Monty Pelerin's World

Economics, Finance and Politics Through The Prism of Classical Liberalism

February 2011 - Posts

Lazy Man's Guide to Mises
The name Ludwig von Mises is synonymous with classical liberalism. He was an unrepentant champion of freedom and free markets. His beliefs, unlike so many of us, were not something he inherited from his parents or society. Many he obtained from others, but many he was the original developer using his incredibly strong and fertile mind. He was unique in the sense that he truly added to the body of knowledge. His ideas were not popular amongst the ruling class and the institutions they controlled, like academia. In our slide towards socialism, how popular might the political elite consider statements like the following?
A society that chooses between capitalism and socialism does not choose between two social systems; it chooses between social cooperation and the disintegration of society. Socialism: is not an alternative to capitalism; it is an alternative to any system under which men can live as human beings.
Mises' uncompromising commitment to what he considered to be the truth resulted in this great man living in relative obscurity during much of his lifetime. He sacrificed prestige and income to stay true to his beliefs. Contrary to the poseurs that proclaim to be economists but are little more than prostitutes for the State, Mises never deviated from his truths. His understanding of economics was complete. Yet his view of the future was not hopeful. In order to preserve society, it was necessary for the people to understand economics. On this matter, he commented:
Is the attempt to guide the people on the right road not hopeless, especially when we recognize that men like John Maynard Keynes, Bertrand Russell, Harold Laski and Albert Einstein could not comprehend economic problems?
Tragically, here was a man who could see the implications of various acts, laws and policies decades before others and lived with the knowledge that these actions could only result in societal destruction. In his autobiography, he wrote, in what must have been an especially sad moment:
My theories explain, but cannot slow the decline of a great civilization. I set out to be a reformer, but only became the historian of decline.
Nowhere was his prescience as clear as his views on central banking. Almost 100 years ago, he laid out the fallacies in central banking and how these institutions would destroy the economies they were supposed to serve. He also foresaw major wars and the Great Depression. For Mises, economics was not some narrow realm of prices and market transactions. It was the realm of all of all human behavior, the very substance of society:
Only he who fully understands economic theory can comprehend the great questions of economic and social policy.
Mises, based upon his solid theoretical framework, was prescient on many historical events and trends.  He was truly a giant of the 20th Century. Mises, not Friedman or Keynes, was the greatest economist of his time. An audio by Ivan Pongracic is a painless way to learn about Mises and what Pongracic considers his five greatest contributions.
Posted: Wed, Feb 23 2011 6:27 AM by Monty Pelerin
Filed under:
Hyperinflation is a Small Price to Pay
The US is hurtling toward out-of-control inflation while the political class tries to convince the hoi polloi that inflation is not a problem. Government-generated CPI data show tame inflation. Federal Reserve Chairman Ben Bernanke claims deflation, not inflation, is the danger to the economy. Despite government propaganda every shopper knows inflation is already a serious problem. The Financial Times presented annual price increases for various items, which included the following:
  • heating oil +41%
  • copper +59%
  • silver +91%
  • palladium +212%
  • corn +91%
  • wheat +79%
  • cotton +143%
These data indicate that inflation is upon us. The magnitude of these numbers suggests hyperinflation. The effects of inflation are not limited to the US and not limited to rising prices. Spiraling food costs have been cited as a factor in political upheaval in several countries, including most recently Egypt. The US Federal Reserve, although it may be argued to be a primary driver, is not alone as a producer of inflation. As pointed out by the Daily Bell there is plenty of blame to go around:
Central banks have pumped something like US$20 to US$50 TRILLION into the world's economy to try to reinflate economies that collapsed in 2008.
