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The
Big Fix
The
Obama administration apparently believes in a trade-off between growth and
debt. It wants to stimulate fast growth and is willing to pay for it in the
form of unprecedented increases in government debt, because it fully expects
the growth to rake in tax revenues with which the debt can be retired. It
invokes the experience with debt retirement after World War II. When the war
ended, government debt stood at 120 percent of the
gross national product, twice what it is now. The rapid economic growth
during the 1950’s and 1960’s quickly reduced the debt. This is
offered as a justification for the $800 billion stimulus package that is
being railroaded through Congress, with more to follow later.
David Leonhardt writes in the February 1 issue of The
New York Times Magazine that governments tend to err in making stimulus
packages ‘too stingy’. This explains the chorus of cheerleaders
shouting “Not enough! Still more!” Leonhardt
says that governments fail to use the ‘enormous resources’ at
their disposal to shock the economy back to life. Japan
announced stimulus measures even as it was cutting other government spending.
F.D. Roosevelt flirted with fiscal discipline midway through the New Deal,
and the country slipped back into decline. The prescription of John Maynard
Keynes works only if administered boldly, without fear or hesitation. We have
the word of Treasury Secretary Geithner, as quoted by Leonhardt,
that his Big Fix won’t make the same mistake that Roosevelt’s
has. “We are not going to do that”, he said, “and
we’ll keep at it until it’s done, whatever it takes.”
Perpetual debt
In
this article I shall argue that there is no trade-off between growth and debt
under the regime of the irredeemable dollar lacking, as it does, an ultimate
extinguisher of debt. Once new debt is piled on the top of the old, total
debt is increased that will never be reduced, and will become perpetual
debt. As protagonists of the stimulus package well know, retirement of
the debt of the federal government is tantamount to deliberate deflation,
that is, contraction in the money supply, by reducing the pool of bonds
available for monetization.
After World War II it was possible to reduce the government debt and expand
the money supply at the same time because of the presence of gold in the
monetary system, which was the ultimate extinguisher of debt, until
exiled by the Keynesians and Friedmanites. To
recover the ability to reduce government debt and increase the money supply
simultaneously, gold would have to be made part of the monetary system once
more, an anathema to the Big Fix cowboys.
Liquidation value
Perpetual
debt is more than toxic. It behaves like nuclear fuel: once the threshold is
reached and exceeded, chain reaction sets in and the monetary system
explodes. To understand the dynamics, we need to refer to the liquidation
value of perpetual debt. This is a concept that, for obvious reasons, is
not recognized by mainstream economists. If it were, they would be far more
careful with their recommendation of unlimited government spending as panacea
for all economic ills. Recognized or not, the liquidation value of debt acts
as a trigger to a cataclysmic destruction of the economy looming large on the
horizon, of which we have had a foretaste in the recent past. The tragedy is
that the Big Fix cowboys want to use the same remedy that has landed the
country in the present predicament in the first place. Home owners with a
mortgage, car owners with a loan, credit card holders, students, state and
municipal governments, and yes, the federal government, are drowning in debt
already.
Burden of debt
The
liquidation value of debt is the amount that would liquidate it here and
now. It obviously depends on the rate of interest. The liquidation
value of total debt is inversely proportional to the prevailing rate of
interest. In particular, halving the rate of interest by the
central bank is equivalent to doubling the liquidation value of total
debt.
I
have been writing about this Iron Law of the Burden of the Debt for
many a year and have met with an almost total lack of understanding, judging
by the feedback from readers. The lack is due to the reluctance of the mind
to admit that cutting interest rates increases the burden of debt
contracted in the past, because it contradicts one’s intuitive
expectation that it should decrease the burden of debt to be
contracted in the future. To be sure, cutting interest rates does
increase the burden of debt contracted in the past because liquidation value
is calculated by capitalizing the stream of future interest payments. Since
at the lower rate the present value of that stream is smaller, a shortfall is
created that has to be amortized upon liquidation.
Perpetual debentures
In
order to understand the Iron Law let us consider the market value of perpetual
debentures (or perpetuals for short; consols in British parlance). They are marketable
securities that never mature: they convert a lump sum into a stream of annual
payments in perpetuity. For example, a $1000, 4% perpetual pays $40 per annum
to its holder, who can sell it in the secondary market at any time. The catch
is that he may recover only part of his original investment if the interest
rate has fallen in the meantime.
Present value
In
calculating the present value B of a perpetual with face value A,
paying interest at a percent per annum, we
have to discount the annual interest payments at the prevailing rate of
interest b. Since the annual interest payment is Aa,
the discounted value of the nth interest payment is Aarn, where r = 1 – b is
the discount factor. We have 0 < r < 1, hence rn approaches
zero as n gets arbitrarily large. The discounted value of the string
of interest payments is:
We
conclude that Aa = Bb. For example,
the 4% perpetual with face value $1000, yielding $40 per annum, can be traded
in the secondary market for $1000 as long as the market rate of interest b
is 4%. However, if it is halved to 2%, the same perpetual can be sold for
$2000, because at the lower rate it would take two debentures to generate the
same income stream.
According to this pleasantly simple formula Aa
= Bb, if the rate of interest b is halved to ½b, then
the liquidation value of the perpetual is doubled. In case of a serial
halving of the rate of interest from 4 to 2, from 2 to 1, from 1 to ½,
from ½ to ¼ percent, etc., the
liquidation value will be multiplied 2-fold, 4-fold, 8-fold, 16-fold,
32-fold, etc.
