Nobody Understands Debt… Least of All Paul Krugman

Good evening, freedom lovers!

A friend of mine posted a link on Facebook to this Paul Krugman article in the New York Times.  Call me an onerous libertarian, call me a stickler for the Austrian school of economics, but honestly, it blows my mind that people listen to this man.  What he says has no basis in reality at all.

If you don’t feel like reading it, the basic idea behind it is that the US debt is irrelevant, because it’s mostly money that we owe to ourselves.  He also says that it’s not that big a deal because as long as our tax base is growing faster than our debt, we’re fine.  Does this sound like shaky ground to anyone besides me?

He talks about people waiting for interest rates to go soaring, citing the Heritage Foundation in particular as a group that has been waiting for this very action.  Well, the Federal Reserve holds the key to the interest rates; it keeps them artificially low.  Were it not for the Fed, interest rates likely would be soaring.  Interest rates serve as a marker for malinvestment, but when those rates are kept low such as we are seeing right now, there is no cue for businesses to stop investing in an area that doesn’t serve the market.  Instead, the malinvestment continues, and the market never rights itself.

What Krugman never points out here is that continual debt creation is a necessity in a fractional reserve banking system.  I have explained in previous articles how banks create money out of thin air to be loaned to other people.  I am not going to give you a re-tread, but you would like a refresher on how the fractional reserve system works, check out this article from the Mises Institute by Robert P. Murphy.  Essentially, if all debts, government and private, were to be paid off, the money supply would effectively cease to exist.  As such, the debt is a fairly decent indicator of how much money exists on the market today.

So why is that problematic?  Easy.  Hyperinflation.  Remember Weimar Germany?  They turned on the printing presses, and look how that worked out for them?  By the time it was all said and done, their money was better suited for heating the house than for buying goods and services.  And unfortunately, we are running headlong down a path that ends with the same fate.

This is not some ruse to scare people.  I am not irritated and going against Krugman just for the sake of being contrary.  When the money supply continues to expand at ever-increasing rates, it is natural that the value of the money will go down because the money is not scarce.  Now, that might not be easy to see in the eyes of the average American.  A lot of folks are struggling to put food on the table.  Money, for these people, does seem like a scarce thing.  However, it isn’t scarce for banks and other direct benefactors of the Federal Reserve’s policy of easy money.  It’s interesting that most Keynesians are so vehemently against “trickle down economics” when it seems like that’s what they’re advocating: pump more money into banks and hope that the American people get some of it!  Well, the middle classes and the poor are the very last people to see that money.

As for the WWII debt not mattering, well, our economy flourished in spite of our debt after the war.  Why?  Because most every other country in the world had to buy goods from us to get their economies up and going again.  America mobilized in a way never before seen in history in order to help win the war.  We were a manufacturing powerhouse, and that’s not bragging; it’s a simple fact.  Because we suffered very little on our home soil, we were in an excellent position to bail others out in the post-war era.  Thus, we were able to pay down our debt.  As everyone knows, the times have changed.

My final (major) beef with this article is the insinuation that the government should be spending money on unemployment.  The government should be doing no such thing.  Taxes do not create wealth.  The government never has and never will be the creator of wealth.  Only the private sector can create wealth, and by increasing taxes on the American people, the result will only be a further destruction of jobs.

For example, let’s say that the rate of taxation for small business is increased by 6%.  That seems like a relatively small number, right?  Let’s then assume that the business has an annual gross income of $950,000.  Now, let’s say that the business has three employees, plus the owner-CEO.  The owner pays himself an annual salary of $75,000.  The three employees are each paid an annual salary of $32,000.  This amounts to exactly 18% of the company’s gross.  An annual 6% tax increase would cost $57,000 for that business.  That is nearly equivalent to the yearly pay for two of the three employees.  When looked at from this perspective, it is much easier to see why that business owner might want to keep that money for the business.  Maybe the business needs new equipment.  Maybe the employees need/want a better health or dental plan.  Maybe the owner wants to increase the size of the business and hire another employee.  These prospects potentially go out the window with the tax hike.

When you judge Krugman’s logic from all angles, it makes you wonder what he’s thinking.  In a nutshell, he is advocating that the Fed continue printing money, that the government raise taxes on all Americans, and that the government spend more money.  How the hell does he think we got into this mess, anyway?

I Wish OWS Stood for “Occupy Washington, Stupid!”

Occupy Wall Street still seems to be bringing the turmoil to cities across the country.  I would like to start off by saying that I think it’s great that folks are exercising their freedom of speech – when they aren’t being maced by John Law – and their right to make a peaceful stink in public.  That said, I still think OWS has missed the boat on the fundamental reasons why this whole financial catastrophe has come about in the first place.  I know that I might as well wish for the moon, but I really wish some “End the Fed” protestors would make the rounds at these things and get some more people educated.  That might bring a bit more direction and sense to OWS, which unfortunately seems to lack a clear focus about what it wants.  The movement, as a whole, knows it’s pissed off, but doesn’t really know what to do to go about getting anything done.  There is no clear platform here.  And yes, this is another post about monetary policy.

