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Why Obama's Stimulus Package
Is Doomed to Failure
Paper
mill on the Potomac
The paper
mill on the Potomac is furiously spewing up new money. According to the
manager of the mill, as indeed according to the Quantity Theory of Money, this
should stop prices from falling and the economy from contracting.
In this
article I present an argument why this conclusion is not valid. On the
contrary, I shall show that new money created on the strength of a flood of
new debt, is tantamount to pouring gasoline on the fire, making prices fall
and the economy contract even more. The Obama administration has missed its
historic opportunity to stop the deflation and depression inherited from the
Bush administration because it entrusted the same people with the task of
damage-control who had caused the disaster in the first place: the Keynesian
and Friedmanite money doctors in the Fed and the Treasury.
Watching
the wrong ratio
The key
to understanding the problem is the marginal productivity of debt, a concept
curiously missing from the vocabulary of mainstream economics. Keynesians
take comfort in the fact that total debt as a percentage of total GDP is
safely below 100 in the United States while it is 100 and perhaps even more
in some other countries. However, the significant ratio to watch is additional
debt to additional GDP, or the amount of GDP contributed by the creation
of $1 in new debt. It is this ratio that determines the quality of debt.
Indeed, the higher the ratio, the more successful entrepreneurs are in
increasing productivity, which is the only valid justification for going into
debt in the first place.
Conversely,
a serious fall in that ratio is a danger sign that the quality of debt is
deteriorating, and contracting additional debt has no economic justification.
The volume of debt is rising faster than national income, and capital
supporting production is eroding fast. If, as in the worst-case scenario, the
ratio falls into negative territory, the message is that the economy is on a
collision course and crash in imminent. Not only does more debt add nothing
to the GDP, in fact, it causes economic contraction, including greater
unemployment. The country is eating the seed corn with the result that
accumulated capital may be gone before you know it. Immediate action is
absolutely necessary to stop the hemorrhage, or the patient will bleed to
death.
Keynesians
are watching the wrong ratio, that of debt-to-GDP. No wonder they constantly
go astray as they miss one danger signal after another. They are sailing in
the dark with the aid of the wrong navigational equipment. They are
administering the wrong medicine. Their ambulance is unable to diagnose
internal hemorrhage that must be stopped lest the patient be dead upon
arrival.
Melchior
Palyi's early warning
In the
1950's when the dollar was still redeemable in the sense that foreign
governments and central banks could convert their short-term dollar balances
into gold at the fixed statutory rate of $35 per ounce, the marginal
productivity of debt was 3 or higher, meaning that the addition of $1 in new
debt caused the GDP to increase by at least $3. By August, 1971, when Nixon
defaulted on the international gold obligations of the United States
(following in the footsteps of F.D. Roosevelt who had defaulted on its
domestic gold obligations 35 years earlier) the marginal productivity of debt
has fallen below the crucial level 1. When marginal productivity fell below
$1 but was still positive, it meant that total debt (always 'net') was rising
faster than GDP. For example, if the marginal productivity of debt was
½, then $2 in debt had to be incurred in order to increase the
nation's output of goods and services by $1. An increase in total debt by $1
could no longer reproduce its cost in the form of an equivalent increase in
the GDP. Debt lost whatever economic justification it may have once had.
The
decline in the marginal productivity of debt has continued without
interruption thereafter. Nobody took action, in fact, the Keynesian managers
of the monetary system and the economy stone-walled this information, keeping
the public in the dark. Nor did Keynesian and Friedmanite economists at the
universities pay attention to the danger sign. Cheerleaders kept chanting:
"Gimme more credit!"
I learned
about the importance of the marginal productivity of debt from the privately
circulated Bulletin of Hungarian-born Chicago economist Melchior Palyi in
1969. (There were altogether 640 issues of the Bulletin; they are available
in the University of Chicago Library). Palyi warned that the tendency of this
most important indicator was down and something should be done about it
before the debt-behemoth devoured the economy. Palyi died a few years later
and did not live to see the devastation that he so astutely predicted.
Others
have come to the same conclusion in other ways. Peter Warburton in his book Debt
and Delusion: Central Bank Follies ThatThreaten Economic Disaster (see
references below) envisages the same outcome, although without the benefit of
the concept of the marginal productivity of debt.
