China and the world economy

Over the last two centuries there have been many obvious examples of different political economic systems in practice. It all began with the Industrial Revolution that occurred in capitalist countries. Latter, there was the rise of communism and its moral/economic attack on human life. We had the immediate comparison between East and West Germany. For years there has been the obvious comparison between North and South Korea and Cuba and the Cuban refugees just a few miles away in Miami. Now we have the fascinating spectacle of communist China having an apparent capitalist bent. Still, with all of this obvious evidence, there are few people paying attention and noticing the consequences.

But even many of the people watching the Chinese economy are not noticing what is happening, not really. The closet socialists in the U.S. bemoan that America can’t act like the Chinese government and just get things done. We have all of those antiquated laws and protections in place. The Chinese, people are saying, have a better approach to making an economy run well. On the other hand, we have some advocates of capitalism who tout Communist China as a sort of new birth of freedom. Neither of these evaluations are correct. China has opened up options for personal action that the Chinese have never seen. It is a heady feeling, and the Chinese citizen is taking this opening and stretching it as wide as fast as he can. But his feeling is based upon the opportunity and not the reality. The reality is that China is still a communist country. It isn’t free. It still embraces the old prerogatives that communism teaches, plus, the government is attempting to become an economy manager in the manner it perceives the Western governments to be. This is not a good mix for the long-term.

My comments are about the problems that underlie Chinese economy today and the big crisis that is coming. But, if my information is correct…

When China bursts and falls, it will be the capitalist elements that will be blamed. Just watch!

People are very surprised about the success of the Chinese over the last 10 years. They tend to forget that the same Chinese government has killed millions of its citizens. They forget the destruction of the democracy movement just a few years ago. In their minds, China seems to have just come out of nowhere recently.

It is the case that there is a lot of productive energy being used by the Chinese citizen for his own benefit. People living in the right areas are seeing an enormous increase in their standard of living. There is real capital accumulation and utilization. Markets are working. People are finding productive jobs. There is a lot of good happening. The productive aspect of the Chinese economy is not an illusion, unlike the Russian economy which was an illusion during the Soviet era. Yet, there are major problems.

The problems revolve around the fact that the government has not renounced either its own communist nature or the general approach that every other government in the world accepts, namely the twisted Keynesian approach to government controls. This communist government isn’t using the traditional five-year plan, but it is attempting to act as if it can perfectly control the economy by using the “mixed economy” rules that have constantly failed in the West.

It has greater control over the banking system than any Western country does. The banks are either owned outright by the government or controlled sufficiently to make no difference. Consequently, the standards for making loans and evaluating the banks soundness are much poorer than in the West. Estimates are that anywhere from one third to two thirds of all loans made by Chinese banks are not performing, i.e., payments are not being made and the loan will be a loss. That is a percentage far higher than any Western bank has had. You can be sure that the Chinese banks do not have the capital or the reserves to cover those losses. When the weakness of Chinese banks is recognized and begins to affect the economy, the Chinese government will step in and create reserves, i.e., it will inflate the money supply even more than it is already doing now.

The real estate market is in much worse shape than it was in the West. There are reports that the Chinese built an entire city for something more than a million people in the interior. This city stands empty and is, no doubt, beginning to deteriorate. In the real cities, reports are that 60% of the apartments that have been sold are not drawing electricity, i.e., no one is in them. Yet the Chinese are continuing to build at a rapid pace. For those who buy, not having the mortgage system that Western countries have (which is not necessarily a benefit for the West because much of the structure is government created, and thus is not efficient or market driven) the Chinese buyer has a much higher percentage down payment on the property. When the Chinese real estate market fails, the losses are going to be more centered on the productive individual rather than on the banks. Suddenly losing a large part of their new wealth will place a strain on the population of the cities. Things may not remain stable.

At some point, some unforeseen event will stop the continued upward spiral of real estate building and price increases. The last buyer will buy, and all that will be left are sellers, and prices will fall, buildings will go empty, loans will be recognized as losses, banks will either fail or have massive amounts of made-up money shoved into them. Inflation in China could increase dramatically.

What will be the immediate economic consequences? Questions that perhaps cannot be answered in advance include, what will the Chinese do with their hoard of dollars, Euros, and foreign exchange? What will they do with their U.S. Treasury Bonds? There are observers who have been suggesting that China is looking to sell off the U.S. government securities. I haven’t thought so, for no other reason than that the Chinese really don’t want to see the value of those holdings to dive. It made no sense for the Chinese to start selling. But when their economy goes puff!! Who knows what they will do? The degree of collapse cannot be appreciated. There has been no economy of that size, with that many people, so connected to world trade, that has had the size of bubble that China now has. Yaron Brook suggested that their bubble is larger than any seen before. So may be the consequences.

We can easily see that one immediate consequence for the rest of the world will be a hit on the commodity markets and those countries that are depending upon the Chinese, e.g., Brazil. These countries will see an immediate fall in revenue. Commodity prices will fall, hard.

For ourselves, the consequences will also first connected to the commodities. The price decline will include gold. The number of buyers will decline and the sellers, especially the Chinese sellers will expand. At least during the crisis and for a while afterward, gold prices will be lower. Other commodities will also decline, especially those that the Chinese have been big buyers, e.g. oil. (See what happened in 2008.) The upward pressure on prices for goods in the U.S. that are tied to commodities will be reduced. Consumer prices could even decline.

What will happen after that is hard for me to predict. The Chinese economy is not as closely tied to other countries as ours is. Their banking system, for example, is pretty isolated, from what I can see. Would companies producing for export be forced into closing? Would their exports suffer? Imports would suffer. To the extent that the gap between imports and exports widened, there could be problems. To the extent that the wealthier countries depend upon exporting to China there would be adverse consequences. We will have to see how all of that plays out.

We have no clue what precisely Chinese government would do, except that they are wedded to the belief in the power of the government. To the extent that they see their citizens’ reactions to be threats to communist power, they could unleash the military again. They could try Western style mixed economy solutions, and expand and lengthen any possible recovery. It is unlikely that they would somehow learn that the governmental actions in the economy do not produce prosperity.

No doubt, in the West, government after government will step forward to save the day. At this point, with interest rates on short-term money at near zero, it is laughable that any might think that their theories are going to have any beneficial results. But, our great leaders are also wedded to their theories. Remember, their theories are not based upon any real evidence, but make believe. That they haven’t worked in the past will not hinder their efforts. The Western world might still be in “recovery” when China blows, which means our “recovery” will dip. Our economy will certainly suffer.

The stock market in the U.S. will definitely decline. Since the financial center may not be hit as badly as before, the decline in equities might not be as large, but it will not stand up to this bad news. I am firmly in the camp that considers the market’s recent rise to be pushed by inflation, i.e., government created money. Riding U.S. stocks is a very risky endeavor today. I don’t see a fundamental justification for stocks to have risen. New pressure from China will undercut the equity market.

Frankly, only commodities seem to me to offer any opportunity for increasing wealth today or even just protecting what you have (besides owing a successful business that can deal with economic shocks). I don’t mean riding commodity prices upward. I mean being able to take advantage of the up and down volatility of the prices of commodities.

When China does blow, as people have done in the last sixty years, there will be a flight into the dollar (another reason why commodity prices will drop for those of us in the U.S.). As badly as the dollar is managed, it will look better than any option (other than gold, maybe). Eventually, the damage done to the U.S. economy will be apparent and the dollar will lose strength. Still, when considering the alternatives, no other currency will look stronger. We are now seeing the weakness of the Euro. Bailing out a couple of Euro zone countries with new loans only broadens those who must suffer under the debt burden. Analysts do their calculations and bemoan the apparent fact that there is no way out for an economy with so much debt. Opening up their economy so that it can actually be productive never enters into their consideration.

When is China going to implode? Sooner or later? China is now experiencing some problems with price inflation. For years, as part of the creation of all of that real estate, the Chinese have been expanding bank credit and thus the money supply. They thought that everything was okay until prices began to rise during their “recovery” from the mortgage-backed securities crisis. In response to the crisis, the Chinese government did its stimulus gimmick, spent a lot of money it didn’t have, patted themselves on the back for the apparent recovery of their economy, and now consumer prices are rising. Surprise! Now the Chinese government has to act again. Since interest rates are still very low, they are having to increase the reserve requirement, i.e., banks there, just as they must under our Federal Reserve System, must keep a percentage of their deposits in accounts at the central bank. The higher the reserve percentage, the lower percentage of loans a bank can have outstanding. The Chinese central bank has now increased that percentage for the third time in the last few months. Further, officials in China have placed price controls on certain items, which as anyone knows, does not work. So we are now seeing some significant cracks in the Chinese economy. I don’t know if these cracks are sufficient to cause the bust, but they are at least the beginning. We can look forward to Bernanke like statements about how there is no problem, how the problem is small, then that the problem is only in one sector, and then how the Chinese government saved the world from another evil consequence of capitalism. Plan on it.

What we can do is to start telling people ahead of time what they can expect to see, especially the “capitalism did it” excuse. Maybe fewer people will believe it this time.

The Attraction of Free Medical Care: Egalitarianism

I have seen several different facebook entries, blog posts, and articles about how bad medicine under state control is. I am sure that an actual effort to put together a history of medical care in Canada, for example, would provide more horror stories and causes for fear than we could imagine. Socialized medicine, medicine under the rule of force, is bad medicine.