There is a great illustration that was created by a guy named James Sinclair, and it looks like this:

In a lot of respects, they’re upset about the same things.  The main differences are that OWS protestors tend to be young adults or students with a socialist tendency while Tea Party members tend to be middle-aged and kinda like Sarah Palin.  Well, I don’t like socialism or “Sexy Sarah,” but I do think it would be nice if some of the “End the Fed” elements popped up more often.

The truth is that the current financial crisis was not created by Wall Street, as such; it was created by the Federal Reserve.  Both current Fed chair Ben Bernanke and his predecessor, Alan Greenspan, are both known for targeting inflation.  That is, they take a look at one measure of the economy – the consumer price index (CPI), for example – and then move to keep that index on a target rate of inflation.  They become fixated on that index and that number.  Without Fed intervention, the market would extend credit based on savings, and investors would take risks based on the rate of returns on capital investment.  The central bank’s manipulation of the money supply, however, throws these things off.

The Austrian business cycle essentially states that the whole thing begins when a central bank buys up assets, which directly leads to the banks expanding credit.  The result here is that prices and inflation concurrently go up.  Businesses will tend to borrow more and, when this money comes onto the market, it will artificially lower interest rates.  The problem here is that when interest rates are artificially low, investments that might have otherwise looked like a losing proposition to business owners will suddenly look far more palatable, and these businesses will start buying up capital goods.  To quote Murray Rothbard: “In short, businessmen react as they would have if savings had genuinely increased: they move to invest those supposed savings.”  I bet you can see where all this is going.

Rothbard continues to explain that, because of an excess of work in the capital goods industries, worker wages are bid higher and higher.  The workers will, in turn, begin to spend this money.  Unfortunately, the lower interest rates reflect saving that is not really happening, and saving is necessary for capital investment to occur successfully.  In effect, businesspeople have a false perception of the real amount of capital available to them.  They have been tricked into believing that people are saving more than they really are.

So what happens when consumers start to get back into their old savings/consumption routine?  Bad news bears, that’s what happens.  Businesses realize that they have invested too much in production goods and not enough in consumer goods.  At this point, an economic depression occurs.  It should be noted, however, that depressions are a necessary evil in the business cycle, for that is the time when bad investments are liquidated and the market rights itself.  As unsavory as it may be, liquidation in the market is vital.

The question now might be this: how is it that booms are allowed to go on for years and years without any retribution, so-to-speak?  This is where you might want to start penning a “thank you” note to the Fed.  By continually increasing the money supply over and over again, the system never has a chance to right itself.  Consumer spending habits never find their norm, and the cost of the capital goods industry never catches the rise in prices.  Only when the banks finally start to become unstable must the money supply be contracted.

Still with me?  Hang in there.  We’re almost at Ground Zero of the current financial crisis.

The problem now is that the Fed is keeping interest rates artificially low.  In effect, they are continuing to expand credit at a time when it oughtn’t to be extended at all.  The Fed continues to print money every day by holding interest rates so low.  They accomplish this, in part, by buying up long-term Treasury bonds (quantitative easing).  They used to only purchase short-term bonds – ones that matured within days to months – but because the interest rates on them are so low, the Fed has turned to buying longer-term bonds.  This has the result of ticking off our foreign debt holders (like China), weakening the dollar, and it’s also going to directly lead to undervaluing risk and misplacing scarce capital – things we can hardly afford at this stage of the game.

I know that I’ve said this time and time again, but I’m going to repeat myself.  (Those of you who know me will be used to that!)  I say again that there will come a time to pay the piper.  We cannot continue to monetize an ever-growing debt.  There must be a correction, and we are only prolonging the time until that eventual day arrives.  And when it does arrive, it is going to speak with authority.

At this point, I’ll bring us back to my original comparison of OWS and the Tea drinkers.  They’re mad about a lot of the same things, quite rightly.  There aren’t enough parties, however, in either camp who truly understand why the US is in its current situation.  It is vital that both camps understand what is really driving this crisis, and then maybe we will begin to see some real results, instead of the usual left-right paradigm repeating itself ad nauseum.

Note: I used the following articles and books to help me write this post.  Hop on over to Cato and Mises.  They will give you a thorough and academic run-down on Austrian economics and the business cycle that is far superior to anything I could ever hope to print.  Have a look!

