs that are a drain to the state’s budget; or they can print new money, increase taxes and fees and sell more government bonds to finance their ever-increasing spending. Fortunately, the general public is not falling for Obama’s rhetoric and there is some real discussion over his plans in the media. But what we lack right now is a full out discussion over the soundness of Keynesian economics, which is the theory behind the whole spending concept.

Short term fix for a long term problem

The size of the US economy is around $14.3 trillion and spending $90 – 200 billion to stimulate the economy is a drop in the bucket. Financing this enormous recovery package is not going to be easy – the US government can’t really raise taxes, in fact, they are proposing the opposite. So the only two options left are issuing more government bonds or monetizing debt by printing new money. In essence, this is equal to taking away money from the public, thereby decreasing their ability to spend, but this is ignoring the fact that the stimulus package is intended to promote spending! So in essence they are taking the money away only to give it back again! This is like taking a hundred dollars from the right pocket, putting it into the left one and claiming you are wealthier. It’s preposterous!

Eventually the US is going to have to repay all that debt. During 2009, the US has to find buyers for $2.2 trillion dollars worth of Treasury bills and bonds (the size of the US budget for fiscal year 2008 was $2.979 trillion). This will drive the interest rate higher for commercial bonds and will further exacerbate the state of the US economy as companies will cut spending and lay off millions of people. In the short run, the stimulus package might work, although the odds for it happening are increasingly slim. In the long run, the US is deeply in trouble and needs to pull it’s act together by spending less, saving more and actually producing stuff, not only consuming it.

Outlook for the world

Even though I’ve been focusing on the US economy, the outlook for the world is pretty bleak as well. The bank bailouts have only had a mild effect on the economy and the financial sector, but they haven’t had a positive effect of the banks’ willingness to lend money, which is why these bailouts were given to them in the first place. This can be attributed to the “boldness and swiftness”, or in other words, blind impulsiveness. The packages were pushed through in a hurry and there wasn’t much debate about how the money should be used. In the case of the TARP, the outlook is even worse as the Treasury Department doesn’t have to tell anyone how the money has been used.

The economies of the world are interconnected and the whole world has gone through a simultaneous real estate boom and a successive crash. Due to the interconnectedness of the commercial banks, there is not really a great amount of hope out there, the credit market is cold as ice and the current trends point to a decrease in the amount of outstanding debt (meaning that more loans are paid back than are taken out).

More on the Greatest Depression in the coming days, when I will be looking at the data – unemployment numbers, GDP, auto sales, exports etc. Also, we’ll be taking a look a other countries’ statistics.

Further reading:
Arnold Kling: Against the Big Stimulus
Martin Fackler (NYT): Japan’s Big-Works Stimulus Is Lesson
Anthony Gregory: Jobs Government Creates, and Destroys
Richard Benson (FSN): Keynes, Upside Down

What are your thoughts on the stimulus package?

This is the second article in the capitalism series. Here are the previous ones: The Breaking Point of the Current Economic System, In Defense of Capitalism.

The current economic system failed due to many mistakes in the underlying economics theory. First of all, the current economic system is not based on sound money, as discussed in the previous post. This makes free capitalism impossible, as the creation of new money always creates inflation and makes saving, one of the supposed pinnacles of a capitalist society, impossible as the money deteriorates in value over time. But the current system is also heavily reliant on Keynesian economics, whereby the state is responsible for improving the stability of the private sector, and thus the whole economy.

The evil of inflation

Inflation is the depreciation of a currency due to increased supply. Inflation has a direct impact on prices, as more money + same amount of goods as before = higher prices. But the prices are only relatively higher, reflecting only the increased supply of currency. Due to the fact that the Federal Reserve and other central banks can print as much money as they deem necessary, there is really no protection from inflation. One cannot predict it and one cannot even hope to measure it, because over time the US government has changed the computation methods for CPI (consumer price index) and PPI (producer price index) to reflect the needs of the Treasury Department not the real inflation, thus making sure that the interest rate at which the US government borrows money is kept as low as possible.