What is even more disturbing is that the citizens who live under government controlled medicine know very well what is happening to them. They are the ones who have to suffer the mistreatment, poor service, lower standards, and rationing that state controlled medicine inevitably leads to. Why haven’t we heard from these victims? Why are they silent?

There are mundane answers to those questions, for example, the fear that speaking out would result in being treated even worse by vindictive administrators and “doctors” who have bought into the “free” system. Fellow citizens also may inflict punishment on “complainers”, who, after all, are threatening a service that everyone has a right to receive, in the local accepted prejudice.

But there is something deeper I think. This isn’t just the ideal of altruism, because socialized medicine isn’t solely, or predominately, based upon the sacrifice for the sake of others or even the state. This is worse. It is egalitarianism. This is the enforced requirement that everyone be treated equal, and lower quality, equally bad medical care is acceptable. To not accept it would require questioning the premise. A person cannot argue that they should have good medical care, because that would be demanding something that cannot be offered to everyone within a socialized country. To demand good medical care is to demand that you be treated as an individual.

In “The Age of Envy”, Ayn Rand offered this example of egalitarianism, “Suppose a doctor is called to help a man with a broken leg and, instead of setting it, proceeds to break the legs of ten other men, explaining that this would make the patient feel better; when all these men become crippled for life, the doctor advocates the passage of a law compelling everyone to walk on crutches – in order to make the cripples feel better and equalize the “unfairness” of nature.” (The New Left, p. 170)

In practice, if that term has any meaning, the medical practice in a socialized country will not go around breaking legs. That would be even too obvious for most people. What it does do, however, is almost the same. Instead it makes treatment egalitarian by limitation (not to be confused with rationing). That means that the treatment a person can receive has to fall within a certain range of acceptability, of equality. This restriction to a range is justified by citing the funding limits. But is actually the reverse. It is the principle of egalitarianism that mandates the “equality” of treatments. Even if funding was unlimited, treating individuals differently would violate the fundamental tenant of egalitarianism.

Thus the result is not that the doctor has to go around breaking legs. He only has to say that available resources and funding limits restricts the treatment options available to different cases, regardless of the severity of their illness. Thus someone with a leg that is severely damaged would suffer amputation or permanent disability, rather than receive treatment that is significantly beyond what a broken leg would normally receive. Then, as funding levels do decline, doctor availability and capability decline, as standards of the population decline, the level of treatment will continue to decline over time, with no noticeable reaction from the populace.

The egalitarian application to health care also means that any medical treatment that is considered optional, such as hip replacements, would be eliminated, as has been the case in Canada for decades. It is not egalitarian to offer options.

Just this week there was a long article on the current status of Canadian health system on Yahoo. In the article there is a significant glorification of the size of the operation, ranking it internationally as a business. There is criticism of some spending shortcomings, as you find in the criticism of many government operations in this country. They are only concerned with waste and fraud, ignoring the inherent incompetence of government bureaucrats attempting to deal with such a complex subject as medical care. The article attacks the elements of the Canadian “system” that still contains some element of individual choice (the doctor’s choice of business organization and medical decisions). It goes on to discuss future funding issues. Nowhere does it discuss the actual level of care a Canadian resident receives. This subject is irrelevant!

You find the disconnect between the promise of government run health care and the quality of the care in every discussion of government run health programs. You find this disconnect in the arguments for government health care in the U.S. The proponents of health care provided by force do not actually care about the quality of care. They do not care about the consequences for the individual recipients of government run health care. Neither, apparently, do the proposed recipients, who seem only to care that they are receiving “free” health care. They only care about the implementation of force by the government. The supporters of freedom fail to point this out. It needs to be emphasized.

To my knowledge there has not been a study of the level of health care in any of the Western nations that have socialized medicine. It is quite puzzling. This study needs to be done. A study of the Canadian experience would be most helpful, since it is the most recent and most like our experience would be. (If anyone knows of a study, please tell us.)

As these arguments go on, and egalitarianism becomes more entrenched, at least implicitly, it will be harder to dig out. We must not forget the ideal of egalitarianism in our arguments and protests. It is a special application of altruism and needs its own special attention. Otherwise we shall see continued adverse consequences from both the liberal left and the religious fundamentalists. Both will push egalitarianism.

This is the way mankind pulls back from civilization, from industrialization, from the digital world, from large populations, from survival. What is killing us is egalitarianism.

Gold is Undervalued

I have come to the conclusion that gold as a financial hedge or currency is undervalued, probably by a very large factor. Actually, a better way of saying that is that today’s currencies, all of them, are very much over valued in terms of gold as a standard of value. A further way of saying this is that as the world population begins to realize the problems that fiat currencies, social programs, high debt, and reduced freedom have created, they will at least try to flee to gold to some extent, and the limited quantity of gold in existence will result in an amazing increase amount of fiat currencies required to purchase a troy ounce.

My conclusion may seem to be obvious, maybe even trivial. My point is that the current price level is not something to be seen as high or remarkable. The current price level is the result of a few people out of our total population, worldwide, who have decided to use gold as a store of value. The current portion of our wealth that is placed in gold is a very small portion.

Currently, the gold market goes up and down (trending upward in what is really a fairly slow assent) as a result of daily random news releases about things of little, long-term significance. None of these news events about government activities or economic events addresses the underlying problems or will stop the consequences of those problems.

What is up in the air, I think, is whether the consequences will be swift and catastrophic or wind us down painfully over a longer period of time. But, the reality of the situation is absolute. Some of those people who claim to be gold bugs who pay any attention to the daily or short-term prices changes, including trumpeting new “highs”, are missing the point. Sure, point out the new high level of fiat currency needed to buy gold, but also keep people’s eye on the necessity of the price going higher. The price is still low. By keeping your eye on the fundamentals, you will not get caught up in day-to-day irrelevancies. If the price of gold should fall for a while, keep in mind that nothing has changed in the fundamentals, you should not be concerned. It is actually a buying opportunity.

The relationship between gold and the present day currencies is just as any other market relationship. There is a limited supply of gold, more so than most items for sale, even more so than most commodities. A higher demand for gold will elicit a greater production, as the prospect for profit encourages a search for more sites to mine and makes it possible to mine ore that would be unprofitable at lower levels of demand. Yet the amount of new production has rarely been sufficient to have much impact on the supply and demand balance. New production will not change the fundamental problem of fiat currencies. New production of gold will not sufficiently affect the day-to-day prices to enter into any purchase decision.

The amount of currency that is needed to acquire a troy ounce of gold depends then on the amount being offered for all the gold for sale. If the amount of fiat currency being offered raises, then the amount per ounce will raise. Supply and demand is a root an exercise of arithmetic. The relationship between the current level of fiat currencies and gold would require a much higher exchange ratio than currently exists. Since nearly all countries are continuing to inflate their currency, the amount of those fiat currencies necessary to buy an oz. of gold will rise even higher.

Gold has reached its current quantitative relationship with the currencies of the world in an environment in which few regard it as a real alternative to today’s fiat currencies and few are willing to take the risk of placing their liquid assets in a mere commodity. Gold has reached a high dollar “price” with only a few people actually using it as a value repository.

When gold was last widely known to be a store of value, the earth’s population was less than a quarter it is today. A century ago, there were perhaps only 5% the number of dollars in existence as there are today (the dollar has lost 95% or its purchasing power since 1913, and there is more loss to come). There are more currencies today and much more of each currency. I doubt that there is more than twice the amount of gold in human hands today than 100 years ago, maybe even less.

How many people own significant amounts of gold, say even $1000? How many people own gold as part of their portfolios? How many Objectivists own gold? The quantity of each has got to be very low, even after the last monetary crises.

As long as people with assets continue thinking that moving into dollar assets, especially U.S. government debt is a “safe” move, the upward pressure on gold will be slight. Probably enough to keep it rising and hitting new “highs”, but not enough to push it toward a realistic value in today’s world. Keep an eye on these people who are using U.S assets for safety. When the U.S. dollar assets are also viewed as less than safe, gold will begin moving upward on a steeper angle. At this point I don’t know what is required for people to realize the dollar’s weakness. The added debt, the continued current account deficit, the lack of movement in the U.S. economy, and the threat of more “stimulus” should have everyone worried. It seems that people worldwide have not accepted that gold could have a real role to play. The attacks by the Keynesians have had some impact. Instead, people are bouncing between the Yen, the Euro, and the dollar. At some point you would think that they would get tired of the bouncing and look for some actual safety. Given the state of the gold market, it would not take many new buyers for the dollar price to balloon. It won’t be an asset inflation, but a dollar fall.

If and when people become worried and there is a more concerted movement toward actually safe, real assets, the number of dollars or other currency necessary to acquire an ounce of gold will skyrocket. We haven’t seen anything yet.

THE CHINESE CURRENCY: A BIG SHOE THAT COULD DROP!

For over a year the U.S. economy has been just chugging along without any apparent stresses. I mean, nothing has happened within our economy to cause panic or increase the level of fear people are feeling. Certainly, the economy is far from healthy. It is not growing to speak of. Unemployment is very high and few jobs are being created. Some communities appear to be in depression, while others are only marginally affected.

In the political area, the focus related to the economy is all of the promises made and no results. The current administration isn’t being blamed for making things worse, just not making them better. The government has declared that the “big drop” is over, the recession has ended, but the signs that growth is occurring or may happen in the future are muted at best.