The
watershed year of 2006
As long
debt was constrained by the centripetal force of gold in the system, tenuous
though this constraint may have been, deterioration in the quality of debt
was relatively slow. Quality caved in, and quantity took a flight to the
stratosphere, when the centripetal force was cut and gold, the only ultimate
extinguisher of debtthere is, was exiled from the monetary system. Still, it
took 35 years before the capital of society was eroded and consumed through a
steadily deteriorating marginal productivity of debt.
The year
2006 was the watershed. Late in that year the marginal productivity of debt
dropped to zero and went negative for the first time ever, switching on the
red alert sign to warn of an imminent economic catastrophe. Indeed, in
February, 2007, the risk of debt default as measured by the skyrocketing cost
of CDS (credit default swaps) exploded and, as the saying goes, the rest is
history.
Negative
marginal productivity
Why is a
negative marginal productivity of debt a sign of an imminent economic
catastrophe? Because it indicates that any further increase in indebtedness
would necessarily cause economic contraction. Capital is gone; further
production is no longer supported by the prerequisite quantity and quality of
tools and equipment. The economy is literally devouring itself through debt.
The message, namely that unbridled breeding of debt through the serial
cutting of the rate of interest to zero was destroying society's capital, has
been ignored. The budding financial crisis was explained away through ad
hoc reasoning, such as blaming it on loose credit standards, subprime
mortgages, and the like. Nothing was done to stop the real cause of the
disaster, the fast-breeder of debt. On the contrary, debt-breeding was
further accelerated through bailouts and stimulus packages.
In view
of the fact that the marginal productivity of debt is now negative we can see
that the damage-control measures of the Obama administration, which are
financed through creating unprecedented amounts of new debt, are
counter-productive. Nay, they are the direct cause of further economic
contraction of an already prostrate economy, including unemployment.
The head
of the European Union and Czech prime minister Mirek Topolanek has publicly
characterized president Obama's plan to spend nearly $2 trillion to push the U.S. economy out of recession as "road to hell". There is absolutely no reason to
castigate Mr. Topolanek for this characterization. True, it would have been
more polite and diplomatic if he had couched his comments in words to the
effect that "the Obama plan was made in blissful ignorance of the
marginal productivity of debt which was now negative and falling. In
consequence more spending on stimulus packages would only stimulate deflation
and economic contraction."
Hyper-inflation
or hyper-deflation?
Most
critics the Obama plan suggest that the punishment for the bailouts and
stimulus-packages will be a serious loss of purchasing power of the dollar
and, ultimately, hyperinflation, as evidenced by the Quantity Theory of
Money. However, the quantity theory is a linear model that may be valid as a
first approximation, but fails in most cases as the real world is highly
non-linear. My own theory, relying on the concept of marginal productivity of
debt, predicts that it is not hyperinflation but a vicious deflation which is
in store. Here is the argument.
While
prices of primary products such as crude oil and foodstuffs may initially
rise, there is no purchasing power in the hands of the consumers, nor can
they borrow as they used to in order to pay the higher prices much as though
they would have liked to do. The newly created money has gone into bailing
out banks, and much of it was diverted to continue paying bloated bonuses to
bankers. Very little, if any of it has "trickled down" to the
ordinary consumers who are squeezed relentlessly on their debts contracted in
the past.
It
follows that price rises are unsustainable, as the consumer is unable to pay
them. As a consequence the retail and wholesale merchants are also squeezed. They
have to retrench. Pressure from vanishing demand is passed on further to the
producers who have to retrench as well. All of them are experiencing an ebb
in their operating cash flow. They lay off more people, aggravating the
crisis further as cash in the hand of the consumers is diminished even more
through increased unemployment. The vicious spiral is on.
But what
is happening to the unprecedented tide of new money flooding the economy? Well,
it is used to pay off debt by the people who are desperately scrambling to
get out of debt. Businessmen in general are lethargic; every cut in the rate
of interest hits them by eroding the value of their previous investments. In
my other writings I have explained how falling interest rates make the
liquidation value of debt rise, which becomes a negative item in the
profit/loss statement eating into capital that has to be replenished as a
consequence. Worse still, there is no way businessmen can be induced to make
new investments as long as further reductions in the rate of interest are in
the cards. They are aware that their investments would go up in smoke as the
rate of interest fell further in the wake of "quantitative easing".
