Where We Are and Where We Are Headed
AS I STATED IN THE introduction, the real crash I predicted in my first book is still coming.
You see, before 2006, I had been predicting an economic catastrophe in the United States, with the burst of the housing bubble being the catalyst. Once that bubble burst and major banks went to the brink of failure, people began crediting me with “calling the crash.” But what we saw in 2008 and 2009 wasn’t the crash. That was the overture. Now we have to sit through the opera.
The economic unpleasantness of those days was definitely part of the real crash, but only because of the way our politicians responded—replacing one government-created bubble with another, thus putting our economy at even greater risk.
The same bubble machine that fueled the last two boom-bust cycles—the Federal Reserve—is already back in high gear, and we must turn it off. The Fed needs to stop fueling inflation and start sucking dollars back out of the economy. It also needs to let interest rates rise. When the Fed does these two things, Washington’s free ride will end—it will no longer be able to borrow at near zero interest. As a result, Congress will have to slash spending, fix our entitlements, and generally shrink government.
These are the right things to do today—they were the right things to do ten years ago. But soon they will become inevitable. We will have no choice.
My past books predicted the crash. This book goes a step further and lays out the steps we need to take in order to make this crash as painless as possible and to rebuild in the aftermath. We need to wind down entitlements, eliminate many government functions, and stop playing with the money supply and interest rates. America needs to start making things again, and the government needs to stop taking. As individuals and as a nation, we need to get out of debt.
And ultimately, we’ll have to face up to the fact that we can’t pay off all our debts.
The later chapters spell out the solutions, but these first two chapters describe the problem.
Our economy today is once again built on imaginary wealth. Like the proverbial house built on sand, it will collapse. When that happens, when America’s tab finally comes due, it will probably be as bad, or worse, than the Great Depression. You’d better be ready for it.
From a Dot-Com Bubble to a Housing Bubble to a Government Bubble
To understand how bad things are and where we’re headed, let’s quickly go back a decade or so, and retrace the steps that brought us here.
Throughout the 1990s, the Federal Reserve injected tons of money into the economy, which fueled a stock bubble, focused particularly on dot-com companies. In 2000 and 2001, when the stock market turned down and unemployment started to creep up, that was a correction.
Assets that had been overvalued (such as stocks) were returning to a more appropriate price. The dot-com and stock market bubble had misallocated resources, and while investment was fleeing the overvalued sectors, inevitably the economy shrunk and unemployment rose while wealth became more rationally allocated around the economy.
Readjustments in the economy involve short-term pain, just as the cure to a sickness often tastes bitter. Short-term pain, however, was unacceptable to the politicians and central bankers in 2000 and 2001.
Federal Reserve Chairman Alan Greenspan manipulated interest rates lower. This made borrowing cheaper, inspired more businesses to invest, and softened the employment crunch. But the economy wasn’t really getting stronger. That is, there weren’t more businesses producing things of value. As there were few good business investments, all this cheap capital flowed into housing.
As housing values skyrocketed, Americans were getting richer on paper. This made it seem as if things were okay. In other words, Greenspan accomplished his goal of forestalling any significant pain. By the same token, he also kept the economy from healing properly, which would have laid the foundation for a stronger and lasting recovery.
When market realities started to bear down on the economy, and the housing bubble popped, with the broader credit bubble right behind, the government was running out of things to artificially inflate. So the Fed and the Obama administration decided to pump money desperately into government.
I’ll explore this “how-we-got-here” story in more depth in Chapter 2, but for now, I’ll make this point:
Just as the housing bubble delayed the economic collapse for much of last decade on the strength of imaginary wealth, the government bubble is propping us up now. The pressure within the bubble will grow so great that the Federal Reserve will soon have only two options: (a) to finally contract the money supply and let interest rates spike—which will cause immensely more pain than if we had let this happen back in 2002 or 2008; or (b) just keep pumping dollars into the economy, causing hyperinflation and all the evils that come with it.
The politically easier choice will be the latter, wiping out the dollar through hyperinflation. The grown-up choice will be the former, electing for some painful tightening—which will also entail the federal government admitting that it cannot fulfill all the promises it has made, and it cannot repay everything it owes.
In either case, we’ll get the real crash.
The National Debt
As a professional investor, when I study the American economy today, I see debilitating weaknesses. Most obvious is the debt. As this book went to press, the national debt was $17 trillion. That works out to approximately $140,000 per taxpayer. Let’s talk a bit about what this means.