The divergence between what governments want you to believe regarding inflation and what is painfully obvious grows larger with time. In the US obvious anomalies in government reports, especially unemployment and claims that an economic recovery is underway, make the reports incredible. Few citizens believe that the recession ended 19 months ago. That claim contradicts what they experience every day. The Federal Reserve has tripled the money supply in an effort to protect the banking system and the economy. Currently, most of this money sits in the banking system as excess reserves which could be lent out, potentially at ten-fold leverage. At some point, these banks will lend these funds out. Then, per the Daily Bell, the Fed must take decisive and rapid action:
As this currency begins, finally, to circulate, price inflation must result, unless such money is quickly removed. Central bankers have continuously claimed that excess currency can be removed from the larger economy before it does its inflationary damage …
Inflationary damage is already evident as per the numbers above. Unless the removal of these excess funds occurs in a timely fashion, the country runs the risk of hyperinflation. Mr. Bernanke has stated on many occasions that he is prepared to withdraw these funds before they can create damage. It is not clear what Mr. Bernanke considers damage, but one might think that rising food and energy costs might qualify. Surely uprisings in Tunisia and Egypt should qualify, if in fact they can be attributed to Central Bank policies. The reality is that Mr. Bernanke is unable to reverse the time bomb he has placed in the banking system. To suggest otherwise reflects either duplicity or unlikely ignorance on the part of Mr. Bernanke. He will not be able to withdraw the funds he put into the banking system for the following reasons: 1. Central banking is not science. Mr. Bernanke has no way of knowing when and what to do. The uncertainty is not due to personal limitations but results from the complex nature of economic activity and monetary transmission mechanisms. He cannot know any of the following:
  • What the rate of price increases ahead will be.
  • How much of a reduction in the money supply should occur to dampen expected increases.
  • What the effect of such a reduction would do to economic activity.
Even if Mr. Bernanke could know the unknowable, he would still be unable to manage matters because lags in the effects of monetary policy are variable and fickle. Further, monetary transmission linkages are complex, which means Mr. Bernanke cannot know what sectors of the economy might be affected and by how much. Mr. Bernanke says he admires Milton Friedman, the father of modern monetarism. Yet, Mr. Friedman was against using monetary policy as a tool to manage the economy. In Friedman’s opinion any attempt to do so would exacerbate economic problems and cycles. That is why Mr.Friedman advocated a mechanical monetary rule for Central Banks rather than discretionary policy decisions. Complicating these problems is what appears to be a personal problem. Chairman Bernanke's ability to forecast anything correctly over the past three or so years should make anyone nervous about his judgment. He appears to be living proof that economic forecasting exists to make astrology look respectable. 2. Political interference is never bi-directional. Politicians never want to remove stimulus. That was evidenced in Europe where Trichet recently reversed on a decision to withdraw currency from the banking system. For the political class (and I do include Central Bankers in that group) there is never a good time to remove stimulus. 3. The Fed cannot return the money supply back to reasonable levels. Of the first two problems, the first is insoluble and the second intractable. Were it possible to overcome them, there is still no way to do what Mr. Bernanke says he will do. The Fed’s balance sheet precludes it. In rescuing the financial system, the Fed bought junk assets, injecting new money into the banking system. They bought these assets at prices greater than their actual value. To remove the excess funds from the banking system, the Fed must sell these toxic assets back to the private sector. Unfortunately, no buyers will pay what the Fed did for these assets. They will only pay what they are perceived to be worth which is less than when the Fed overpaid for them. It might be possible to sell Treasuries into the private sector to reduce the money supply; however the Fed doesn't have enough Treasuries to accomplish the task.  Furthermore, the more Treasuries that leave the Fed's balance sheet, the more the Fed’s balance sheet becomes a collection of junk assets, jeopardizing the viability and continuity of the Fed. 4. Monetary expansion cannot stop. The secret behind all of Bernanke’s bravado is that monetary expansion cannot stop. Deficits of $1.5 Trillion are the current and expected norm. There is little political will to stop them. Has anyone suggested balancing the budget in a year or making meaningful cuts, probably in excess of $500 billion? (Apparently Rand Paul has suggested this latter number, although he appears to be quite alone in his boldness.) Without dramatic political action, the Fed will continue Quantitative Easing. Otherwise the Federal government will default on at least some of its obligations. Foreign and domestic demand is insufficient to absorb the new Treasury debt necessary to fund the deficits. Mr. Bernanke, to the extent he even has a choice, will continue to expand the money supply rather than be responsible for a government default. Get prepared for QE3, QE4, ... ad nauseum. The phrase "lender of last resort" described the intended role of Central Banks. They were created to provide liquidity to assist banks in trouble and prevent bank runs. Today the phrase has taken on new meaning. Central Banks have become the lenders of last resort for insolvent governments. The Fed is unable to withdraw funds from the economy for the reasons above. They will be forced to continue to add funds to keep the government liquid. We will have hyperinflation because there is no way or intention of withdrawing the excess funds from the banking system. Mr. Bernanke, regardless of his intentions, now has one client – the Federal Government. It is his duty to keep them solvent regardless of his job description. The myth of government must be preserved no matter what the costs, including a hyperinflationary depression. This article originally appeared on American Thinker
Faking Our Way to Sovereign Bankruptcy
As political events in Egypt play out, including likely contagion to other parts of Africa and the Middle East, attention is diverted from the real threat to our country -- government insolvency. From Jeff T. Allen, writing in  American Thinker:
There will soon be a crisis affecting US citizens beyond any experienced since the Great Depression.  And it may happen within the year.