My own mood is that of waiting for the other shoe to drop. Well, there are many shoes that could drop. And any of them could be more disastrous than the big dip of 2007. Which one will it be? Or perhaps the question to ask is which one will be first? Only time will tell. Let’s think about one potential shoe, the push to have the Chinese revalue their currency.

One issue that the politicians are focusing upon is the international value of the Chinese currency. It is contended that if the Chinese currency is valued more in line with real relative national purchasing power, the U.S. dollar would be stronger and the U.S. would benefit from a greater demand for its products. There are several things that are difficult about this. It is true that China’s approach is the old, thoroughly discredited view (among those who are aware of the history of economic ideas) that a nation’s wealth is achieved by hoarding valuables. At the beginning of the exploration of the New World, for example, countries would scour for gold and silver in the Americas, bring it home, and put it in a vault and declare that they were wealthy. So, several Asian countries, including Japan and China, insist on controlling the exchange rates (although Japan is trying counter balance that now) and hoarding the dollar and the Euro (China has a large surplus with the Euro Zone as well).

Of course, hoarding anything is not wealth. A dollar, or any currency is only as valuable as what it will buy. A currency, especially a fiat currency, in international trade is a claim on that country’s production.

On the other hand, a country does need reserves (speaking within today’s structure), i.e., a stash of cash available when and if needed to settle international debt or payments. What cash is available? Well, they aren’t going to begin using gold, if for no other reason than that the process of beginning to use gold would cause the value of the dollar to die. The same problem holds for any other currency that could be chosen other than the dollar. If the process of changing to another currency was done slowly, perhaps the dollar wouldn’t collapse. Unfortunately, such a process should have started a couple decades ago.

As it is, the international system is stuck with dollars into the foreseeable future. Okay, but there is no need for countries like China and Japan to continue accumulating dollars. They have more than they need, and they are worried about the constant flow of dollars and what that means for the future. What they could do is to turn around and begin buying stuff from us with the dollars that they would have hoarded, the current cash flow. Sounds good, right?

We will even ignore the probable, immediate consequence that the dollar would lose significant value just because it wasn’t being hoarded as before. Forget that. Forget that immediately, foreign goods would be significantly more expensive. Let’s just concentrate on our own goods.

The mainstream economists think that to create growth, what is needed is consumption, more spending. That is why they set things up to expand the money supply. More money, more spending, more wealth, they think. Great, huh! So, these same economists would be happy for foreigner to be spending more in the U.S. It means more demand. They felt the same way years ago when the economy seemed to be humming right along, with very high employment, and very low unemployment. We had what some called “full employment”. I always wondered what they thought was going to happen. The unions, progressives, Keynesian economists all thought that more money running after our goods was going to be good, when there was no one to produce them.

Today things are a little different. We have a large number of people unemployed and lots of capacity that is sitting idle. It is not the most efficient capacity, but it is there. What we don’t have is a significant amount of raw material sitting around. Nevertheless, as foreigners began to send those dollars that they don’t hoard back to the U.S., we will now see more dollars running around. At first, the new demand will cause some shortages, and prices will begin to rise, since the actual stock of good will be unaffected, at least for a while. Then, over time, more capacity will be used, more people rehired, more produced. But, then the real bottleneck appears. Or rather two bottlenecks. One will be the need for raw materials for the higher level of production. Costs will have to rise to compensate for the higher costs of materials as users bid for the material available. The other bottleneck is that some new investment will be needed, but the government has soaked up all available savings for its deficit. To get loans or attract investors, businesses wanting to expand will have to bid against the government for savings. That will also tend to raise costs, and the cost of government borrowing will also increase.

What this really means is that the return of all of the money we send out in a year for foreign trade will result in higher prices, both for domestic goods and much more so for foreign goods. It is unlikely that we would see the “gentle” 1-3% inflation we have seen with few exceptions over the last couple of decades. It will be higher.

Now why would we see higher inflation just because foreigners spend the money that we sent for goods? It certainly wasn’t the case throughout our history, right? Wouldn’t it make sense for there to be a balance? Well, yes. But our situation over the last decades is very different. It is hard to understand, apparently. Some supposedly free market bloggers don’t accept my thinking here.

For decades we have had not only a trade deficit, but a cash-flow deficit, called a current account deficit. While the trade category covers trade, obviously, it doesn’t include investment flows between nations and government transfers. Normally, if a country has a trade imbalance, the difference is made up by the return of the deficit in investment, or the purchase of government bonds, for example. Even then, if the current account is not in balance one year, it swings back the other way the next, or at least over time a country’s current account will balance out. This has not been the case for the U.S. for a long time. The current account deficit will be less than the trade deficit.

One way to understand what is happening would be to imagine that you are a country and buying from other people – countries – often. Your purchases are all made by check. You send out many checks and everybody honors them and sends you the merchandise you want. But, you find out, by analyzing your checkbook that some of your trading partners are not cashing your checks. They are just keeping them (for some strange reasons – your crazy cousin has all kinds of weird theories as to why, saying that they want your checks as reserves, that your partners use them as cash with other people, etc.). So, you have both the things you bought and the money you with which you thought you bought them. Sounds like a good deal. It is sort of. But, if your honest, and know that there is a future, you might be somewhat worried about what happens when all of those checks come wondering back, especially if they all come back at once!

Let’s take 2009. The U.S. bought more stuff than it sold by $374 B. The current account difference was $378 B (usually, the current account deficit is smaller than the trade deficit). You can look at the history of the U.S. current account here. So, there have been billions upon billions of dollars that have left the country and not come back, not even as loans to our government. My discussion in this post is limited just about this year’s money not returning. (Think how bad things would be if the money from past years returned as well!)

Under a gold system, if money left every year and didn’t return, the money supply would continue to shrink and there would be a corresponding drop in prices. There would be ramification of a continued outflow of dollars. There are ramifications under the present circumstance, just not the ones that would occur in a rational economy. In the present circumstance, the U.S. price level actually continues to creep up. That is because the money supply continues to creep up. The money supply creeps up in spite of billions of dollars being lost every year to foreigners. Where is the money that is being lost coming from? I am sure that you know the answer. It is the Fed., the official U.S. money maker upper!

One key fact to remember about international trade is that it functions completely on credit. When an importer buys, he sends a letter of credit, which does not pay the exporter until the goods are received and accepted by the importer. The letter of credit is a bank document, and is what it says it is, a credit, a loan. Purchases by U.S. importers are financed by bank credit pushed by the Fed. We see that even though banks in the U.S. are not making loans to businesses for new production, they are making loans for importing, i.e., we still have a big trade deficit. The money we have been exporting for years is all made up, Fed. produced money. So the Fed increased the money supply, we sent it overseas to buy stuff, and those people kept the money, just like the example with your checks. (Why? See my discussion of Schiff’s book, Crashproof. The “Why?” is even more a big question after they have kept so many dollars after so many years.)

The situation is not good for the Chinese and other countries that have built up big surpluses of foreign money (which is mostly in digital form). Recently, there was a push to move away from dollars toward a “basket” of currencies, including Euros. The wisdom of that idea was demonstrated this summer as many of the Euro Zone countries have been shown to be in financial difficulties. Maybe people will begin to realize that fiat currencies of any stripe will not stand up to normal, mixed economy political processes. The dollar became strong, i.e., higher priced against the Euro, for a while because the dollar again looked like the strongest, safest currency. That view will fade. So the Chinese, to use them as the example because they have the biggest hoard, are sitting on vast sums of dollars, some of which are “invested” in U.S. government debt, a little of which is invested in other countries, both real assets and government debt, and some of which is sitting as reserves, as gold would sit. If and when the dollar falls, the value of these massive holdings will fall, which would not be good for the Chinese economy. Thus, the Chinese are walking a tight rope, trying to keep the dollar from a death dive, which also means their currency at a lower price, and make small moves to reduce their dependency on the dollar. Everyone is watching them. They have to be careful.

Which also means that they are confused by the U.S. political leaders constant demands that they increase the value of their currency. The Chinese realize to some extent the consequences of that action. They can only be astounded by the U.S. politicians. Those fine people, the Congressional leaders don’t seem to have much understanding of international economics (not surprisingly, since they don’t have much understanding of domestic economics, either). They do understand that the jobs issue plays very well in this country. They see that demanding that the Chinese buy more U.S. stuff there might be more U.S. jobs, and play it for all they can. Real consequences are far out weighted by political appearance. They can always blame someone else for the unexpected consequence.

But if the Chinese, and the other Asian countries begin spending those dollars on U.S. goods, we begin to see those made up dollars running after the few goods we have purchased and prices begin to rise, interest rates begin to rise, and the quiet calm that we have had, a quiet calm in which we have been able to have good fight for our lives, will end and who knows what could happen then.

Update: Treasury Attempt to Control Retirement Assets

The Labor and Treasury Departments have announced hearings that are the next step in their attempt to control and probably divert individual retirement savings. These hearings are next week.

There is nothing new here particularly. The wondrous workings of bureaucracy require many obtuse steps working toward making recommendations to the legislature. The hearings are that next step. At this point the apparent goal is still just requiring employers of offer a lifetime income option as part of a 401(k) plan. A lifetime income option that is not a pension is called an annuity. (Most non-government pensions are effected by the employer buying an annuity for the pensioner.) The step to government seizing or controlling retirement savings is contained in the justification for beginning this process: retirees are not adequately managing their retirement assets to provide for their entire lives. (I won’t go into the entire discussion on this point. For that discussion see my original post and this for background .)