Self-fulfilling
speculation on falling interest rates
The only
enterprise prospering in this deflationary environment is bond speculation. Speculators
use new money, made available by the Fed, to expand their activities further
in bidding up bond prices. They pre-empt the Fed: buy the bonds first before
the Fed has a chance; then turn around and dump them in the lap of the Fed. This
activity is risk-free. Speculators are told in advance that the Fed is going
to move its operations from the short to the long end of the yield curve. It
will buy $300 billion worth of long dated Treasury issues during the next six
months, and probably much more after that. Speculation on falling interest
rates becomes self-fulfilling, thanks to the insane idea of open market
operations of the Fed making bond speculation risk-free. Deflation is made
self-sustaining. (For another view of risk-free bond speculation, see the
article by Carl Gutierrez' in Forbes mentioned in the References
below.)
Note also
the crescendo of the dumping of equities and the desperate attempt to redeem
toxic assets by private parties, sending the demand for cash sky high. The
dollar, at least the Federal Reserve note variety of it, will be increasingly
scarce. Rather than falling through the floor as under the hyper-inflationary
scenario, the purchasing power of the dollar will soar. You say that Ben
Bernanke and his printing presses will take care of that? Well, just consider
this. The market will separate vintage Federal Reserve notes from the new
issues with Bernanke's signature on them. In a classic application of Gresham's Law people will hoard the first, bestowing a premium on it relative to the second
variety, which will fall by the wayside.
Bernanke
can create money but cannot make it flow uphill
Already
some tip sheets openly advise people to hoard Federal Reserve notes in
amounts up to twenty-four months of estimated household expenditure, while
cleaning out all deposit accounts. Depositors are urged to forget about the
$250,000 limit on deposit insurance, which is rendered literally worthless as
the resources of the F.D.I.C. have been hijacked by Geithner and diverted to
guaranteeing the investments of private parties that were foolish enough to
buy into toxic debt at the behest of the Obama administration.
Karl
Denninger envisages unemployment in excess of 20%, with cities going
"feral" as showcased by downtown Detroit (see References below).
What has
all this got to do with the marginal productivity of debt? Well, once it is
negative, any further addition of new debt will make the economy shrink more,
increasing unemployment and squeezing prices. Bernanke can create all the
money he wants and more, but he cannot make it flow uphill.
Bernanke
is risking something worse than a depression
The newly
created money will follow the laws of gravity and flow downhill to the bond
market where the fun is. Risk-free bond speculation will further reinforce
the deflationary spiral until final exhaustion occurs: the economy will
collapse as a pricked balloon. Instead of hyperinflation and the destruction
of the dollar, you've got deflation and the destruction of the economy.
Denninger
says that the "death spiral" will lead to fire sales of assets in a
mad liquidation dash and, ultimately, to the collapse of both the monetary
and political system in the United States as tax revenues evaporate. He
opines that probably not one member of Congress understands the seriousness
of the situation. Bernanke is risking something much worse than a Depression.
He is literally risking the end of America as a political, economic, and
military power.
Indeed,
the financial and economic collapse of the last two years must be seen as
part of the progressive disintegration of Western civilization that started
with government sabotage of the gold standard early in the twentieth century.
Ben Bernanke, who should have been fired by the new president on the day
after Inauguration for his part in causing irreparable damage to the American
republic may, in the end, have the honor to administer the coup de
grâce to our civilization.
References:
No Time for T-Bonds by Carl Gutierrez, March 28, 2009, www.forbes.com
Bernanke Inserts Gun in Mouth, by Carl Denninger, March 20, 2009, http://market-ticker.denninger.net
Debt and Delusion: Central Bank Follies
That Threaten Economic Disaster, by Peter Warburton, first published in 1999; WorldMetaView Press
(2005)
Antal E. Fekete
www.professorfekete.com
Professor, Intermountain
Institute of Science and Applied Mathematics
Missoula, MT 59806, U.S.A.
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE
AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY
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BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS
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STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
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Copyright © 2002-2008 by Antal E. Fekete - All rights reserved
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