Whenever the government wants to spend money it doesn’t have, it borrows. Our government borrows by selling T-bills and Treasury bonds, or “Treasuries.” The buyer gets an IOU, and the government gets cash. So, various bondholders—individual investors, U.S. banks, the Chinese government, the Federal Reserve, even parts of the U.S. government—hold in aggregate $17 trillion in IOUs. These bonds and bills come due all the time, and typically, the Treasury pays them off by borrowing again.
Every day, the debt grows. First, it grows because it accumulates interest. In 2010, taxpayers paid $414 billion in interest on the national debt, but that wasn’t enough to keep the debt from growing. Another reason the debt keeps growing: our government keeps borrowing more in order to spend more.
Barack Obama’s $800 billion stimulus in 2009, for instance, was entirely funded by borrowing. In Fiscal Year 2011, the U.S. Government spent $3.6 trillion, but brought in only $2.3 trillion in revenues. The extra $1.3 trillion—the budget deficit for the year—was paid for through borrowing.
As a businessman or the head of a household, if you spend more than you earn in a given month, you’re doing one of two things: you’re either spending down your savings, or leaving a balance on your credit card. But the federal government has no net savings. That leaves only one option: every dime of deficit is added to our national debt—plus interest.
State governments are in the red, too. Nearly every state ran a deficit in 2010, and the aggregate of state debt is about $1.3 trillion. Local governments owe a combined $1.8 trillion. Add that $3.1 trillion in state and local debt to Uncle Sam’s $17 trillion, and our public debt tops $20 trillion. Much worse, when off-budget and contingent liabilities are thrown in, total government debt tops 100 trillion!
State of Bankruptcy
In some ways, our state governments are in worse shape than the federal government. While most states don’t have huge ticking time bombs like Medicare, they have just as much—or more—trouble breaking even.
For Fiscal Year 2012, more than forty states were in the red. Twenty-seven states (a majority of states and a vast majority of the country) were running deficits of 10 percent or more, according to data from the Center on Budget and Policy Priorities.
California is probably the most famous of the insolvent states because of the massive size of its annual shortfall: more than $25 billion in 2012.
To poison the fiscal waters so completely, it took a special brew of big-government liberalism, anti-tax-hike ballot measures, powerful public employee unions, and ridiculous public pension laws. These factors created what Manhattan Institute scholar Josh Barro calls “California’s permanent budget crisis.”
Indeed, since 2005, the California state legislature has been fighting an annual “crisis.” Barro explains:
California’s permanent budget crisis stems from institutional failures. Ballot measures have made it nearly impossible to raise taxes or cut spending, and have cemented the idea in voters’ minds that they can get government services without paying for them. The state has repeatedly failed to reform its inefficient tax code (which relies too much on highly volatile taxes on high-income people, and not enough on property taxes) or to tackle the problem of runaway public employee compensation.
California is special in many regards. (For instance, no other state has city managers paying themselves nearly a million dollars a year, as the folks of Bell, California, were caught doing.) But many of the problems with California are present elsewhere.
One is the tendency of states to go wild during boom years in revenue. Many individuals who did well during the boom years bought McMansions with huge mortgages on the assumption that every year would be just as good. Many states did the same thing. Nevada is a classic example. Nevada enjoyed faster population growth than any other state in the 1990s and most of the 2000s. This coincided with the nationwide housing bubble, and sent home prices through the roof. As a result, property tax receipts went way up. State and local politicians spent all this money on the crazy theory that Las Vegas—in the middle of a desert—was being “Manhattanized.”
You might recall that Nevada was hit harder by the housing bust than any other state. Record foreclosures both sent people out of the state and dragged down property values. Revenues dropped, but expenditures didn’t keep pace. The result: huge deficits.
Public employee unions are another central cause. Like any union, the American Federation of State, County, & Municipal Employees, the American Federation of Teachers, and their cohorts exist to get as much pay and benefits as possible for their members.
But unlike most unions, government unions are negotiating with people who are spending someone else’s money: politicians. Often those politicians were elected thanks to campaign contributions from the unions. This is a vicious cycle: taxpayers pay government workers whose money goes to government unions, whose money goes to the campaigns of politicians, who approve more taxpayer money for the unions, who then contribute more to the politicians.
How has Washington responded to the budget crises in the states? Mostly by making things worse.
The 2009 stimulus bill included hundreds of billions of dollars in aid to states, allowing them to continue their spending binges. Had federal money not been available, states would have been forced to do the right thing and cut their spending.