The creation of new money (which some like to think is new wealth) debases the value of money that was in the system before, hence making saving money ridiculous. This has led to the creation of mutual funds, hedge funds and pension funds of all sorts. People trust their money with the bankers because they know that inflation is going to eat it up anyway. And although there is inherently nothing wrong with people investing their money in stocks, bonds and other securities, it is wrong if this is an inescapable situation. Think of this way: you are given two options:
1) lose money for sure (through inflation) by doing nothing, ie. Keeping your money on a savings account; or
2) trust your money with the bankers, who will grow your money and take care of it like it was their own child, while also filling their pockets with fees and bonuses and also retaining the option of a complete failure (there are plenty of examples of market crashes)

Usually, the people look at those two options as if they were the only ones, leaving out the third option, which would look something like this:
3) establish a new gold standard and make it a free choice as whether to save or invest

The evil of Keynes

According to Keynesian economics, which the US has been using for the past half century, the state should stimulate economic growth and improve stability in the private sector – through, for example, adjusting interest rates and taxation and funding public projects [1].

People are so accustomed to this kind of interpretation of the government’s role in society that they are no longer able to see the inherent flaws in this kind of argument. They no longer have criticism for this kind of behavior, but they most certainly should. By wanting to improve stability, the state creates many programs, which are thought of as temporary at first. But over time, these turn into long-term money drainers, which become a burden to state, which in turn has to find new ways to fund it’s budget, which leads to higher taxes, direct and indirect. The Federal Reserve system in a gift for the politicians of today, because it allows them to spend money that they don’t have – they can just print it if they need it. It is the lack of a gold standard that gives the state the means to increase spending without consent form the voters.

At first, the state’s problems are few, but over time they accumulate as the state, or rather the politicians who are after our votes, suddenly find that the state now has to increase funding for public health, education and even manufacturing (GM and Chrysler bailouts). For the easily distracted voter, this might seem like a good idea as the wealth is recycled in society and given to those in need. But this kind of argumentation lacks in common logic! By creating taxpayer funded public programs, the state essentially become a central planner. The fault of central planning is that it doesn’t consider any kind of limits. The Soviet manufacturing industry is a great example of this because the state owned all resources and manufacturing capabilities. It didn’t see the need to improve, to increase efficacy and quality. It didn’t have to because the state was omnipotent and capitalism or any other form of private enterprise was prohibited. This created huge waste and low quality products. But it is the same with state funded programs because when a state program runs out of funds, it can always tax its citizens or print new money.

Because the constitution or any other document does not limit government spending, it can increase spending ad infinitum. Because the state has taken upon itself the power of taxation, it can fund its programs without having to think of constraints. In a company, this would be quite different as it could only spend the money that it already has; or in the case of a loan, it could only spend the borrowed amount considering it’s ability to repay it in the future.

What all of this comes down to is liberty. I agree that the state should collect some taxes, to fund the police and firefighters, but this should be done on the local level and the amount of taxes that the state can collect should be limited. Roads and bridges aren’t built when and where they are needed, they are built according to the interests of political parties. Isn’t it strange that the road repair season always starts just before the elections?

According to Keynesian economics, the people at the Federal Reserve and in the government are always smarter than the market, thereby granting them the permission to control the economy. In reality, the market is way more complicated than the politicians would like to admit and one cannot hope to fix anything by increased state spending. But the politicians won’t admit this, because this would make the irrelevant, what they really are in terms of economics.

The use of Keynesian economics models has made each and every recession worse than the one before it. The state has been all over the place with its spending, never even thinking about letting the mistakes correct themselves. The Unites States government has been able to shorten the previous recession since WWII due to its spending, but in the long run, this kind of action is only going to make the end game so much worse. The spending will end with a dollar crisis, pulling the whole world down with it, because the dollar is the reserve currency of choice for most central banks, accounting for 64% of world reserves in 2007 [2]. This will hopefully lead to the creation of a new gold standard.