Story of the British consols
This is no idle theorizing. Britain
actually issued consols in the 19th
century up to 1914. They were marketable instruments that traded at values
determined by this very same formula. Clearly, issuing consols
would be sheer madness under the regime of irredeemable currency. But in the
halcyon days of the gold standard interest rates were stable. Cutting
interest rates into half, or doubling them, were as unheard of as they were
unthinkable. In the 20th century Britain
stopped all payments in gold, and consols were
discarded along with the gold standard. Nevertheless the formula survives and
can be used to calculate the liquidation value of total debt since, under the
regime of irredeemable dollar, total debt is perpetual debt.
Serial halving of the rate of interest
In
this new interpretation of our formula Aa
= Bb, A is the total debt contracted at an average rate of
interest a, b is the current market rate, and B is the
liquidation value of total debt. We see that B is inversely
proportional with b. In particular, every time the rate of interest is
halved, the liquidation value of the total debt is doubled. If the interest
rate is halved serially by the Fed (which has happened in the past, and may
happen again, as interest rates can be halved any number of times without
hitting zero or going negative) then, for example, upon a ten-fold
serial halving, the liquidation value of the total debt is increased
more than a thousand-fold (210 = 1024). This means that
trillion is promoted to quadrillion, quadrillion is promoted to quintillion,
and so on, in direct consequence of the serial 10-fold halving.
Those who argue that these frightening numbers are merely
‘notional’ and, as such, they have no relevance to the real
economy, do not know what they are talking about. The size of the derivatives
market is fast approaching the quadrillion dollar mark (if it hasn’t
already surpassed it by the time this article is published). It has been
talked down by mainstream economists and the financial media saying that
“there is nothing to worry about, it is notional value anyhow”.
Yet that notional value was able to break the back of the mighty American
banking system (along with that of the British). This is so because the total
notional value of derivatives represents the liquidation value of insured
bonded debt.
We
can expect much greater increases in the debt of the federal government, in
the trillions of dollars, but the really frightening numbers are not so much
the actual increases in the outstanding debt but, rather, the increases in
the liquidation value of the total debt caused by the serial halving that the
monetization of the increased federal debt will necessitate.
Capacity to expand Treasury debt
Peter Orszag, the new budget director in the Obama
administration has declared, as quoted by Leonhardt, that “one
of the blessings of the current environment is that we have a significant
capacity to expand and sell Treasury debt. If we didn’t have that, if
the financial markets didn’t have confidence that we would repay that
debt, we would be in even more dire straights than
we are.”
The
budget director is dreaming. The financial markets don’t have a shred
of confidence that the U.S.
government will ever repay its debt, certainly not in dollars of the same
purchasing power. The Treasury paper is not being purchased by investors; it
is bought by bond speculators pursuing risk-free profits. The Big Fix cowboys
create unlimited demand for the bonds by holding out the carrot of risk free
profits. Speculators plan to dump the paper in the lap of the Fed at the
first given opportunity. They know full well that the Fed has to monetize the
Treasury debt to provide the wherewithal to pay for the bailouts and stimulus
packages. Without the promise of serial cuts in interest rates the U.S.
Treasury paper is unsaleable.
Real investors, foreign governments and central banks, are already sitting on
mountains of paper losses due to the loss of purchasing power of the dollar
in their own currency. For them, U.S. Treasury debt is a toxic asset which
has no real market value because there is no real market for it. Any sizeable
offer to sell will result in a swift withdrawal of all bids. U.S. government
debt has grown out of proportion to economic activity. It will never be
repaid, except in the dreams of the budget director.
The Obama White House has been hijacked
The
outlook is very bleak. The Obama White House has been hijacked by a
reactionary clique of Keynesians and Friedmanites
before the new president even had a chance to take stock. They are
doctrinaires who would never admit that they have made a fatal mistake when
they promised permanent prosperity, a world free of bank runs, panics,
domino-style bankruptcies, mass unemployment and depressions, provided that
they were allowed to quarantine gold and manage synthetic credit as they see
fit. They now open all spigots and let all the genies out of their bottles,
in particular, the genie from the monetary bottle and the genie from the
fiscal bottle, to roam freely over the land and visit great disaster and
suffering upon millions of innocent people.
It
is the same clique that has landed the country and the world in this economic
disaster that now arrogates to itself the right ‘to fix things’
according to its own failed blueprint. The Big Fix cowboys’ ideas of
debt and its relation to production is a recipe for total economic ruination.
Latter-day Moloch
The
result of the bailouts and stimulus packages will be a vast expansion of
government debt, and a serial halving of the rate of interest to accommodate
it, followed by the escalation of the liquidation value of total debt to the
quadrillion and quintillion dollar range and beyond. Deflation will sweep
through the land making prices and wages fall. The depression will surpass in
severity any previously experienced. Industrial capital will continue to be
destroyed along with finance capital. Pension funds will go up in smoke,
unemployment will grow. Meanwhile the threat of hyper-inflation will not be
removed and will continue to threaten all countries, a
‘first’ in world history. When the liquidation value of
government debt reaches a certain height where Federal Reserve notes in
existence will no longer be sufficient to supply the bond market with
gambling chips the Fed will, Zimbabwe-style, start adding serials of zeros to
the face value of its notes. You don’t have to be a rocket scientist to
be able to calculate the purchasing power of Federal Reserve notes
denominated in the millions. You just make a field-trip to Harare.
There is no trade-off between growth and debt. Under the regime of
irredeemable currency, debt is no longer a servant. It is a Moloch,
devouring its children.
Reference
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 SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright
© 2002-2008 by Antal E. Fekete
- All rights reserved
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