Congress even took up a bill in 2011, the Public Safety Employer-Employee Cooperation Act, that gives special bargaining privileges to the unions of police officers, firemen, and emergency medical personnel. Many Republicans even backed the measure, probably because these public safety unions are far more supportive of Republicans than other government unions.
Bankrupt states are one more virus in our sick economy.
Government Driving People Deeper into the Red
The American people are pretty deep in hock, too.
Thanks to a housing bubble and artificially low interest rates, a lot of people borrowed money that they could not pay back in order to pay inflated prices for houses they could not afford. All told, Americans are laboring under about $13 trillion in mortgage debt.
But it’s not in the past. After a brief period of paying down debt and increasing savings, thanks to the Fed, American families are once again borrowing more than they’re saving.
Total consumer debt is $2.5 trillion, while credit card debt is $789 billion. That’s a grand total of $16.2 trillion in personal debt, or $200,000 per family. In addition, federally backed student loans now top one trillion, exceeding total credit card debt for the first time in 2011. On the other side of the ledger is approximately $7,000 in savings per family.
In the next chapter, I’ll talk more about how private indebtedness got so bad, but for now let me just note that bad government policy and the bad economics of the chattering class have contributed to this situation. Government rewards borrowing (the biggest tax deduction for most families is the deduction for mortgage interest) but often punishes saving (by taxing investment gains and interest on CDs and savings accounts).
The biggest culprit in discouraging savings, though, is the Federal Reserve. For one thing, the Fed creates new dollars, driving up prices. That means the dollars you sock away today are worth less when you pull them out next month. Better to spend them today.
Even when there is not a significant increase in consumer prices—such as existed from late 2008 through 2011—the Federal Reserve deliberately warded off falling prices by inflating the dollar supply. Put another way: the Federal Reserve is putting upward pressure on prices, and thus keeping the dollar from gaining in value.
The Fed also keeps interest rates artificially low. Were interest rates as high as the market would set them, and were dollars not being cheapened, people would have more incentive to save and less incentive to borrow.
Spending Is Patriotic
Part of the problem, peddled by the media and politicians, is the notion that prosperity comes from consumer spending.
Listen to any TV or radio newscaster discuss economic news, especially during a downturn, and there’s one hard and fast rule for them: consumers spending more money is good, and consumers spending less money is bad. Shopping is good for the country. Paying down debt or saving is bad for the country.
That’s not just overly simplistic, it’s almost completely wrong. If people are spending money they don’t have, that may be good in the short term for stores and manufacturers, but it’s often bad in the long term for the whole economy.
If people are borrowing as a way to finance productivity, then indebtedness isn’t bad, and it is often beneficial.
Sure enough, this isn’t the first time Americans have borrowed lots of money. But in the past, we borrowed money to invest in productive capacity, such as building a factory. That factory makes goods at a profit, and that profit then pays off the loan. Today’s borrowing and debt, however, isn’t primarily for investment.
These days, because people are going into debt for the sake of consumption—buying a fancy dress or tickets to a basketball game—then U.S. indebtedness grows while productive capacity doesn’t. That credit card debt doesn’t go away. The dollar a person charges today is a $1.10 he’ll have to pay off tomorrow.
Imagine a rational, well-informed owner of the general store in a small town. If he sees all his customers running up credit card debt, what is he going to do? He’ll stop stocking the shelves as much, because he knows the day will come when his customers will max out their cards. Not only will the customers no longer be able to spend more than they earn, they won’t be able to spend even as much as they earn, because some of their income will go toward paying off debt, plus interest.
When that day comes, the prudent storeowner might be fine—if he saved up his surplus from the boom days. Many downtown businesses will suffer: if they believed this boom in spending represented real wealth and so they expanded or hired more employees, those higher overhead costs will not be sustainable when the town’s shoppers become more austere.
Yet, whenever the economy slowed down in the past decade, politicians always looked for ways to get people borrowing and spending as much as before. In other words, Washington wouldn’t let people recover from their spending binges.
On September 20, 2001, nine days after terrorists took down the twin towers, President Bush told average Americans how they could help the economy: “Your continued participation and confidence in the American economy would be greatly appreciated.” Bush urged Americans to go out and spend. (In contrast, when World War II broke out Americans were urged to save. The public purchased war bonds and consumer goods were rationed.)
Barack Obama rightly mocked Bush’s version of civic duty, saying on the 2008 campaign trail of Bush after 9/11, “when he spoke to the American people, he said, ‘Go out and shop.’”