1.    definition from Wikipedia: http://en.wikipedia.org/wiki/Keynesian_economics
2.    from wikipedia according to IMF and ECB statistics http://en.wikipedia.org/wiki/Reserve_currency#Global_currency_reserves
Image courtesy: Federal Reserve

This is the second article in the capitalism series. Here is the previous one: In Defense of Capitalism.

The current economic system has failed miserably, but it wasn’t because of capitalism. As I will show you, it’s the exact opposite of it. It’s because the current economic system is not based on sound money and free trade. We don’t have free market capitalism, which would’ve made the system work; instead, what we have is a system where the select few are guaranteed a hefty profit no matter where the underlying economy is heading.

The gold standard

With the creation of the Bretton Woods system in 1944, the United States and 43 other countries agreed upon the rules for commercial and financial regulations under a tight monetary management system which was based upon the gold standard. An ounce of gold was valued at $35, and according to the new rules, for every 35 dollars in circulation, the US government would have to have an ounce of gold in their reserves. Other currencies were tightly tied to the dollar and due to increasing global trade, the US dollar became the reserve currency of the world.

This essentially meant that any one country with dollars on its balance sheet could go and exchange them for gold, which could then be used as a reserve or exchanged for another currency. Because the amount of dollars in circulation had to be consistent with the amount of gold reserves, any decrease in gold reserves would mean that a corresponding amount of dollar would have to be removed from circulation to keep the value of the dollar stable.

During the years that followed, the world saw a huge increase in economic activity. This was the greatest step toward free market capitalism because the creation of new money was tied to available reserves of gold in the vaults of the United States Treasury. As the system was based on honesty and mutual trust, it was vulnerable to deception, which is exactly what happened in the following years.

After the creation of the Bretton Woods system, the US held $26 billion in gold reserves, of an estimated $40 billion in total. As trade increased and the US started to produce less and consume more, it needed more dollars. The Eisenhower administration quickly placed import restrictions on oil all the while the Federal Reserve created huge amounts of new dollars to pay for the imports, all the while the gold reserves were only slightly increasing. What they did was they devalued the dollar on a consistent basis.

As gold prices rose on the London market, central banks of the world started to realize what was going on, they demanded gold for their dollars as they could buy the Bretton Woods gold for $35 and sell it on the London open market for a profit. Under increasing pressure from other countries, the US Treasury started the physical delivery of gold, while trying to suppress the London gold market by inflating the supply of gold (London Gold Pool) to maintain the dollar-gold fix at $35 an ounce.

In 1967, there was an attack on the British pound and a run on gold in the group of countries whose currencies were tied to the British pound sterling (the sterling area), which forced the British government to devalue the pound. Market participants bought increasing amounts of gold to secure their currencies, which led to the dissolving of the London Gold Pool.

Going off the gold standard

As increasing amounts of dollars were being printed to fund the Vietnam war and social programs, the US gold coverage deteriorated from 55% to 22%. The mounting pressure on the US dollar required decisive action from the government, which hence enacted numerous trade restrictions to keep the dollar from depreciating. In 1971, President Nixon cancelled the Bretton Woods system, in effect ending the convertibility of the dollar to gold and thus devaluing the dollar. This led to the creation of the floating rate currency system, in which the marketplace decides the value of a particular currency in relation other currencies. Of course, some currencies like the Chinese yuan are still tightly tied to the US dollar, but the reason behind that is to make Chinese goods cheaper for the American consumer. The currency markets have a huge daily turnover – about $5 trillion.