The only comments of the government’s interest in this issue that I have seen is in the far right blogs and in a couple liberal think tanks. The right has immediately jumped to the conclusion that the government intends to grab the assets, which isn’t irrational. They also propose that this is BO’s idea, which I tended to endorse in my earlier posts. I wonder. I think that the Labor Department is quite capable of thinking this one up on its own.

The blogs ranting about this issue have included IRA’s as threatened by the Labor Department’s intensions. At this time IRA’s have not been mentioned.

The interesting question now is will this process continue if the Dems lose control of the legislature this November. I bet that it will. I think that the process has just as good a chance of succeeding with the Republicans. They are just as paternalistic as the Dems, just as eager to show concern for people’s retirement. After all, Social Security reform was a Republican “achievement”.

The initial legislative step would be to pass a law requiring employers with standard 401(k) plans to offer a lifetime income option. At that point the lifetime income option would probably be an annuity provided by an insurance company. The bad thing about this law would be the added expense and waste of time needed to meet the requirements, plus the fact that the new option would add another bad element for the participant from which to choose.

Soon, the Labor Dept. would discover that few people were choosing to put their money in the annuities, and that, in the opinion of the Labor Dept. the population was still failing to adequately manage their retirement funds. It would also be determined that the insurance company annuities were too expensive (dirty capitalist, profit mongering, insurance companies). Something more would need to be done. Then they would start the hearing, etc. process over again to come up with the need for the government to offer the annuity and that at least a certain percentage of retirement fund contributions be placed in that annuity.

There we are, a large new source of government financing.

(I edited the title because people were getting the wrong idea.  The Treasury & Labor Depts will want to control where you can put the money and fund the U.S. debt, but there is no evidence that their intent is to steal those assets.)

Combating Altruism

In a previous blog posting I argued that it is important for the supporters of capitalism, freedom, and reason to know what capitalism is from the economics standpoint and to understand the economy in which they live. If we want people to support it, we must be able to explain it. That position is still a correct one. Many supporters of capitalism do not know the economics and certainly do not know what is happening in today’s economy.

Recently I reread Ayn Rand’s 1960 speech, “Faith and Force: The Destroyers of the Modern World” and had the opportunity to deeply examine chapters 2-5 of Andrew Bernstein’s The Capitalist Manifesto. These writings have again underscored to me the importance of the moral arguments. The central point in both works regarding the morality of the altruist is that altruism is independent of reality, of reason. Pointing out the necessarily disastrous consequences of the policies proposed by an altruist will not influence his commitment to the irrational.

In recognizing that position, we must realize that the altruist politician and policy maker and their supporters are somewhat immune to our direct, pointed statements about the consequences of those policies. That group of people includes many of their supporters in the electorate. We must recognize that that we need to attack their own closely held beliefs. I don’t think that they will be influenced by our arguments, but they will be harder for them to ignore, perhaps. They seem to be able to ignore nearly anything.

More useful will be making those attacks when arguing publicly, i.e., articles, editorials, and lte. I don’t think that a philosophical discussion of altruism is helpful. Generally there isn’t enough word count to do so and readers might not stay with you. I propose that instead we use the consequences, that is, we spell out the “human” cost of these policies in the context of morality: We talk of the suffering of countless Americans. We talk of the loss of the ability to acquire the items that make our lives better or even comfortable. We talk of the potential of depression and hardship. We talk of the recent dire recession we are living in. We talk of human sacrifice. We spell out how these policies are going to make life harder and worse. We talk of how the politicians do not care about the consequences of their policies, only that they fit with their morality of human suffering. We talk about the disconnect between reality and their policies. But these consequences must be discussed within a moral perspective. The discussion has to focus on specific consequences of the morality being used. It seemed to me that the accusation that ObamaCare included “Death Panels” was effective. It carried the idea and the real meaning of ObamaCare. This type of tactic needs to be carried further. We must not mince words or be “nice” or polite. Being nice and polite allows the evader wiggle room.

Clarity and the relation between the altruist’s policies and the welfare of the reader are what are important. We don’t talk about their rational self-interest, but the values that are rational that they have, for example, their families. We talk about how these anti-man policies are going to impact their families. How their hopes for their futures and the futures of their children are being destroyed by the specific, destructive policies being offered and made into law. We talk about how their children will not have their parents around as long as they expected. We talk about how their children are not going to have a better life. We talk about their children’s shorter life span. We talk about their children’s not receiving the inheritance either expected. We talk about the lower standard of living that their children will have. We talk about the fact that this will be the first American generation to leave their children worse off.

Offer real images to the reader contrary to their general morality, i.e., what are they going to say to their child when they complain about their illness and the government run health plan won’t help? Are they going to tell them that morally it is good for them to suffer? Are they going to give them stories about helping poor people when in fact they themselves are now poor and there is no help for them? Being too nebulous will not bring the point home. Talking about paying back the current debt will not be useful mainly because these predictions in the past have not had an impact on the current economy (at least that people have realized).

What we must keep in mind is that the explicit or implicit holder of the morality of altruism does not regard consequences of his actions as pertinent. That is why Congress rarely examines the consequences of the laws it passes. Consequences are not important. What is important is taking actions consistent with altruism, “helping others”, sacrificing for the good of others. We know that this cannot be practiced successfully. We know that individuals cannot and do not practice this morality personally. They just support their government’s actions. What can only break through this compartmentalization by concretizing the consequences they will connect to themselves. Using concretization in a directed manner, utilizing our reader’s own values will help bring the real meaning home.

It will help you to also keep clearly in focus the consequences of failing to stop the direction of the federal government. Too often we are seeing the future in terms of economic consequences, i.e., reduced standard of living and opportunity. We are thinking in terms of loss of being able to state our views. These images are too peaceful and mild. This is the most complex, interconnected economy in mankind’s history. It will not be able to maintain its cohesion if several parts come apart. In Atlas, the trains stopped. Food could not reach New York City. Food shipments stopped. In our world, oil deliveries will be imperiled and food deliveries will become undependable. What will happen in our cities if food is not readily available, not to mention other requirements of living? Digital systems will prove to be fragile. As the economy comes apart, so will the society. There is much more anger, fear, and resentment today than during the 1930’s, for example. We have riots today over court cases. Just think about food riots. Just think of a lack of food and starvation in American cities. This is what human sacrifice looks like in practice. That’s right, human sacrifice. Not ritual sacrifice, but the human sacrifice that results from the government’s practice of altruism.

I am not trying to be alarmist here. I am not projecting a crash within the next few months, or even the next couple of years. The election coming up will give us a good indication of what our immediate future holds. I am only saying that our arguments must keep in mind the fact that holders of the morality of altruism (or the god oriented version) do not consider consequences to be an issue. To be effective and meet the threat, we must shape our arguments accordingly. The moral context and the real consequences have to be pared and driven home.

If in the next election we have a Republican Congress, we will then talk about the Christian right and that they have the same mind frame. They are not interested in the welfare of individuals. They are interested in making their god happy. Human happiness doesn’t help. They require suffering, just as the progressives do.

To reduce the role of altruism as the dominant political philosophy and replace it with reason and capitalism, we need to make our arguments as effective as possible.

Outlook: The Economy and Inflation

If I haven’t mentioned this before, let me do so now: keep an eye on “business news”. So many people are focused on the political issues that they don’t take time to look at the business pages. People also tend to consider business news as very specialized, I think. I mean that the stories involve finance and accounting concepts that are not sufficiently understood by the average, intelligent person. I would agree if the articles on the business pages in the normal daily newspaper or news web site were about actual businesses and markets, etc. Most articles, unfortunately, are actually about the government and its activities. What would pass as actual news in the business world is ignored there just as real news is ignored in the other sections. Further, the “reporters” in the business section are not people with an education in business, finance, or economics. Nor do they have business backgrounds or even a history of intelligent investing. They are people with journalism degrees who could not make it to the front pages. Years ago someone did a survey of the people writing for Money Magazine. They found that few of the writers had any investment background. The writers for Money Magazine were young, inexperienced, and had bought into the Money Magazine “philosophy” (and advertising strategy) without question.

So it would seem that I have just given you good reasons to ignore the business pages. Well, even so, it is the reports on the government that you need to look out for. A few of those reports are considered significant enough to reach the front page. Many of the others are important to know about. You need to have a broader view of the economy we live in and its prospects to better understand what could happen in the future. You need that for yourself, to better plan for yourself and your family.

For example, some people are carrying on about high inflation and you might think that inflation is raging and creating havoc. Look around you. Do you see prices in general going up? Significantly? There is some, of course, but nothing big has happened as of yet and may not for a while. People who are carrying on about inflation happening now are ignoring the actual situation. (I am not suggesting that there is no threat of inflation or hyperinflation. There is. But it is a threat, a possibility and can be avoided.) Many people are ignoring the issues of Social Security and Medicare and their impact on the budget, today. You don’t keep track of this stuff without looking at the business section (and reading this blog, of course!).

Okay, so lets talk about outlook, or what I have called the Inflation Watch in the past. This time I am broadening my focus.