Unlike the Great Depression, however, we will enter such a shock in a weakened state, with few producers among us and record mountains of debt.  More cataclysmic is the specter of inadequate food, as less than 4% of us farm ...
Fantasy Land Political lip service will not solve this problem, only spending cuts will. Yet lip service is all we get. President Obama's State of the Union address spoke of the problem but not to the problem. Obama offered no spending cuts, while proposing a host of new spending programs. The release of his budget reflects more of the same - phony promises but no real action President Obama continues to revel in his world of fantasy and duplicity while the economy and world crumbles. Mr. Obama appears delusional and more interested in political posturing than constructive effort. Newly elected Republicans seek $100 billion in immediate cuts but struggle to get to this level. Smaller numbers elicit calumny from Democrats and the media. Democrat Majority Leader Harry Reid reacted this way to the potential cuts:
"In many cases, these proposals may mean taking workers off the assembly line or taking teachers out of the classroom or police off our streets," Senator Harry Reid, the Nevada Democrat and majority leader, said.
Characteristically, Reid touches the political hot buttons in an attempt to scare people. While Reid is correct that low-level cuts will be harmful, it is for an entirely different reason than he suggests. Small cuts ensure a government default, civil unrest and economic collapse. Head-in-the-sand politics must end. Feigned ignorance and cowardice will not serve politicians well. Reality is on the way and they are apt to be run over by it. For politicians like Majority Leader Reid, the remainder of this article may be detrimental to your health. Do not proceed without a cardiac care unit on standby. Fiscal Conditions John Mauldin, in his recent newsletter, argues that public spending in welfare states has reached a turning point:
Clearly, we are looking at a watershed event in public spending in the United States, United Kingdom, and Europe. Because of the Great Financial Crisis, the usual benefit of a sharp rebound in cyclical tax receipts will not happen. It will take much longer to achieve any economic growth that could fill the public coffers.
Welfare states are faced with life-or-death problems that may not be soluble. To understand the gravity of the situation, two studies are useful. The BIS Study The Bank of International Settlements (BIS), is known as the Central Banker for central banks. In addition to other duties, BIS produces respected research pertaining to the world economy. They warned of the inevitable debt crisis long before it was apparent. They are less political than central banks. As a result, their analysis can be more objective. Below is an excerpt from a BIS Working Paper which presented the necessary surpluses by country necessary to regain sounder fiscal condition.
[Table 6.1] presents the average primary surplus target required to bring debt ratios down to their 2007 levels over horizons of 5, 10 and 20 years. An aggressive adjustment path to achieve this objective within five years would mean generating an average annual primary surplus of 8-12% of GDP in the United States, Japan, the United Kingdom and Ireland, and 5-7% in a number of other countries. A preference for smoothing the adjustment over a longer horizon (say, 20 years) reduces the annual surplus target at the cost of leaving governments exposed to high debt ratios in the short to medium term.