The following decades saw a huge increase in the amount of dollars in circulation, because now the Federal Reserve could now print as much as it pleased without having to worry about gold reserves. To this day, the US dollar accounts for about 60% of the total world currency reserves, one of the reasons being that it is artificially backed by gold and oil since all the trades done on oil and gold markets are done with dollars, which creates demand for them. This keeps the dollar relatively more valuable as companies are forced to buy dollar to be able to buy oil or gold. One of the reasons the price of oil spiked in the summer of 2008 was precisely because the value of the dollar fell 40% from 2001 (from 120 to 72). And isn’t it surprising that just before the Iraq occupation started in 2003, the Iraqi oil ministry decided to start selling oil for euros? Venezuela and Iran have been thinking about the same thing but haven’t done anything to this day.

Fiat money

Going off the gold standard means that the Federal Reserve can print as many new dollars as it wishes. Due to bank reserve rules, which command that a bank has to have only 10% of the deposits in reserves, the banks are able to lend out the remaining 90% of the deposits. Now, if a lender deposits that money on its bank account, the same thing happens again. This means that a million dollars will actually be turned, through numerous loans, into ten million dollars. It also means that the bank will not get a 4% profit (in the case of a 4% interest rate), but instead, a 40% profit – instead of 40,000 they will receive 400,000. What’s even worse is that in the case of a huge budget deficit, the Federal Reserve can create hyperinflation, which makes paying off foreign debt much cheaper, in the process wiping out all assets and deposits held in dollars.

The governments of the world have created the taxation system so there would be a demand for their central banks’ currencies. If the local government demands taxes in dollars, you earn dollars before you can pay your taxes. The whole world has been blinded by this system until now. Some economists are even debating over whether to create a new Bretton Woods agreement. A system which is governed by fiat money is not a free system and hence it cannot be called free market capitalism. In the next article, I will show you what led to the current financial crisis

In the recent months, capitalism has received a lot of criticism from a number of sources. The actions and words of politicians and central bankers have only exacerbated the situation. Some people have even blamed capitalism for the current unfolding financial crisis. To refute these claims, I have written a series of articles to explain the basics of why capitalism is good for society, why the current system is not based on sound money, why the current economic system failed and why we are headed for a depression.

Increase in living standards

Thanks to the capitalist system, we have witnessed an increase in living standards unrivalled by any other in human history. Before the industrial revolution, there were only the rich and the poor. Things have changed a lot since that time and you don’t have to be rich to afford housing, food, medicine, transportation and a vacation every now and then. The Green Revolution, led by the increased production of fertilizers and other agricultural chemicals, increased agricultural production, which increased the world population, which, in turn, gave birth to new industries that would have been unimaginable before.

A larger population means there is a bigger market, hence economies of scale were born. Economies of scale make everything from toothpaste and toilet paper to household appliances and cars affordable to the average person. This is only possible in a market where the producers are rewarded for their innovation. The fact that they produce better and cheaper goods only because they are interested in bigger profits is not of significant importance. Making a profit is not inherently bad and should not be viewed as such, because it is not only the companies that aim to increase their utility in life, but also the people who work for these companies. Money is the only thing that keep these companies in business, whereas in a planned economy it is the state that keeps the companies afloat. This means less innovation, more inefficiencies, more job injuries, lower quality standards et cetera, all due to no competition between companies.

Trade

“Productivity is what makes us rich. Specialization is what makes us productive. Trade allows to specialize.”[1]

These are the words of Charles Wheelan, from the book “Naked Economics” (a superb read). The point he is trying to make is pretty clear – we would not have the kind of specialization witnessed today without global trade because everyone would be growing wheat, weaving baskets and repairing their homes. The system is not perfect, illustrated by the fact that a large percentage of people still live below the poverty line, but I am not saying it is. Child workers in China and Thailand are clearly something we should try to change but not through boycotts and trade barriers. Not so long ago, Victorian England was using child labor and the only thing that led to the de facto abolishment of this, was economic development. It was economically more reasonable to use child labor in factories and have adults work on more complicated things, until the development and implementation of better machines that could replace child labor. Once again, I lend a helping hand from Mr. Wheelan:

“They are paid very little by Western standards because they accomplish very little by Western standards. If foreign companies are forced to raise wages significantly, then there is no longer any advantage to having plants in the developing world. Firms will replace workers with machines, or they will move someplace where higher productivity justifies higher wages. If sweatshops paid decent wages by Western standards, they would not exist. There is nothing pretty about people willing to work long hours in bad conditions for several dollars a day, but let’s not confuse cause and effect. Sweatshops do not cause low wages in poor countries; rather, they pay low wages because those countries offer workers so few other alternatives. Protesters might as well hurl rocks and bottles at hospitals because so many sick people are suffering there.”[2]

When you take a look at the facts, you will see that for a rural family in China, it is more sensible to send a child to work rather than send him to school, which bring with it additional expenses. What we are witnessing here is an economy in transition and the children are just inevitable victims of it. Over time, as their economy develops, people will have better access to education, which will lead to more skilled workers. Obviously, a person with a diploma will not be sowing together jeans; but maybe he will be designing a machines that would do the work better than humans or perhaps find a cure for cancer. The thing that keeps workers in sweatshops is not the mean capitalist, the oblivious consumer or the central planner; it is, rather, the combined effect of lack of skills and the need to earn income.

The price is right

The sensationalist news media is always on the hunt for market speculators because they make a great story for the masses, who usually do not understand basic economics. During the summer of 2008, crude oil prices were pushed to $147 a barrel, a price that was not sustainable, witnessed by the precipitous fall afterwards. The only reason the price was driven so high was the excess capital on the marketplace, which led investors and speculators to allocate their assets in commodities and stocks. One could argue that governmental price caps would keep these wild fluctuations from happening but this would completely miss the whole point of free markets. The idea behind a free, capitalist market is that companies will compete to offer the best product and the lowest price. Short-term fluctuations will occur every now and then due to the increased supply of goods, or, in this case, capital. If the state were to keep a lid on the price of goods and services, companies would have no interest in research and development and would halt new projects as soon as the market goes against them. When the price of producing something is bigger that the government mandated sale price, there would be no reason for the company to produce anything. It would simply seize to exist! In a free market, companies are allowed to adjust prices according to production costs, which will lead to long-term price stability because higher prices draw more investment, which makes for increased supply.

Capitalism created freedom

Capitalism has led to the development of highly specialized sciences, which the modern world is built upon. It has freed the human population from having to spend day after day on the field, growing food. This has led to the creation of true freedom in which a person is free to choose a lifestyle and occupation that best suits his needs and aspirations.

“Under capitalism, each person’s life is his or her own, not the property of the state, the public nor the “common good.” As capitalists, we are neither slaves nor masters, but traders whose relationships are voluntary and to mutual benefit. And while we are free to pursue happiness, we aren’t guaranteed to find it nor permitted to sacrifice other individual’s rights in order to obtain it.”[3]

Compare a capitalist society with a state planned society and you will see that capitalism is not about limits, it’s about choices. You are free to pursue your dreams, whatever they might be. There are so many success stories out there and you could be one of them. Choices require decisions and commitment, which is one of the reason so many people are unhappy with capitalism. Society has changed so much and people have not been able to keep up with it, they are confused and want someone to make those decisions for them. People of all races and nationalities want stability in life and in work. The rapid development of technology means that millions of people who used to do the work of machines have had to readjust their whole lives. But this should not be viewed as something inevitably bad, rather, it should be taken as a chance to start over, to learn new skills and develop into a better person for the good of society, but, more importantly, for the good of oneself. Learning new skills is not only about getting a better job, it is about pushing the limits of personal development, of finding out who you truly are and what you want from life. This allows you to take greater pleasure from your work and you life.

References
1. Charles Wheelan, “Naked Economics”, p 191
2. Charles Wheelan, “Naked Economics”, pp 201-202
3. “In Defense of Capitalism” by Jonathan Hoenig, Smart Money