Fire Hydrant of Freedom

Detlev Schlichter is one of the clearest thinkers I know on the subject of Austrian Economic theory applied to our current crises. Read his book, Paper Money Collapse. More more thoughts on investing in this environment, see the questions and Detlev's answers on the referenced page.

Tom

http://papermoneycollapse.com/2011/10/unstoppable-why-this-crisis-will-keep-unfolding/

Unstoppable: Why this crisis will keep unfolding
by DETLEV SCHLICHTER on OCTOBER 20, 2011 · 20 COMMENTS

Image by Salvatore Vuono
When the tectonic plates underneath society shift, confusion reigns, together with wishful thinking.

It appears that financial markets have again managed to get themselves into a state of unrealistic expectation. The European summit this coming Sunday (or the follow-up summit on Wednesday) is now supposed to bring a “comprehensive plan” to solve the European debt crisis. Of course, nothing of the sort will happen, and for a simple reason: it is impossible. Those who cherish such fanciful hopes are naïve and will be disappointed.

Let’s step back and look at the problem, which in a nutshell is this: The dominant societal model of the second half of the twentieth century – the social democratic nation state with its high levels of taxation, regulation and stifling market intervention, and thus increasingly dependent on a constantly expanding fiat money supply and artificially cheap credit –is rapidly approaching its logical endpoint everywhere, not just in Europe: excessive and unmanageable piles of debt, systemic financial fragility and weak growth.

For many, including quite a few of those demonstrating under the ‘Occupy Wall Street’ banner, this whole mess deserves the label “crisis of capitalism”.  That this is nonsense I explained here. What we are witnessing is not the crisis of capitalism but the failure of statism. The present system, certainly the financial system, has very little to do with true capitalism, and if financial markets are now being demonized for their failure to go on funding political Ponzi-Schemes, than this means shooting the messenger rather than addressing, or even understanding, the root causes of the malaise. As I said, this is also a time of great confusion.

Failure of statism

The monetary madness of recent decades was only made possible by the transition from apolitical and inflexible commodity money (free-market money) towards limitless, entirely discretionary fiat money (state money). This shift was completed on August 15, 1971, when this system was also made global. What does such a monetary system logically entail?

In a complete paper money system, banks cannot be private capitalist enterprises but must be extensions of the state because the state holds the monopoly of unrestricted money creation. The banking sector is cartelized under the state central bank. To operate a bank, you need a state license that requires that you open an account with the central bank.


Photograph by M. Bartosch
In such a system, the central bank can create bank reserves out of thin air and without limit, and has thus full control over the level and the cost of such reserves. The central bank has therefore ultimate control over the funding of the banks and the availability of credit in the economy – which is now supposed to be magically freed from its natural constraint under capitalism: voluntary savings.

In such a system, it is generally assumed that the state cannot go bankrupt as it can always print more money to fund itself. It is equally assumed that the banks cannot fail and do not ever have to shrink, at least collectively, as ever more bank reserves can be made available to them – if need be at no cost, as has become – now that the system arrived at the point of ultimate excess – the global norm.

It can hardly be surprising that those who are in charge of the banks and those who are in charge of state finances have behaved for decades as if the Great Regulator of economic life, the threat of bankruptcy, was of no concern to them. Now that the system has finally overdosed on cheap credit and that the forty-year fiat-money-fed boom is over, reality is sinking in. And it comes as a shock.

There is a lot of talk of return to normality. The market has, of course, a way of returning to normality, which involves liquidating the excesses, clearing out the dislocations, defaulting what will not be repaid, and deflating prices that do not reflect real demand. Liquidation, default and deflation, however, are politically unacceptable, as they cut right to the core of our system of state-managed ‘capitalism’: the notion that the state is above the laws of economics and that it can bestow a similar immunity on its protectorates, most importantly the banks.

What’s €2 trillion among friends?

Back to the alternate reality of the policy debate in Europe. The hope of many financial market participants seems to be that the summit will reveal measures by Germany and France to erect a firewall around Greece in case it will default, that the banks will get ‘recapitalized’, and that steps will be taken toward further ‘fiscal integration’. The wish here is evidently that Big Daddy will finally step forward, that he draws a line in the sand, and says, hey, this stops here. Time out on the crisis.

There is only one problem: Nobody has the money to do it.

Two days ago the British newspaper The Guardian broke the story, unconfirmed so far, that Germany and France had agreed to a €2 trillion bailout fund. In response, equity markets around the world enjoyed a brief rally. Finally, the big bazooka had arrived.