 Malfeasant Central Bankers, Again
Business Cycle Primer
Tea Party, Meet Occupy Wall Street
For a New Liberty – Murray Rothbard

Predictable: European Leaders Calling for Further Integration

I am generally unsurprised by the European meltdown.  I mean, the way that their banking system is set up doesn’t exactly induce member states to live by their means.  In the wake of this meltdown, European leaders are calling for closer integration which, in my mind, is just about the last thing these folks need.  I’ve found two articles today where in Angela Merkel, the chancellor of Germany, and Jose Barroso, EU Commission President, claimed that Europe needs to be more closely bound in order for the Euro to survive.  I have no idea what logic they’ve used to arrive at this faulty conclusion, but they’re wrong.

We need to look at why Europe is in this trouble in the first place.  The European Central Bank operates in much the same way that the Fed does, except that it is a “produce money and lend” (PML) approach, while the Federal Reserve used the “produce money and purchase” (PMP) approach.  Although the process is similar, says Philipp Bagus via the Mises Institute, the results are the same: the money supply is expanded, which allows governments to keep living beyond their means.

I will admit that the article, while excellent, can be a bit, well, scholarly (i.e. boring for most people and hard to read in parts).  Nonetheless, it has diagrams that go along with it to show the reader exactly how the money supply is being inflated.  Let’s start with the Fed.  In a nutshell, the government issues bonds or, as they are commonly referred to, T-Bills.  The government must pay interest on these T-bills.  The Fed buys them in an open-market scenario which, according to Bagus, “monetizes the debt in a way that does not hurt politicians.”  Basically, politicians make a promise to pay at a later date for money they spend today.  The government pays interest to the bond’s new owner, the Fed.  At the end of the year, the Fed pays a bulk of its interest profit back to the government.  When the bonds mature and the principal must be paid in full, the government simply issues new bonds to pay the principal on the old ones and continues the cycle of monetizing the debt.

At the same time as the Fed is buying government bonds, it will also allow credit extensions to private banks, which operate on the fractional reserve system.  Fractional reserve banks loan out money at a rate of about 6:1, meaning that, at any point, they are unable to pay back all of their depositors’ cash.  Essentially, the Fed uses the interest money to expand the supply of credit to the banks.

In the case of the ECB, it receives the government bonds from banks, rather than directly from the government itself.  The banks use those government bonds as collateral against ECB money, which it then loans out at interest.  At this point, you can see how fractional reserve banks are inherently bankrupt, for they are always increasing the money supply at a greater rate than they would be able to pay back, were those loans ever recalled and the money supply contracted.

In any case, since the bonds are merely collateral held by the ECB, the bonds still belong to the private banks, and the governments pay interest to the banks, rather than to the ECB directly.  The banks then pay interest on their loans from the ECB, and the ECB provides a portion of its profits to the governments.  In one sense, the Fed is actually more up-front about its dealings, because we can see the bonds on its balance sheets, whereas the ECB doesn’t directly declare this, since the bonds are still property of the banks.  The effect is essentially the same, with the major difference that the profits are often distributed unequally between participating governments, and this is where we run into problems with the likes of Greece, Italy, Spain, Ireland, and anyone else who needs a bailout this week.

Basically, what has happened is that banks have been buying up Greek bonds when they should have been rejecting them outright.  The whole fiat/fractional reserve system avoids meltdown by being held in check by the behavior of other banks.  In truth, there is very little to prop up the system, once it begins to spiral out of control, which is exactly what we’re seeing now.

The problem with Europe is what is commonly referred to in economics as a “tragedy of the commons.”  Because of the misdeeds and irresponsibility of a few, everyone is going to suffer.  In this case, Greek bonds were being purchased for rates similar to German bonds, but the Greek government was spending at a furious rate.  Now that banks aren’t buying Greek bonds, the interest rates have gone up, and the Greeks have been left out in the cold, unable to monetize the debt.  That’s why the news media keeps bleating on about Greece raising taxes on everything – heretofore, they were able to avoid raising taxes by monetizing the debt via the ECB.  Now everyone is going to end up paying for the misdeeds of individual as well as the EU government.

I hardly see how closer integration is going to solve anything, as the EU government has been a vehicle in creating this catastrophe.  It seems more likely that countries like Germany and France will force out the economically impoverished ones such as Greece, although none of Europe is in a glowing situation right now.  The only reason I can figure for Merkel and others calling for closer integration is so that there will be more regulation on the banking sector.  Still, I don’t know how that’s going to solve the essential problem that is inherent to all banking systems such as these.  It seems a far better idea to let go of this half-baked idea about the Euro and go back to currencies that are printed by the governments themselves.  It might not be such a bad idea back home, either!

Note: I owe Philipp Bagus a debt, as I used some of his ideas and source material to help me write this article.  While I have some different ideas about intellectual property, I wouldn’t want to begrudge a true scholar the recognition he deserves.  Please head over to the Mises Institute and check out his articles.  He makes the mess in Europe seem crystal clear.

“The Bailout of Greece and the End of the Euro”
“The Fed and the ECB: Two Paths, One Goal”
“The Commons and the Tragedy of Banking”