But Obama was no different during the recession in 2009. A month into his presidency, he declared it his goal “to quicken the day when we re-start lending to the American people and American business.” One of Obama’s programs, “Cash for Clunkers” was designed to get Americans to buy cars they otherwise could not afford. So we destroyed fully paid-for cars that still worked, to go deeper into debt to buy newer ones, many of them imports, saddling car owners with additional debts at times when they should have been rebuilding their savings.
He put it more forcefully elsewhere in the same speech: “We will act with the full force of the federal government to ensure that the major banks that Americans depend on have enough confidence and enough money to lend even in more difficult times.”
Of course, banks’ lending more means consumers’ borrowing more. Both Bush and Obama told the American people that when times are bad, they should run up credit card debt—it’s the patriotic thing to do.
Saving Is Unpatriotic
While Obama was “act[ing] with the full force of the federal government” to get Americans borrowing and spending more, many people were—smartly—going in the other direction. In the second quarter of 2009, personal savings hit a seventeen-year high of 7.2 percent as a percentage of disposable income.
According to the Bureau of Economic Research, the American people saved $793 billion that quarter. This was at a time that personal income, at $12.2 trillion, was far lower than it had been during any point in 2008. People were behaving rationally—the economy had turned down, their friends and neighbors were losing jobs, and so people with income started saving it.
This had to stop, according to President Obama. Sure enough, artificially low interest rates and subsidies for home buying helped discourage people from saving, and the savings rate quickly dropped.
By the end of 2010, consumer debt was rising again, according to data from the Federal Reserve,1 and the contraction of overall household debt had ended. We were back on the road to “normal levels of lending,” that is, normal levels of indebtedness. Mission accomplished.
Of course, the biggest problem is that savings is the key to economic growth, as it finances capital investment, which leads to job creation and increased output of goods and services. A society that does not save cannot grow. It can fake it for a while, living off foreign savings and a printing press, but such “growth” is unsustainable—as we are only now in the process of finding out (more on that later).
Why Our Trade Deficit Isn’t Harmless
Just as politicians and liberal economists will tell you that savings are bad and borrowing is good, conservative economists are likely to tell you that trade deficits are a good thing.
Why should we care, they ask, if our goods are coming from outside the U.S.? They rightly point out that money isn’t a good in itself, and, all else being equal, we’d all rather have the stuff money can buy than have the money itself. So, if we’re importing more than we’re exporting, we end up with goods, and the other guys—such as the Chinese—end up with dollars. The only thing the foreigners can do with dollars, ultimately, is to buy stuff from us. Ultimately, the argument goes, it all evens out.
Here’s the problem with that argument: we’re not making enough stuff for our trading partners to buy with all those U.S. dollars they have been accumulating. But foreigners aren’t simply sitting on those surplus dollars—they’re buying the one thing we are producing prodigiously: debt.
The idealized story of international trade says we buy Chinese televisions with dollars, then the Chinese use those dollars to buy U.S. cars. Ultimately, it’s a trade of goods-for-goods (TVs-for-cars), with currency merely smoothing out the transactions.
But, the real story of our international trade ends not with our selling physical goods overseas, but with our selling U.S. Treasuries. We end up with Chinese TVs and the Chinese end up with our IOUs. Put another way, we borrowed to buy the TV.
Our Trade Deficit by the Numbers
I’ll go into this issue more later on, but for now, let’s look at the lay of the land on trade. In early 2011, we were averaging about $160 billion in exports every month. We were also averaging about $210 billion in imports.
That’s a trade deficit of $50 billion a month, or $600 billion a year. Put another way, we would need to boost our exports by more than 30 percent in order to reach balance. Vis-à-vis China, we typically run a goods deficit of about $20 billion per month.
Much of our exports to China are coal and iron ore, which the Chinese use to make steel—steel which they then sell. On the other hand, most of what we buy from the Chinese are electronics, toys, and sporting goods. In other words, Chinese imports are largely investment, and our imports are largely consumption (electronics, of course, can be investment, but only if we’re not talking about Xboxes, but about computers that businesses use to be more productive).
The same is true with all our trading partners. One third of our exports, according to the Census Bureau, are “capital goods”—machinery or other things businesses buy in order to be productive.2 Another third are “industrial supplies”—again, investment in things to which foreign businesses will add value.