Really? I was wondering if nobody ever heard of Brian Cowen.

He was the hapless Irish chap who in 2008 played Big Daddy himself and implemented an official government back-stop for the Irish banks. And duly bankrupted his country.


Life of Brian (Image by Maxime Bernier)
If Merkel and Sarkozy were really stupid enough to launch a €2 trillion bailout fund, it would certainly pay to go short French BTANs and German Bunds right away. Germany and France have no money to bailout anyone. All they could do is pile on more debt on the already large and ever-growing debt pile of their own. It would not take the market as long as it did in 2008, in the case of Ireland, to figure out what the endgame must look like.

But surely, everyone involved must realize that the little boy in the crowd has already pointed out that Emperor Sarkozy and Empress Merkel have no clothes. Interest spreads on French bonds have already blown out, and Moody’s has warned that France’s AAA-rating (what? Triple-A?) might come under review. Credit-default spreads on German bunds have widened of late, and the cost of insuring against the bankruptcy of the Bundesrepublik Deutschland will most certainly only go one way: up. Have I mentioned that Bunds are the short of the century, and U.S. Treasuries, too?

The whole notion of ‘ring-fencing’ Greece is, of course, absurd, as if Greece had contracted some rare contagious disease from which healthier nations, such as Italy or Spain, had to be isolated. Ongoing, endless fiscal deterioration is, however, not a virus but a self-inflicted and ultimately fatal wound that all European states, and in fact, almost all modern social democratic states are already suffering from. The difference between Greece and Germany is one of degree, not principle.

For these reasons, the idea that some form of ‘fiscal integration’ could be the solution, is equally absurd, as if pooling the finances of the already-bankrupt and the almost-bankrupt will somehow give you a community of the fiscally strong, as if you could improve the financial standing of a trailer park community, in which some inhabitants are maxed out on their credit cards while others still have some borrowing capacity left, by giving all of them a joined bank account.

So does this mean that all political options are exhausted, that default, liquidation, and deflation are now unavoidable?

It will get worse

Not so fast. There are still some options left to governments. None of them will solve the problem, all of them will make the crisis worse. All of them are scarily ugly and destructive. Of course, I expect that all will be adopted by governments soon.


Unlimited Euros!, photo by Florian K.
There is, of course, always the prospect of growing regulation and market intervention, of capital controls and the banning of short selling of government debt. I expect all of this to be enacted at some point in the not-too-distant future. Like all government intervention, it will make things worse and accelerate the demise of the system.

But the biggest of all policy mistakes is already being made, and we will get more of it, much more of it: printing ever more money ever faster.

The ECB will be forced/asked/convinced to support the market for government debt of ever more European states to an ever larger degree. Central banks and fiat money are not creations of the free market but of politics. Their role has always been to fund the state. We have already reached the point at which all major central banks are dominant buyers, frequently the largest marginal buyers, of their governments’ debt. The U.S. Fed is already the single largest holder of U.S. Treasuries, and when the just-announced second round of ‘quantitative easing’ in Britain will have been completed, the Bank of England will own almost a quarter of all outstanding Gilts. Funding the state directly with the printing press is the logical penultimate stage of the demise of the present global fiat money system, and all major economies are approaching it fast. The eurozone will be no exception. The ultimate step is loss of confidence in paper money and inflationary meltdown.

If there is one outcome from the European debt summit that I am most convinced about it is that another crucial step will be taken to accelerate the ongoing debasement of fiat money.

"Now we really are fuct"

Yes indeed. In the 1920s, the charge was "price stability." Professor Irving Fisher was the initiator of that failed doctrine. With sound money in the 1920s, prices would have fallen slowly due to rapidly rising productivity, but the Fed used the stable price indices as a license to step on the monetary accelerator. Price stabilization policies were very popular during times of falling prices, not so popular during times of rising prices -- the objective is always to increase monetary inflation, not to tame it.

It will be the same with nominal GDP targeting. It'll be very popular when GDP is falling short, meaning that more monetary inflation is called for. When nominal GDP is exceeding the target ... well, heck, what's wrong with that?

And the problem with both of these ideas, as I have said in earlier posts, is that monetary inflation does its serious damage by distorting prices and interest rates. When interest rates are artificially lowered, people spend too much on capital goods and durable goods. Since 1980, the Fed has not allowed a recession to run its course, so we must have quite an impressive total of malinvestments by now. Anyone doubting that needs to take another look at the aggregate trillions of dollars poured into Fannie Mae, Freddie Mac, GM, AIG, and all the other Wall Street institutions and banks that have been sucking the country dry.