In spite of all the pushing, money pumping, stimulating, and general noise making, the government, including BO and Bernanke, has been unable to get the economy functioning, producing consistently, and growing. They don’t know why. Their mental framework, the “understanding of the world” they utilize to make decisions, has not brought them to the shining success they expected. But don’t despair; they know why it didn’t work. We didn’t cooperate, we being the banks, the business, the capitalists, the consumers, all of the non-government types. It is our fault. They will just have to try harder. Don’t worry. They, BO and his gang and Bernanke and his colleagues, will not question their ideas.

In the meantime, the economy is floating along, not improving, deteriorating marginally in areas that are hidden. More houses are being foreclosed upon (funny how there are few if any news reports about foreclosures these days, which was big stuff a year or two ago). BO is considering “restructuring” Fanny Mae and Freddy Mac. You know that won’t be good.

There is more unemployment and few new jobs, relative to the available workforce. (Notice that in my area, just outside of Washington, DC, unemployment is low. Isn’t that strange. Notice also the various comparisons between federal government employee incomes and the private sector.) Industrial production rose for a while, but has now slowed, if not stopped growing. Imports are again exceeding exports significantly, and the gap is growing. The balance of payments (all money transfers as opposed to just trade) shows that foreigners are still keeping dollars (idiots).

Not to be left out, foreign governments are doing just as much to screw things up as the U.S. government. Many who are looking at the Chinese to be shining stars are ignoring the fact that their Communist government believes in doing the same thing that the U.S. government does. We are the great capitalist nation and the Chinese are emulating us.

Someone could reasonably say to me that it isn’t really today that we need to be worrying about. It is the future, maybe the intermediate future. I agree. There are certainly significant seeds of terrifying doom planted in today’s economy, i.e., the debt, the made-up money at the Fed, the lack of any savings available for investment, the flood of new regulations, etc. The list is very long. Even worse is the lack of understanding of the true nature of the situation where the decisions are being made or where the decisions are being evaluated, i.e., the press.

Nevertheless, the American economy is not just the government or the Fed. There are millions of other actors who are seeking their best interest and working to achieve their own goals. These people have learned over the last century how to work around and within the government actions to minimize the consequences of those regulations and laws. Their ability to do so is not unlimited. But they have shown amazing creativity and resilience. We aren’t necessarily doomed.

Just as the government and mainstream economists don’t question their premises, those who have cried doom often in the last decades don’t seem to question why that doom hasn’t occurred. At root, they seem to give the government a kind of power in the economy that means that the non-government population is completely helpless and their actions have no consequences. Destruction is inevitable. Consequently, these doomsayers tend to pounce upon any small indication that things are coming apart as proof to the government’s power.

We must keep perspective.

The economy today is wallowing. The people making decisions are idiots. In many respects the average American cannot be relied upon to make good decisions. Even so, there is a lot of good stuff going on in our economy and society (including us). We can make it through with only a little damage. It would help if people listened to us. It would help if the American voters put in a non-Dem house of the legislature. Unfortunately, we can’t count on those events.

So what is the “Outlook”? At best it is very uncertain. Under current conditions and leaders, the best we can look forward to is more of what we have had over the last couple of years: no growth and floundering. With some positive results in November, maybe things will move toward the early part of this decade (not really good but better than now). But the potential is there for disaster. It isn’t unavoidable, just a potential.

Inflation and the International Wheat Market

One site that I monitor that discusses inflation is loudly trumpeting the recent rise in wheat prices as proof of their longstanding belief that we will be seeing lots of inflation, and future hyperinflation. They have forgotten or did not know that inflation is a domestic issue, revolving around a nation’s currency, that price inflation is a rising of the general price level, and that many different things can cause a specific product’s price to change, even without regard to any government activities. They also do not seem to understand the importance of looking at the context of the facts of reality, in this case the international wheat market.



Before looking at the wheat market, I want to emphasize that there is no free market in the world. All markets, including international markets, are affected by individual nation’s attempts to manipulate their own domestic currencies and product markets. Nearly all nations today are manipulating domestic markets directly or indirectly with little restraint. International markets are the total sum of the actions of each nation, plus the actions of individuals and associations of individuals (companies) both to meet normal business objectives and to avoid government restrictions. Whenever international markets are discussed today, these basics must be remembered. If someone talks as if markets were free of interference, we know that they are missing, ignoring, or evading current conditions. It is true that international markets do act independently of any one nation and that the controllers of a nation’s economy are often unhappy with what happens in different world markets. But the markets themselves are fundamentally affected by the actions of different governments, which often overcome real, purely economic or business factors.


Occasionally, and maybe surprisingly within today's context, a market will move as a result of events, real events, not government activity. That is what has happened in the world wheat market. Interestingly, the Russian economy after communism (notice I didn’t call it “capitalistic”) has turned its production of wheat into an export crop. Before, under the communists, Russia had to import wheat, in spite of its very fertile agricultural regions. Russia, as a mixed economy has managed to become a major exporter of wheat. Even so, Russia is not an advanced economy, not even where agriculture is concerned, so that it is more vulnerable to “mother nature”. Russia is suffering from a major draught (see news stories about fires around Moscow, too). Its wheat production has fallen dramatically (the Russian government has now banned wheat exports), and the world price for wheat has risen as supply has fallen, as you would expect.


A rise in a commodity’s price due to a shortage is not inflation. Certainly, if there is inflation, the situation would be worse, which is true today in nearly every country, but they are still two different things. Someone who doesn’t notice the difference does not understand the issues or the economy.


The price of oil is similar to that of wheat, with some additional provisos. The effects upon the international oil market of the actions of individual governments are more obvious, to anyone who looks, that is. The most important result of government action on the oil market is that of reducing the supply of oil, enforced shortage. Governments in many nations have restricted the search for and the recovery of oil. Further, many oil rich nations do not allow private companies to operate in their country, so their search for oil and its production is generally less competent and less successful.


If you have read my earlier posts you will have seen that I have been expecting oil prices to rise to close or above the prices from earlier this decade. The basis of my expectations were that the reasons why the prices was above $100 a barrel would exist again, i.e., increasing demand from the two largest populated countries in the world, India and China. Chinese demand for oil has resumed. India doesn’t seem to be as strong as it was, however. What we have seen is a price that has gone up, but still is significantly lower than it was earlier this decade. I think that the lower price is due to lower demand in the U.S., and probably Europe as well, due to the fact that neither area has recovered from the 2008 recession. Neither area is poised to actually recover, so for the immediate future, we can expect world oil prices to remain lower than the earlier highs. This may be true even though U.S. production of oil is bound to be further constrained by the backlash from the Gulf of Mexico oil spill.


To further my point in this post, oil price increases are not necessarily the result of inflation, either. International oil prices are going to be generally impacted more by direct manipulation by each countries domestic controls. There are so many examples besides the obvious restrictions on drilling and refining, which predominate in the U.S. Most of Europe has taxes on gasoline that make it very expensive, thus cutting demand. Some countries subsidize gasoline sales to consumers, increasing demand. Many of the oil rich countries have nationalized oil ownership and production. It would be interesting to research Indian and Chinese government policies regarding the discovery of oil reserves, production of petroleum products, and the importation and distribution of oil and gasoline. Regardless of those policies, both countries currently require significant importation of oil to support their growing economies, and their increasing requirements will tend to push international prices up. Which is not inflation. An investor, in a fairly rational context, would look upon the emergence of large economies that were actually developing as opportunities for enormous profit.


To that let me add a note regarding commodities in general. I want to talk about the basic stuff of production, i.e., metals, not foodstuffs. Consider a world in which all economies, all countries, were becoming capitalists. The initial supply of the basic materials of production would be stressed to meet the demand of newly productive economies. New mines and processing facilities would be competing for investment funds. Initially, prices for these materials would increase and products worldwide would become more expensive. This would continue for a while because the new mines would be producing material that was harder to extract and more expensive to mine or process. Over time, new mining and processing technology would be discovered which would tend to reduce the cost. Some of the upward pressure on commodity prices is happening now with the emergence of more productive economies. There are opportunities both in the short-run and longer term for investment, profit, and creativity.

INFLATION, WHERE?

With the efforts of BO, the Congress, and Progressives everywhere, the federal budget, the federal debt, and the Fed. balance sheet would seem to be doing all that would be necessary to push consumer prices upward very fast. My question is, “What are prices doing?”



The statistic offered by our friendly federal government, the CPI, suggests that there is little in the way of prices rises. Food prices, according to the CPI are volatile, but not soaring upward. The shadow stats offered as a more realistic indication of inflation shows something higher reaching 6 to 7%. If this is so, people would be starting to make some noise, I think. There are a number of people who are forecasting hyperinflation within the next few years. On the other hand, there are many analysts who maintain that we are staring deflation in the face


My approach has been to suggest to people that they pay attention to their own situation to assess what is happening. Hence, this post.


Readers, what are you seeing in your own shopping? Are you seeing prices moving upward? Significantly? Please respond. Thank you.

Deflation

As with inflation, there is a great confusion as to what deflation is. The people who steadfastly insist that inflation is raising prices are consistent in insisting the deflation is falling prices. This is why, time and time again, since the 1930s, they insist that prices need to be kept at least level when the economy hits a bad spot. They hold this position in the face of overwhelming evidence to the contrary, but that is another issue that involves considering their philosophy. Maintaining price levels has resulted in some of the most insane actions that we have seen in the free world. The classic is FDR’s requirement that crops be destroyed and land kept out of production when there were bread lines and people going hungry.