Crashproof Yourself: Don’t Count on the American Consumer
Americans aren’t making things, and they’re not saving. That doesn’t bode well for their future purchasing power. If my business depended on selling things to Americans, I’d be worried.
Think about this issue as an investor. It’s no good to invest in a company that’s in a growing economy if that company depends on selling things to Americans. Many Chinese manufacturers who don’t adjust will find themselves running out of paying customers.
When you’re investing, avoid companies that depend on Americans’ continued ability to consume or repay their debts, and look for companies whose customers will have greater purchasing in the future. Who is selling washing machines to the Chinese? Who is selling cars to India?
When foreigners buy from us, they are laying the groundwork for productivity. The converse is not true.
One quarter of what we import are consumer goods, slightly more than what we spend on capital goods. Again, we’re consuming more than we’re investing. While our “industrial supplies” imports are proportionally equal to our exports in that category (about one third of our total imports), there’s a key imbalance on this score: half of those imports are foreign oil—most of which is used by vehicles.
So, generally, we’re importing to consume. Other countries are importing to produce.
Consumerism Does Not Equal Capitalism
These problems go unappreciated in part because some of the regular watchdogs of government folly give Uncle Sam a pass here.
Those who profess belief in the free market often confuse free markets with Wall Street, profit, and perceived economic growth. They dismiss worries about a trade deficit as protectionist carping. They see massive consumer spending as a sign of prosperity, and rising gross domestic product as the only measure of economic health.
This is wrong. In a free market, our economy wouldn’t have the sort of indebtedness and leverage it has had. The housing bubble was one instance of the government’s tendency to foster debt and create inefficiency.
Inflated home values—both their absurd climb before 2006 and the lack of a full correction afterward—are clearly the result of big government rather than the result of the free market. Everyone knows that Fannie Mae, Freddie Mac, and the Community Reinvestment Act helped pump up the housing bubble. High income tax rates combined with the deduction for mortgage interest helped, too.
But the main problem was the Federal Reserve keeping interest rates artificially low.
The Fed’s manipulation of interest rates not only artificially boosts the housing market, it also boosts all borrowing and indebtedness. Without the Fed, our indebtedness and consumption would both be much lower. Of course, in the long run, with sound money and limited government, our consumption would be even higher, but it would result from increased production rather than debt.
Government interference is often behind consumption. State and local governments subsidize shopping centers because they “create jobs.” Banks—and thus credit cards—are all subsidized by the federal government. Fractional reserve banking, which would be fraud if it wasn’t explicitly endorsed by the Fed, allows banks to lend out the same dollar many times.
Now, don’t take me for some sort of anticonsumerist hippie. There’s no such thing as too much spending or too much borrowing in the abstract—it’s only a problem when spending and borrowing outstrip productive activity.
As it happens, a huge portion of our economy is simply about helping us consume—the service sector largely fits this bill. A shrinking portion is about helping us produce: Out of $14 trillion in GDP—gross domestic product—in 2009, according to the latest census figures, about $1.1 trillion of that was capital investment. A decade before, capital investment was $965 billion out of a Gross Domestic Product 3 of $9.4 trillion. Capital investment as a portion of our economy fell by more than 20 percent in a decade.
In other words, we have been trading production for consumption.
Fighting the Cure
Just as in 2008, we have too much consumption and too much borrowing. We also have too little production and too little savings. Since the depths of the economy in early 2009, most of the “wealth” we’ve created has been—once again—imaginary wealth.
Judging by their actions, it’s clear the politicians thought the problem was simply that all our pre-2008 imaginary “wealth” disappeared. Thus, they think it’s their job to re-create the illusion.
The Troubled Asset Relief Program (TARP), the stimulus, the auto bailouts, and the inflationary actions of the Federal Reserve all treat the symptoms of our 2008–2009 downturn. It’s all superficial.
Government can slow the fall of housing prices, and so our politicians make sure that it does. For example, Obama has used TARP to keep people in their homes—often only delaying foreclosure and thus making homeowners even poorer. Fannie Mae and Freddie Mac ramped up their subsidies, thus keeping demand for homes higher than it would be. The Federal Housing Authority is subsidizing mortgages to the point that people are once again putting down zero percent—this applies upward pressure to home prices, slowing their fall.
But falling housing prices are part of the cure. Inflated prices are part of the disease. It’s as if a doctor saw a patient had an inflated count of white blood cells—the cells that respond to and fight infections—and so he decided to remove the white blood cells.