Doug Noland has been commenting upon credit expansion bubbles for a long time now (http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10586). He worries more and more that we will eventually reach the point where, suddenly, US debt obligations will fail to find a bid. That would change everything.

<I fear global market dynamics and Fed policymaking are propagating the worst-case scenario for the U.S. government finance Bubble.  As was the case in Greece, Ireland, Portugal, Spain, Italy and elsewhere, a distorted market is content to accommodate profligate borrowing until it’s way too late.  Is another round of Fed MBS QE going to help?  A dysfunctional marketplace has, almost without exception, been incapable of imposing any degree of market discipline until the point when only exceptionally harsh and destabilizing “austerity” suffices.>

It's reached the point now where the US desperately needs a deflationary correction. Left to run its course, such a correction would soon put this once great nation into to shape to grow and prosper again. But our rulers will never allow that to happen. It appears that they will take us all down "fighting" battles that not only don't need to be fought -- but guarantee our destruction.

Tom

GM,

This may seem completely flippant, but as it stands now virtually ALL of our money might as well be counterfeit. When the Fed creates a few extra trillion dollars in a few months, that has a tremendously negative impact on all dollar holders. The process is indistinguishable from counterfeiting except that the beneficiaries are usually government and financial industry personnel instead of a bunch of misfits slaving over a press in the basement.

Money was not a free market creation in the 19th century. Far from it. There were many government players passing laws that limited the rights of money users. State sanctioned banks were encouraged to lend a greater percentage of their reserves, for example, to create a boom -- and then state governments gave those banks the right to suspend specie payments when they were found out. Lincoln dumped unbacked "Green Backs" on the people. There were lots of legal tender laws and other market interventions. Problems needed to be addressed, but we certainly didn't need to follow the path we have traveled.

Tom

Well, DougMacG, I think we have enough overlap of positions for a discussion. But we are miles apart. I have read Keynes and some other elements of mainstream economics, but I must say I have found the economics articulated by Mises and a few other "Austrians" to be absolutely compelling. Keynes' General Theory, on the other hand, should have been laughed off the stage as a bad joke. Within that book, at least, Keynes could not even apply consistency let alone logic.

It's true that governments have used their coercive powers to give themselves a monopoly position in the production of money. But that isn't the way it has always been, nor is it the way it should be. Mises has argued that money began as people simply looked for better ways to conduct indirect exchange. People naturally found they could exchange their product for a good that was highly marketable and then exchange that good for the things they needed. This process doesn't require government and, in fact, benefits from government's absence. All of our problems with money, in fact, are the result of government. Governments rarely do anything positive for the concept of money.

I can't agree with this statement at all: "If the oil price (or corn or lumber) is too high, too low or too volatile, that screws up other industries." First of all, if markets are free, there can be no such thing as a price "too high" or "too low."  Prices just "are."  The price of one good rising or falling dramatically, on a free market, can only happen if there is a large change in supply or demand for that good. Instead of "screwing up" other industries, a suddenly high price simply allocates the supply of that good to the people who value it most highly. Those people who are unwilling or unable to buy at the higher price will naturally shift their attention to substitutes which they now find more appealing. All prices will adjust dynamically to market clearing levels, giving both producers and consumers appropriate signals. If a higher price for one good also results in higher profit, entrepreneurs will shift resources toward its production. This is the principal reason why capitalism works as well as it does to produce the right mix of goods.

As to the "general price level" -- it is actually impossible to measure. Consider the equation of exchange: MV = PT (one variation of the theme). The total physical product of the economy, T, cannot be defined in any sense whatever. Irving Fisher didn't even try to define the elements of this equation, demonstrating how smart he was -- because it can't be done. There are no common units with which to add up the total physical product. Given that you can't define T, the price level P is undefined as well. I have been pushing to have everybody take a look at a newly written book that beautifully addresses many of these questions in a compact form. Take a look at Paper Money Collapse by Detlev Schlichter.