That dropping prices are not a bad thing has lots of evidence. The best I think refers to the time period from the end of the Civil War to the end of the 19C in the U.S. I have seen some suggestion that prices tended to stay level during this period, so there needs to be some more research (anyone know of some good references?) but there is also strong evidence that prices tended downward. Certainly, several important products saw sharp price declines as new technology was applied, including better business management techniques (e.g., Standard Oil managed by J.D. Rockefeller).

In today’s world we see prices dropping for many important items in spite of the continuous inflationary pressure of new made-up money being pushed into the economy. But overall, even the much maligned CPI shows some upward trend of consumer prices. The “core” inflation rate (which excludes what is considered volatile, energy and food; isn’t that really dumb) is slightly up year on year at less than a percent. Those who figure that the CPI has been manipulated for political reasons and to keep the masses from getting restless prefer the shadow statistics analysis that says we are seeing closer to 6 or 7% inflation this year, especially in food. Bottom line though is that we are definitely not seeing falling prices.

Those who are deathly afraid of falling prices would be demanding that the Fed, the White House, and the Congress do something, anything, if prices do start to fall. They fear a depression. If prices do begin to fall, we will see such a massive pumping of money, demands for price controls or supports, and really weird stuff that will take our breath away.

It was the fear of falling prices that prompted many of the actions at the beginning of the recession in 2008. The consequence of that was the prevention of the liquidations and readjustments necessary in the economy to allow it to return to productivity. It is why we are still in a mess. More actions to keep prices level would not be helpful.

Another group, to which I belong, regards deflation as a reduction of the money supply. The money supply indicator for the U.S. that I use (MZM) has dropped about 3%, but has now stabilized. The main driver of the money supply in the past 50 years has been the expansion of bank credit, primarily to businesses, but also to consumers. Bank credit has decreased almost 25% in the last 18 months. Even so, the money supply has not shrunk. Further, we are continuing to have balance of payment shortfalls, which means we are sending dollars we don’t miss out of the country.

So what? What would it mean to us, now and into the future? Remember that one issue of inflation is the entry point of new money. In the same way, in deflation, it matters where the money is being taken from. Right now, money is being injected into the economy via federal payments, i.e., stimulus, medicare, “jobs” programs, social security, and other payments. Where has money being taken from? Loans to businesses are decreasing, as I mentioned before. What isn’t? Loans to government. The Federal Budget is in massive deficit in 2010, and will be so in 2011 and thereafter unless something extreme happens. Money is not being taken out of the economy so much as savings is being diverted from any activity except government debt.

The question I keep coming back to in the discussion of deflation is how actual deflation could possibly happen. Those who argue for deflation of the money supply do not actually explain how it could come about. They merely point to certain trends and extrapolate from there. That’s fine. But the trends have not actually reached deflation. And those trends have now been going on for a while, and still no deflation.

So how could the money supply decrease? One idea given is that if we go into (further into?) recession again now, business lending will decrease further and total checking deposits will fall. Checking is ready money, which is the backbone of the money supply. So far, however, bank loans have decreased 25% and money supply has remained flat, even with the export of dollars as our balance of payments have remained in deficit. The fall in banks loans is not leading to deflation.

As I see it, the federal budget deficit and BO’s expansive spending (he wants more stimulus) is pushing on the money supply faster than any deflationary trend. If, somehow, BO were to stop spending, the budget deficit stabilized, someone figures out that we don’t need more fake jobs and production-killing regulations, and no panic response comes from Congress or the Fed, we could wonder into deflation. Yeah, that is likely to happen.

An actual deflation would do some good in that it would wipe out more made-up money. The real issue, of course, is what happens to savings and actual productive investment. It doesn’t matter that much what the money supply is doing (if the government is not actively inflating it), if there is actual savings and the savings is being put to use productively, profitably. In fact, real money supply deflation is fine if savings is invested productively. In deflation, a saved dollar is becoming more valuable, i.e., can buy more as time goes on, and, therefore, saving a dollar automatically increases one’s wealth. Putting it into the hands of someone who can turn it into a profitable endeavor makes the dollar even more valuable. All of this doesn’t happen when the government is sopping up every dollar it can find to fund its deficit.

The bottom line isn’t whether we are in deflation or not. It is what the government does. Since there is no one in position to make decisions that holds principles in ethics, politics, or economics that are connected to reality, we can be certain that what they will do will not be beneficial. But that is true whether we have inflation or deflation. They are right now taking every bit of savings, and with the recent new law increasing the regulation of the financial sector, the power and flexibility of our system for funding production is further damaged.

Deflation, then, is a fake issue. It is another way in which analysts, politicians, bureaucrats, commentators, bloggers, and journalist can feel as though they are grappling with the important economic issues and evade reality.

Reich: From Regulation to Restructuring

In the second article by Dr. Robert Reich that caught my eye recently, the good doctor is actually criticizing BO and his gang. BO is not being assertive enough and thus the problems that both BO and Reich want to “solve” are not receiving the best solution, according to Reich.


First, Reich addresses the failures in the financial reform bill in Congress. He reiterates the criticisms that I mentioned in my last blog, i.e., that banks are being subsidized to cover their derivative activity (amazingly he includes the AIG transactions, which were actually straight insurance purchases).

But Reich’s primary criticism is that the banking system is not being “restructured”. Reich wants the major banks to be broken up and prohibited from reaching a (unspecified) size. (I wrote about that issue in a previous blog where I pointed out the very drastic consequences for the U.S. and world economy.) His reason is that he does not want them to be “too big to fail”, and thus be bailed out by the federal government if, rather, when things go bump again. Reich is not willing to consider the notion that maybe the government shouldn’t be bailing out banks or anyone. No, he thinks that part is fine. He thinks that the government is “protecting” the economy by bailing out people. Reich wants to break up the banks. I liken it to wanting to play tinker toys with real world businesses.

He does recognize that there may be adverse competitive consequences for U.S. banks, but he brushes those objections aside. This part of his argument is very strange. He says, “…since when is it up to taxpayers to guarantee profitability at America’s largest banks relative to foreign ones?” But, the Dems have never suggested that they wanted to undercut American businesses. Their claims before have always been that their “solutions” for the American economy have been beneficial to all. Reich is propounding a new attitude, a new policy that says that American businesses, and thus its citizens, should be “restructured” in spite of the obvious disadvantage that results.

To further make his case for restructuring, he turns to the healthcare industry. He says, “Similarly, the underlying system of private for-profit health insurance is a key driver of America’s bloated and ineffective health care delivery. We can try to regulate it like mad, but no amount of regulation will cure this fundamental problem.” Similarly, in this case, the problem is the “private for-profit health insurance”. Again, we need restructuring, i.e., a single payer system, socialized medicine.

Regulation for Reich is an attempt to “mend” capitalism. Instead, “The only way to have a lasting effect on industries as large and intransigent as banking and health care is to alter their structure.” And he further lets the cat out of the bag, “That was the approach taken to finance by Franklin D. Roosevelt in the 1930s, and by Lyndon Johnson to health care (Medicare) in the 1960s.” The former maintained a depression that lasted over a decade and LBJ can be thanked for the current mess in healthcare in the U.S., which no one, either Democrat or Republican, is willing to admit. So, all of the past attempts to deal with capitalism’s failings have themselves failed.

Reich’s criticism of regulation, especially in the two industries that he is using as his examples in the article, is that lobbyists and the industries can wiggle out of the intended consequences. He says, “A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It’s always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue to go on much as before.” That is, the victims can try to make some decisions of their own and try to run their own lives and businesses. He says, “And that’s precisely the problem.” The problem is that there is some semblance of freedom. That is unacceptable.

The problem in the American economy, according to Reich, is structural. What is the structure now, in Reich’s view. It is capitalism. It is for-profit. It is what the bankers are doing, basically by themselves, without Reich’s approval. The solution is for the government to mold the structure of the economy. Mold the activities of the people. Mold the people themselves.

As I said at the beginning of the first of these two posts, Dr. Robert Reich is a Marxist economist.

This article is unusual for two reasons. He explicitly proclaims that the actions of government should not be considered for their benefit for the economy or business but should be taken in the face of adverse consequences. He is admitting that the left’s solutions should be taken regardless of consequences. Instead, he calls for sacrifice (my word) for the benefit of the “taxpayers”. Second, his demands that the economy be restructured signal a new strategy. Regulation is now something that will be regarded as merely a accommodation to capitalism and rogue businessmen. What is needed is structural change, changes that make the government the direct controller in the economy. Regulation tends to be set up in terms of what business can’t do or what it must do to assure safety or fair play or some supposed good. Reich’s articles are pushing the government to become the primary force in determining the make up of businesses and the economy. Next, it will be the five year plan.

Robert Reich: Stop Subsidizing Wall Street

Robert was on a roll this last few days. He has published articles that have popped up on different web scans as significant comments.


Dr. Reich is an academic that loves to serve his fellow man. He has been a member of three Democratic administrations and believes that he is an expert on “public policy”. Surveying his “policy” recommendations, I conclude that he feels that he was born too late. He would have been very happy to be a leading Marxist economist. At every turn he has recommended turning away from capitalism toward state control of all aspects of the economy. He regards actions taken by the government as wiser and morally superior to individual action. The use of force is okay with Dr. Reich.

What brings him to mind is that I came across his blog. This particular entry is entitled: “Financial reform bill unlikely to end taxpayer subsidy of derivative trading on Wall Street”

This may not sound particularly controversial because the federal government subsidizes many industries and companies. Handing out federal money is a major activity of both political parties and nothing at all new.