Along the same lines, government can keep interest rates low, and so it does. But low interest rates contributed to the disease. High interest rates are part of the cure that we need. Again, government makes sure that we never get the cure.
Falling prices and wages are another cure the government won’t let us swallow (more on this in chapter 3). Ask an economics writer today, and “deflationary death spiral” is the biggest threat facing our economy today. This is bogus. In the Depression, falling prices were a rare boon. They were a saving grace for anyone who lost his job and was spending down savings.
Today, Washington does everything it can to prevent falling prices. Mostly, this means (1) Keynesian stimulus to drive up demand for goods and services, and (2) inflating the money supply.
Falling prices would be a cure, and so government pumps up prices.
In other words, the market is trying to cure the economy, and the government won’t let it. The government’s “cure” for the market’s cure is more imaginary wealth.
Government doesn’t exactly pull this imaginary money out of a hat, but it does create it out of nowhere. Where did the $700 billion to bail out Wall Street and Detroit come from? That money was created by the Federal Reserve. Literally, the Fed just credited banks with money. Those dollars didn’t come “out of” anywhere. The Fed simply declared that more dollars existed.
The stimulus? None of that was paid for with tax dollars. All of that money was borrowed. That means the U.S. Treasury sold bonds and treasury bills, and then spent all the money it borrowed.
Because the federal government runs a deficit, every year it is borrowing more. Everyone who owns U.S. debt today knows that if they redeem their bond or cash in their T-bill, the government will pay for it by borrowing again.
So every dollar with which our government tries to save banks, create jobs, and keep interest rates low comes either through (a) inflation (new dollars that dilute the value of existing dollars) or (b) revolving debt.
The Government Bubble
Throughout the 1990s, we had the stock bubble and the dot-com bubble. The Fed replaced that with the housing bubble and the credit bubble. Now, the Fed and the administration are replacing those bubbles with the government bubble.
The Fed is creating money that banks are then lending to the Treasury to pay for ever-expanding government. The same artificially low interest rates that made it easy to buy a house in the last decade are making it easy for the government to borrow in this decade.
Of course, the government isn’t borrowing for investment, it’s borrowing for consumption. That means Uncle Sam is simply going deeper into debt, and the only way we’re going to pay off our current loans is by borrowing again.
How do we get away with this? Why does anyone lend us money when they know we’re only going to pay it back by borrowing, and that we’re going to pay it back with dollars that are worth less than they are today?
We get away with it because the dollar is considered the “reserve currency” of the world. In other words, all major governments in the world hold dollars. Global commodities, like gold and oil, are typically priced in dollars.
As of 2010, 60 percent of foreign exchange reserves are in U.S. dollars. That means, as a foreign country, you’re willing to take dollars because you know some other country will be willing to take dollars. That other country will take dollars because some third country will take dollars. If this sounds familiar, it’s because we’ve seen it before.
In 1999, people were investing in dot-coms not because they thought these companies might make a profit, but because they thought someone else would be willing to buy the stock at an even higher price.
In 2006, people were buying houses not because they thought the house was worth that much, but because they thought they’d be able to flip it for more money to someone else.
This is only slightly different from a Ponzi scheme. It all depends on the existence of a greater fool. Eventually you run out of fools and the bubble pops.
When the dot-com bubble popped, companies evaporated and retirement accounts shrank. When the housing bubble popped, foreclosures ran rampant and credit dried up. When the government bubble pops, the consequences will be worse.
Government Spending Is the Opposite of Investment
Economists and politicians point to government spending as economic growth. After all, it counts in our GDP, right?
But our government spending doesn’t actually create wealth, because it’s not really investment. In fact, government spending often destroys wealth by allocating resources to unproductive sectors of the economy.
The government bubble inflates housing values, which are still being propped up by Fannie Mae, Freddie Mac, housing bailouts, artificially low interest rates, and other government policies.
Much government spending goes to government-favored technologies, which do not add value to the economy, such as subsidized wind turbines or solar panels. Republicans and Democrats alike have increased subsidies for whatever they consider to be cutting-edge technology.
These subsidies create very narrow booms: some solar-panel maker gets rich, or some company that makes windows expands and adds another plant. Politicians point to these successes as proof that their subsidies help the economy.
But these subsidy-induced booms actually hurt the economy. The tax credits and handouts draw rational businessmen to invest in technologies that don’t really add value. If these technologies were valuable, they wouldn’t need subsidies in order to draw investment. Government turns these useless or inefficient technologies—like ethanol, or solar power—into profitable undertakings.