Now, of course, this problem with the price level is ignored by our mainstream economists. They just take a relatively short list of consumer products, apply arbitrary weights, and calculate a price index and ... presto, they have "the price level."  Well, a little thought should tell you that the CPI and other various deflators give us very, very little information about anything important. Read Schlichter, please. However, I agree that when monetary inflation is significant the value of money is materially reduced and that certainly is a problem for everybody. The reason I am de-emphasizing price level rises is simply is that mainstream economists want us to believe that they can beneficially manage the money supply with reference to the silly price index. They cannot do that at all. There are very long lags before monetary inflation results in broad based price increases -- and there is no reason to suppose that price increases will EVER be spread uniformly over all products.

And finally, I believe the "dual mission" problem you cite comes from Keynesian and macro-economic thinking that I find to be just plain foolish. Full employment is easy to achieve if you run a totalitarian government. Just force people to stop using trains and trucks, for example. Let everything be carried on human backs. That will surely put everybody to work! What we need as a goal, instead, is an economy that meets all consumer needs as well as can be accomplished in a world of limited resources. There is only one way to achieve that goal -- a division of labor economy with privately owned factors of production and totally free markets. Including the market for money. A sound money is the only money consistent with any country's proper economic goal.

Tom

I would doubt there is anyone in the Pentagon, or in our government anywhere, who knows enough economics to design an "economic warfare" simulation.

To move the economy to a sound money system, the government only needs to get out of the way. We already have the private "GoldMoney" service that could expand into a serious payment system if the government would allow that to happen. Governments, however, jealously guard their coerced monopoly on money for a good reason: it gives them the ability to spend money they don't have.

Lots of people seem to think the small quantity of gold means that it could no longer serve as money. That idea comes from the inflationists' mindset ... the idea that an increase in the quantity of money causes economic growth. It's not true. Gold's most important monetary quality is scarcity; more gold cannot be brought into the economy without expending resources to find it, mine it, and process it. The problem with paper (or electronic) money is that it costs zero to make more. The nature of money is that people are motivated to make more of it until the value of the new money falls below its marginal cost. So in the case of paper money, the authorities will ultimately drive its value to zero.

Gold prices are arbitrary, especially with electronic record keeping. We could transfer any arbitrarily small quantity of gold from one account to another. To make gold money again, though, would require absolute rights to redeem the paper (or electronic chits) for gold and vice versa. That is the market mechanism that prevents over issue of paper.

Tom

 

Quijote,

Just to try and clarify my opinions on a couple of things. I have no knowledge or opinion about Steyn's claims of imminent "Islamification" in Europe. My comments are aimed at the general damage done by the welfare state concept. If there is an Islamic and demographic problem as severe as Steyn claims, my instincts are to blame the welfare state. My hostility to the welfare state is based on extensive readings in so-called Austrian School economics and observation of the welfare process within the US.  By the way, I didn't mean to imply that the European countries are in any way homogeneous. If I seemed to generalize my anecdote about France, your point is very well taken -- I shouldn't do that!

I disagree that the welfare states are up and running well. Even in Scandinavia the problems are brewing.  See "How the Welfare State Corrupted Sweden" for another view on that issue
( http://www.mises.org/story/2190 ). The biggest problem with the welfare state concept is that it is progressive --- in the sense that the state tends to keep getting bigger and bigger. When the idea is pushed too far, you can lose liberty on nearly every dimension. If you have never read Hayek's "Road to Serfdom" you might find his views challenging.

Marc posted a comment from me, just above, and I have decided to try my hand on this interesting forum. It looks like everybody here has lots of intelligent commentary on an amazingly broad array of subjects.

With respect to this topic of the Islamic challenge to Europe and America, I think the diagnosis shared in the preceding post is wrong or at least incomplete:

<As Tom Bethell wrote in this month’s American Spectator: “Just at the most basic level of demography the secular-humanist option is not working.” But there is more to it than the fact that non-religious people tend not to have as many children as religious people, because many of them prefer to “enjoy” freedom rather than renounce it for the sake of children. Secularists, it seems to me, are also less keen on fighting. Since they do not believe in an afterlife, this life is the only thing they have to lose. Hence they will rather accept submission than fight. Like the German feminist Broder referred to, they prefer to be raped than to resist.>

The suffocating state is, IMO, more the point. Germany was the first of the welfare states and therefore has become one of the most damaging. "... many of them prefer to 'enjoy' freedom ... "? There is precious little freedom left in the European welfare states. I know a young couple who immigrated to Florida from France to start a single-store eyeglasses business -- because the French made it virtually impossible for them to do the same in that country! What does the word "freedom" mean if you can't start and run a small retail business? It seems to me that these factors, together with the intolerable tax burden, explain the lack of desire to raise children -- more so than a failure of religion.

TB