You might ask, which specific taxpayer subsidy is he talking about? How are the taxpayers subsidizing derivative trading. One answer could be that our government has decided that financial companies who traded derivatives were bailed out because of the “too-big-to-fail” irrationality. That is, some financial companies got carried away trading derivatives, lost gobs of money, and the government bailed them out by giving them money. That would be a subsidy, you say. Sorry, no. That is not what our Dr. Reich has in mind.

Just like any other sector of the economy, existing banks do receive a portion of the public dole. Considering how convoluted and contrived federal spending and the means of providing subsidies and support has become in the U.S., there are possibly many different actual subsidies that the banks receive. I have not researched it. But, upon reflection, I can think of two. One is that a considerable proportion of the money that the bank lends comes with no expense. It comes from the expansion of the money supply by way of the Fed. When the Fed. expands bank credit the bank receives new money in its reserve/deposit account at the Fed. The bank can then take that money into it’s own coffers and loan it out. The bank’s only expense or risk is that the Fed. may decide that the amount of money it has put into the economy should be reduced and begin a process of restriction and shrink the reserve accounts, which would require the bank to call in loans. The risk of restriction is small. It rarely happens.

Another benefit that existing banks receive from the current situation is a considerable reduction in competition. The regulatory burden on banks (and the rest of the financial sector as well as the economy as a whole) is extremely large. Even someone who has some understanding of banking would be staggered by the amount of paperwork, filing, extraneous record keeping, staff, and expense of the regulations. Just keeping track of all of them, and learning about and implementing new ones takes a considerable staff and administrative expense. The cost of regulation is one of the factors leading to bank consolidation. The economies of scale of a larger bank make it easier to cover the cost of regulation. Competition is reduced by the consolidation and by the tremendous expense and risk involved in starting a new bank of any size.

But none of these means of supporting the current banking establishmen is what Dr. Reich means is that banks are protected against their folly by government guarantees of customer deposits. What he is referring to is the Federal Deposit Insurance Corporation, which isn’t a corporation at all but a government entity. You see its initials all the time. Somewhere on its promotional and contractual material, every bank has placed “Member FDIC”. I’m not sure that “membership” is optional, but the marketplace, supposedly, would punish any bank that wasn’t a member. I mean, who wouldn’t want their deposits insured?

The FDIC collects funds from the banks, just like insurance, and guarantees that if the bank defaults, the FDIC will cover the difference between the bank’s assets and the deposits, up to $250,000 per customer (not per account). The FDIC was created during the depression to try to give people some confidence in their banks. Banks had been failing at a rapid pace for want of capital. People were afraid that they wouldn’t be able to get their money. Deposit insurance seemed the ticket.

But it is a fraud. It isn’t insurance. The fees collected by the FDIC could not cover much, and are certainly not sufficient for the size of the major banks today. Even when it was created it was recognized that the FDIC could not stand on its own, so it was backed with federal government guarantees. When the FDIC runs out of money, the federal purse bails it out. It did, too, during the 70’s when Thrifts began failing in large quantities (more government malfeasance). So, today, everyone who has paid attention knows that if banks begin failing the feds will have to pony up more money to cover the FDIC’s obligations.

Now along comes Dr. Reich, who wishes to expound on the virtues of government and, since it is popular to bash banks these days, bash the “rich” bankers. He capitalizes on the ignorance and poor education of most Americans, and forthrightly declares that the banks are being subsidized.

He has to ignore that the precarious situation of the banks over the last five years is directly related to the cheap money policies of the Fed., the efforts of the federal government to eliminate sound credit practices in the mortgage industry, and the forced semi-nationalization of the largest banks. Ignoring facts and reality is a way of life for Dr. Reich.

So the subsidy that Dr. Reich is referring to is actually no subsidy at all but a insane obligation left over from the 30’s that could put the federal government on the hook for trillions. Now, does Dr. Reich want to end the subsidy? No. He thinks that the FDIC is a fine organization. Instead, he is focusing on the derivative trading.

Not just any derivative trading, but the defensive or hedge trading. There are really two different approaches to derivative trading. One approach is intent on making money, just like most investment. This derivative trading is generally short term and is a form of speculating, i.e., expectations of advantageous price changes. This kind of trading can often result in significant losses, just like speculating on the price of a stock. You expect the price of the stock or derivative to go up, but it often goes down, and until you sell it, you lose money on the market price. Not all derivatives function that way.

A defensive or hedge approach to derivative trading is exemplified by the corn farmer, perhaps the source of one of the first derivative markets. When the corn farmer plants his crop he founds his expectations on the current price of corn, or perhaps on what his experience suggests the price will be when he harvests and delivers his crop to market. But of course, the future is not known. The price could be very different in a few months. It the market price for corn is lower, the farmer is sure to lose money. So the farmer buys a derivative. He buys a financial product that will pay him money if the price falls. He buys what is called a put option. If the price of corn on his delivery date is the same as the put or higher, the farmer reaps his expected profits and is happy. The money he paid for the put is lost. If the price of corn has dropped, the farmer makes up for his losses from his crop by the return on the put. The farmer has maintained his position.

The put option is purchased from another party who holds the same view of the future as the farmer, that the corn prices in future will be the same or better than today. He knows that he has a risk of lower prices, but he has factored that into his business, and has either reserves or a hedge of his own to cover potential losses. The farmer regards the cost of the put as a business expense and the seller of the put regards the potential loss as a factor in his business. The transaction and the decisions are done in a very businesslike manner.

So the bank has certain exposures to interest rates. If the interest rates change in a manner that is unprofitable, the bank will lose money. To offset potential losses, the bank buys derivatives just as the farmer did. For these derivatives to make sense, they must offer significant return with little cost, just like the corn farmer’s put option. The bank regards this as a business expense. It is a good banking practice.

What Dr. Reich does is confound the two different types of derivative activities. It may be true that some, most, or even all banks engage in both types of derivative trading. But it is clear that Dr. Reich is trying to have it both ways in that he yells “derivatives” in such way to capitalize on the danger of volatile aggressive trading, while also mentioning in an aside that banks are using hedge derivatives.

Reich says, “If derivative trading is so useful to them in order to “mitigate the risks” of other banking activities, the banks should be willing to foot the bill.”

Dr. Reich wants it to seem that the taxpayers are getting ripped off by overly aggressive banks who are risking huge taxpayer funds by aggressive, semi-rational derivative trading. He says that taxpayers are footing the bill. This is the same thinking that considers tax breaks or reductions to be a government expense. No money is going to the banks (in fact it costs the banks money to “belong” to the FDIC). As noted above, the reason the taxpayer may pay any money is if the Fed. policies drive many banks to the brink of default. If one or two banks fail because of poor business practices or banking decisions, for example, the FDIC will generally be able to meet its obligations. The problem is when there is a systemic or broad problem. But, according to Reich’s thinking, the bankers have a sweet deal: if the bankers have “bet” right, they pocket lots and lots of money; if they “bet” wrong, the taxpayers will have to pay. He says, “Derivatives can generate huge risks for the economy unless carefully regulated. Neither logic nor experience suggests that you and I and every other taxpayer should be subsidizing this gambling.” But none of his argument is related to reality from start to finish.

Let me make one observation about derivatives and the banks. The derivative tools banks and other intelligent large volume traders use are the result of brilliant inductions from highly complex, high-speed, high volume, international trading. They are intellectual marvels. But, at root, the banks and other financial traders are being taken for a ride. The tools work very well when the basic data they depend upon are real, but the data isn’t. Instead, the data, which is interest rates and money flows, is contrived and manipulated by governments around the world, mainly the U.S. In the long run, and when they need it most, the banks will be let down by their tools precisely because the tools depend upon being connected to reality, and the governments interfere. This situation is an excellent example of von Mises observation that prices are cognitive tools.

At the beginning of this entry I mentioned that Dr. Reich had two articles of interest recently. I will discuss the second in my next blog, hopefully in a day or two.

What next? Negative Interest?

A couple months ago I saw an analysis that showed the rate of interest targeted by the Fed Open Market Committee had declined over the last twenty years or so. Each cycle showed the targeted interest rate to be lower than the previous cycle. The question posed was, what would happen the next time, and if the economy gets going again, there will be a next time, But the Fed is already at zero. What will they do?


The target interest rate is what we hear called the Federal Funds rate or the Discount Rate. It is the rate the Fed charges banks, members of the Fed, to borrow from the Fed to maintain the minimum level of their deposits (sometimes called reserves) at the Fed. The law that set up the Fed. requires all member banks to maintain deposits (reserves) at the Fed. These funds are not available to the bank to use for any purpose except the Fed’s manipulation. The amount of the deposits that a bank must have with the Fed is a percentage of its demand deposits, called checking accounts by you and me. The Open Market Committee decides what percentage of demand deposits a member bank must have on hand, currently 10%.


If a bank’s deposits falls below 10% at any point, the bank must either deposit funds, borrow from another bank, or borrow from the Fed. And the Fed charges an interest rate, which, as I said, is called the Discount Rate or the Federal Funds rate. This is the interest rate that you hear or read about all the time in the popular press. It is considered a big deal. “Investors” buy or sell on expectations about the rate, banks connect their “Prime Rate” to the Discount Rate, mainstream economists connect their predictions on the economy based upon the Discount Rate, and so on.