Every dollar invested in these unproductive activities is drawn away from something that people would value more—and that would be able to grow on their own. This makes us poorer, and it is unsustainable in the long run. People getting rich from making things that don’t have real value—it’s just like the housing and dot-com bubbles all over again.
Since investment has a positive connotation, government likes to describe spending as investment. When it comes to transfer payments, at least the government is more honest. But spending that results from transfers comes at the expense of spending or investments that otherwise could have occurred. While diverting spending from those who earn money to those who receive benefits has adverse moral consequences, the economic consequences are far greater if the money diverted is money that otherwise would have been saved. Such transfers convert savings to consumption, undermining investment and stifling economic growth.
Hair of the Dog
You probably see by now how the 2008–2009 crisis was merely the overture to a coming crash. The collapse of housing prices, the downturn in the stock market, the tightening of credit, and rising unemployment all triggered a government reaction that caused a far worse sickness.
Why do the politicians do this? I think there are two reasons.
The first is that they mistake the cures I discussed above—falling prices, rising interest rates—for the disease. They don’t realize that our economy was sick for years beforehand. They mistake our decade-long sickness for health.
The second reason is less about bad economics and more about good politics. Politicians refuse to allow the short-term pain that the cure entails. They’re like a doctor who won’t give a patient any bitter medicine, or like a rehab counselor who won’t let the addict go through withdrawal.
The politicians might be behaving rationally—that is, acting in their own political interests. If people face higher interest rates, smaller 401(k)s, falling wages, or foreclosure, they get upset. Presidents, governors, and congressmen know they will get blamed.
So, like an Enron executive trying to hide losses off the books so that shareholders are happy, Congress, the White House, and the Fed take short-term gain, even though the price is long-term pain.
Put another way: throughout the 1990s, the Federal Reserve created a stock bubble. To cover up for this downturn, Washington created a credit and housing bubble. When that popped, government started papering it over with a government bubble. What will we do when this bubble pops?
Thus we are pushed toward an awful decision.
When the Government Bubble Pops
“In the long run, we are all dead.”
That was the foundation of John Maynard Keynes’s economics. The idea is that you can keep blowing up bubble after bubble, regardless of the long-term consequences. Who cares about long-term consequences, as long as we can put them off until after we’re in the grave, or in the case of a politician, until after the next election?
But the moment of crisis can be pushed off only so long. Imaginary wealth cannot indefinitely mask a weak economy. If you keep replacing one bubble with another, you eventually run out of suds. The government bubble is the final bubble.
The bedrock of our bubble economy had always been the full faith and credit of the United States government. At some point, the lenders of the world begin to lose their faith in us, and that credit dries up.
Those who lend to the U.S. government these days don’t expect that tax revenues will pay them back—they know they will get paid back with more borrowed funds. Once would-be creditors begin to see the risk in this Ponzi scheme, they’ll start demanding a higher risk premium. In other words, Uncle Sam will need to pay higher interest rates on its Treasury Bonds.
Lenders will also be tired of getting repaid in dollars that are worth less than the dollars they loaned. In order to be able to borrow again—and to be able to buy anything with dollars—the Fed will have to start swallowing up those extra dollars it created in its bouts of quantitative easing and bailouts.
Tightening money supply and higher interest rates on Treasuries will drive up interest rates across the economy.
Normally, rising interest rates aren’t disastrous—they’re a market response to a high demand for capital and low supply. In the early 1980s, the Fed raised interest rates, and there was pain, but it was not devastating. But back then we were the world’s greatest creditor nation. Today we’re the greatest debtor nation.
So this time around, companies, homeowners, and banks are so highly levered, as the numbers earlier in this chapter showed, that rising interest rates will be devastating.
Anyone with an adjustable-rate mortgage will see his monthly payments skyrocket. This will cause more foreclosures, triggering another collapse in the housing market. Plus higher mortgage payments will be even more problematic for those who lose their service sector jobs, which will vanish as rates rise.
The tidal wave will also hit the banks and hedge funds that have already returned to the pre-2008 game of risky bets and massive leverage. In fact, most of our banks are only “solvent” as a direct result of these extremely low rates. If rates merely returned to historic norms, many of the banks we bailed out in 2008 will be wiped out again when the real crash comes, only this time around the losses will be even bigger.
As to the nightmare scenarios fabricated by the Bush Administration officials selling the TARP—some of them will become reality this time around, because government will have made us so much more vulnerable.
Of course, the biggest debtor of us all, the Federal government, has the mother-of-all adjustable-rate mortgages. Most of the national debt is financed with short-term paper, much of it maturing in less then one year. Rising rates would send debt-service costs soaring, and at a time when the deficits themselves were rising due to the economic contraction that higher rates would surely produce.
And the federal government would have to spend less. This is a good thing, of course, but it will certainly impose short-term economic pain, especially on those whose benefits are cut. Many of our biggest companies—Boeing, General Electric—are government contractors. Many others depend on government spending, either through subsidies or government consumption.
When the biggest spender takes up an austerity budget, a lot less money gets spent. Initially, this will cause some companies to go under and unemployment to rise. Other companies will expand and new ones will form as resources formerly used to support government spending are freed up for more productive purposes, but this transition will take time to play out.
The Alternative: Devalue the Dollar
Instead of this scenario of excruciating tightening, politicians could opt to try to cover up reality one last time by pumping even more dollars into the economy.
Need to pay off the national debt? Fine, just print more money, and pay it off with that money.
Need to pay for unsustainable entitlements like Medicare and Social Security? Fine, just print more money, driving up nominal wages and thus tax revenue. Of course, the real value of these benefits would collapse, but maybe politicians could maintain a pretense of keeping up benefits.
Some politicians might prefer this route, because it could deflect some blame: they could blame businesses and service providers for raising prices (even though the price hikes would be a necessary and natural response to inflation). For example in 2011, as oil prices rose as a result of the inflation created by the Fed, Ben Bernanke and President Obama blamed the rise on oil speculators, and commissions were convened to investigate the wrongdoing.
But this path leads to hyperinflation, which will be even more economically destructive for the average American. Anyone on a fixed income would starve. Price and wage unpredictability would cause chaos even more harmful than what would result from soaring interest rates.
Devastation as the Cure
While tightening money supply, skyrocketing interest rates, and slashing of government services and spending will cause immense economic pain, it will be the right thing to do.
With high interest rates and tight credit, borrowing will slow down. Slowly, people will start to pay down their debt. High interest rates will also incentivize savings. Those savings will eventually become investment capital—the foundation for new enterprises. A shrinking government, of course, will open up the economic playing field for market actors, who will invest in what’s promising rather than what’s politically favored.
The process will simply be the delayed—and more painful—cure that should have come in 2001 or 2008. It will be the crash we should have had in 2002 or 2009, but it will be worse, because the imbalances are now greater as a result of the extra debt the government has accrued for itself and induced in financial institutions and individuals.
There will be plenty of politicians who call on government to avoid the painful tightening and cutting, and when people like me say, “bring on the pain,” we’ll be called heartless, just as we were heartless to oppose bailouts in 2008.
But pain will come one way or another, either through contraction or through hyperinflation. The difference is that tightening money supply and rising interest rates will be productive pain—like medicine—while hyperinflation will be destructive pain.
As a nation, we’re going to have to accept a lower standard of living than we may be accustomed to enjoying. For one thing, with tighter credit and tighter monetary policy, it will be harder to live beyond our means. Along the same lines, the United States will no longer be able to consume more than we produce—we will have to start making things, too. In other words, we’ll lose that credit card that we were never paying off.
But for the short term, things will be even worse. The economy will need to regain balance, and this will involve plenty of displacement. People working in bubble industries—solar panels, banking, real estate, and government—will lose their jobs and need to find new ones. This is not a painless process.
Most costly might be the loss of our role as the issuer of the reserve currency of the world. Most people don’t understand the value of the United States being the reserve currency. It’s what allows us to buy something without really paying for it. Once we lose that status, the free ride ends. The dollar will dramatically lose its value vis-à-vis other currencies, and it will become more expensive for us to buy things.
But for many people, especially in the long run, the crash and what follows will be beneficial. For one thing, this crash might finally bring about tax cuts. Government will be forced to shrink, thus freeing up more space in the economy for entrepreneurs. Maybe when the debt is paid down, we can keep government small. Also, those who have saved, and who have low debt and hard assets, such as farmland, gold, or natural resources, will benefit from a contracted money supply. The contraction will clean out the malinvestment and government bloat, sort of like the Old Testament flood cleansing the world’s iniquity. When the floodwater recedes, there will be an opportunity for a sensible economy to take root. As long as we don’t just repeat the mistakes that brought on the flood in the first place.
Copyright © 2012 by Peter D. Schiff