The Discount rate is not maintained by decree, actually. It is a market rate, which is why it is called a target. The Fed. maintains the rate by adding or subtracting the amount of money available for bank member borrowing to cover minimum Fed. deposits. Ultimately, this is how the Fed. manipulates the money supply, but adding or subtracting money in the member banks Fed. deposit accounts (see elsewhere in my blog for a detailed explanation).


Therefore, the Fed. lowers the discount rate by adding money to the economy through the banks deposits. Currently, the Fed. Discount Rate is 0.00 to 0.25%, or nothing. The rate has been zero for well over a year. Supposedly, when rates are low, banks will loan more money, and, in current “thinking”, the economy will whiz along. Oh. You noticed no whizzing? What a surprise. Actually, banks have been contracting lending for well over a year, both to businesses and to consumers. Even with a zero percent interest, the Fed. can’t get the economy going. Even with the “stimulus” packages, they can’t get the economy going. What a surprise.


The chart I mentioned at the beginning suggests that future efforts of the Fed. will have a problem. That each successive round of encouragement from the Fed. has required lower interest rates. Well, you can’t get lower than zero. Free money would seem to be the ideal from these people. Hmmmm. The current situation is somewhat confused by the fact that the Fed. is paying interest for the first time ever on the Fed. member bank deposits. Before September, 2008, the way banks made money on expanded Fed. deposits was by taking 90% of the dollars the Fed. had given them in their member deposit account into their bank and loaning those dollars out (theoretically, there was nothing stopping them from just creating new demand deposits in their bank that equaled ten times the new Fed. deposits, but accounting niceties kind of made that difficult). Because the Fed. had created a massive amount of member bank deposits, about $1T vs. the normal $50B, the Fed. wanted to encourage the banks to keep the money at the Fed. so it began paying interest (not much, but more than zero). It turned out that it wasn’t necessary to offer interest, since the banks aren’t lending.


The Fed. keeps talking about the time when the economy begins growing again and it can raise interest rates, absorb all that money it created, and wallow in its self congratulations. But, here we are, a few months from two years of Fed. and BO encouragement, and no recovery. Some slight good news is published and everybody gets excited, and the next week there is new bad news and everyone feels worse. Unemployment figures continue to look bad. Well, I won’t dwell on the sorry picture.


So the chart I mentioned implies that if and when things get going, to the extent they can go at all with the huge burdens the BO has saddled us with, the Fed. is going to have to keep interest rates lower than in the last cycle, which was lower than the cycle before that. Of course, that will mean huge flows of made-up money, both in bank credit expansion and government spending, asset inflation, price inflation (currently 2.4% in the much criticized CPI), and probably very slow, real growth. Then, a couple years down the road the next bust comes (in a shorter cycle, I would think), the Fed. will have nowhere to go. The interest rates for the boom would be very close to zero, say 1-2%, and zero will not do much, probably even less than now. True to his convictions, Bernanke, the Fed. Chairman, will have flooded the country with more made-up money (we need to start calling him “Flood Money” Bernanke), and the next recession will just continue. We can expect more condemnation of capitalism, more destruction of our productive capacity, further crippling regulation of our financial system, a move toward greater violence and despair, and no economic growth or future. At least the cycle of boom and bust might have come to an end.

A Prediction from Henry Hazlitt, Meaning for Us

Recently I was searching for a book on telescopes in my library when I came upon a book that I didn’t recall owning. It was obvious why I owned it, when I bought it, and from whom. I just didn’t remember it. I probably haven’t read it. I will. The book is The Inflation Crisis, and How to Resolve It, Second Edition (1983), by Henry Hazlitt. I read the Preface to the Second Edition and was shocked. It was written in March,1983 and suggested a future far different than what we lived through. I have copied all but the first couple paragraphs:



I do think it necessary, however, to call attention here to a development of the last two or three years that was not analyzed in my earlier book because it had not occurred up to 1978 – at least not to such a dramatic extent. This has been the sudden and sharp rise in real interest rates to a level that brought about a deep recession in business and consequent mass unemployment.

Economists have long pointed out, of course, that in an inflation that has gone on for some time, and is expected to continue, nominal interest rates rise. Lenders want not only a normal rate of return, but a “price premium” to compensate them for the expected fall in the purchasing power of their dollars when they get them back. I discussed this in my 1978 book. (Ch. 17, pp. 121 et seq.)

But the rise in interest rates in the summer of 1982 was much grater than the general expectation of the future inflation rate prevailing at that time would have brought. It was a “real” and not merely “nominal” rise in interest. It made private borrowing almost prohibitive.

This was a result of a combination of two factors. The first was a sharp increase in the size of the deficit. The second was the refusal of the Federal Reserve System to monetize the debt to any but a minor extent.

The deficit for the fiscal year 1982, which ended Sept. 30 of that calendar year, was $110.7 billion (compared with an average deficit in the tree preceding years of $48 billion). If the Federal Reserve had bought the government’s securities in the open market to an equivalent amount – a frequent practice in the past – this would have led immediately to an accelerated inflation. But it refrained. The result was that the government’s enormous borrowings in the open market sent interest rates soaring, and “crowded out” part of the private borrowing that would otherwise have taken place for business expansion or even for continuance of normal production.

As long as deficits of the dimensions of fiscal 1982 continue there is a prospect of either prohibitive interest rates or galloping inflation in the immediate future, depending on how the deficits are financed. We could easily have a combination of both.

Yet this is precisely the policy that is now officially planned. The President’s budget message of Jan. 31, 1983 projected a deficit of $188.8 billion for the fiscal year 1984. And even on the assumption that his proposed cutbacks and freezes in spending are adopted, his budget message forecasts deficits of $194 billion in fiscal 1985, $148 billion in 1986, $142 billion in 1987, and $117 billion in 1988. When we consider that we have already had 44 deficits in the 52 years since 1930, that future budget deficits have been chronically underestimated, and that President Reagan himself, at the beginning of his term, projected a balanced budget for the fiscal year 1984, the outlook at the moment of writing this is frightening.



Now I have several things to say about this, the foremost being that every time I write or say something about the future of the economy I am well aware that it might be just as far off as Mr. Hazlitt’s remarks. There are just so many potential influences on an economy that it is very difficult to get a prediction correct. This is especially true when predicting gloom and doom in the American economy. Americans do not want to experience declining standards of living. They’ve seen it and want no more of it. So, in spite of what the government might do, Americans will work very hard to avoid really severe consequences.


Another comment that can be made is that Mr. Hazlitt did not and probably could not anticipate the understanding and competence of Fed Chairman Volker or the advisors supporting Reagan. Volker did not want a return to the inflation of the 70’s, and he led the Fed away from the actions that would “monetize” the federal debt. Reagan put money back into the hands of actually productive people by reducing taxes. So, in spite of the apparent level of deficits, the economy had room to grow. Of course, we have neither of these benefits in today’s government.


But probably, most of all for me to point out is the lesson for the reader. Economic predictions by those who oppose the government are often presented as definite, precise conclusions. People offering products or who have prominently presented a prediction will argue that their expectations will come true regardless of other, unforeseen events or influences. It doesn’t mean that their reasoning is wrong so much as that they do not realize the limitations of predictions in an economy as complex as ours.


The worth of my last set of comments can be seen in today’s financial crisis. Many, reasonably drawing on the insanity of U.S. government actions, have predicted the continued drop in the dollar. It isn’t happening. Why? Because of higher levels of insanity in other governments, plus a crisis in minor countries attracts as much attention as any other crisis. How long will the idiots in other countries keep acting in such a way that people don’t notice how poor an asset the U.S. dollar is? Who knows? There are literally dozens of other countries with their own set of idiots and insane economic programs. In comparison, the dollar might be a better option. How long will this situation favoring the dollar continue? Again, who knows?


What is a person who wants to protect themselves from the very bad policies of the U.S. government going to do? After all, the current situation is one of high risk. The dire predictions that I have been referring to and my own comments in this blog are all grounded in well thought out economics and accurate information. This is why caution, diversification, vigilance, reading, and just paying attention are all important. Patience, too. Be prepared for bad news, and do not react, by which I mean, do not be one of those who makes big changes on bad news (and be selective on the good news you react to).


In a wider perspective, Mr. Hazlitt’s comments suggests that there are some epistemological issues to consider about economics. Some contend, for example, that Ludwig von Mises is really, at root a rationalist. His presentation is seemingly deductive. I understand the source of that accusation, but in reading, for example, his Theory of Money and Credit I see significant references to events that support his position or counter the claims of another economist. He seems to me to be very grounded in real events. But, at the same time, economics is not a science that allows the type of isolation of causal factors that a physical science does. Even in the analysis of past events, in which all the information may be available, separating out the events and identifying the causal factors is far from easy and often open to ambiguity. The question of which analysis you accept ultimately falls to your understanding of the process of production and of human action (to coin a phrase). It is exactly like history. What factor in human action do you identify as primary: human intelligence, individual genius, geology, or philosophy? If your understanding of mankind is correct, your understanding of history, and also economics will tend to be correct also. Exactly how that works out in a specific situation, however, may be very complex, and the uncertainties in predicting what will happen before the event sufficient to throw off apparently well-reasoned expectations.


The lesson: figure it out as best you can, and hedge your bets. Don’t tie your actions to specific expected events but to the general trends, and don’t be surprised when actual events go against you. The point to remember is that when living within a generally irrational culture, the irrational will happen.