These numbers have deteriorated since the table was constructed. For example, the US budget deficit is now expected to be in excess of 10% of GDP in 2011, not the 7.1% shown. The implications of the table are discussed below, but first a look at the problem from a different perspective. The Jagadeesh Gokhale Study Almost a year ago, an article entitled Welfare States - R. I. P. showed debt levels from around the world. This analysis included funded and unfunded (Social Security, Medicare, etc.) liabilities while the BIS study dealt only with funded debt. The US government then had debt and unfunded liabilities equal to 8.4 times GDP. Today the number is almost 9 times. In 2005 the EU averaged 4.3 times GDP. The ratios for the PIGS, those troubled EU countries, were as follows: Portugal 4.9, Italy 3.6, Greece 8.8 and Spain 2.4.  A methodological difference understated these ratios versus the US.  It was crudely estimated that using the same methodologies, the EU and the US would be comparable. An Intractable Problem According to BIS, the US must run higher than a 2.4% budget surplus (higher than the Table above to reflect worsened conditions). A surplus this size has not occurred since the inception of the modern welfare state. To achieve this surplus, the US would have to cut spending by $2.0 Trillion in one year! (Note that any combination of cuts and tax increases necessary to produce this figure would suffice. This discussion assumes cuts only and tax increases would drive economic activity down and likely not be effective.) Obama claims his new budget produces $1 Trillion dollars of cuts over 10 years. (At first blush, it is seen to contain at least 15 different tax increases to achieve his claim.) Even if his numbers were real, that is half of what BIS says is required in the first year and every year thereafter for 20 years! Over Obama's 10-year horizon, the BIS say that $20 Trillion is required. To achieve it, requires spending cuts of more than 50% of total government spending immediately! The BIS solution is daunting, but not satisfactory for two reasons:
  1. It only returns governments to their 2007 fiscal conditions. After 20 years of extreme austerity the US would return to the condition that preceded the financial crisis. That assumes that markets would allow us this much time. Returning to the condition precedent to a financial collapse does not seem too assuring.
  2. The BIS cuts do not address the unfunded liability problems which would have to be dealt with as well, although presumably with less urgency.
The Gokhale study, based on 2005 data, concluded that government finance was unsustainable. By 2007, financial conditions had worsened. The simplest way for most to understand the implications of the Gokhale data is to put it in terms that they can relate to. Several examples of that were provided in Spiraling to Bankruptcy. One illustration had the government confiscate all private wealth and apply it to their liabilities:
If the Government confiscated everything, the social programs would still be $50 trillion short and the Government would still be bankrupt. Furthermore, no company or individual would be left with anything.
Another translated government debt into the equivalent amount owed by each individual:
Assuming a total population of 315 million people, the portion of Federal Government debt that is owed by every man, woman and child in this country is about $381,000! Or, a family of four owes $1,525,000 of which they are unaware. This amount is in addition to whatever mortgages, credit card debt, car loans or other loans a family might have.
Both the BIS and Gokhale studies convey the desperate situation we are in. The BIS provides a solution via massive cost-cutting. Gokhale does not provide a solution. Neither study accounts for the additional state and local liabilities. Neither takes into account the federal guarantees of Fannie and Freddie which amount to another $5 Trillion. The Federal Government is in what is known as a Debt Death Spiral. They are unable to pay the actual and implied interest on their debt. Hence, the unpaid balance is added back to the amount owed, making the problem worse next year. This debt spiral is growing exponentially. Unless this spiral is reversed, there is no way to escape a certain mathematical end. Faking It To Bankruptcy The supposed budget-cutting Republicans are having trouble agreeing on $100 billion of cuts. That is considered too much by some. Obama, on the other hand, claims he is cutting even as he submits a record-shattering spending budget. Politicians, unless their last name is Paul, believe budget cuts of any reasonable size are not possible. In the fantasy world of politics, perhaps they are correct. The real world, however, is ruled by higher laws, unconcerned with politics. Physics and mathematics are beyond political influence. These forces don't think or care; they just are. They unemotionally influence events, oblivious to human needs, wants or suffering. Pure forces of nature cannot be bargained with or overruled. A clash between these two worlds is imminent. A year ago in Welfare States - R. I. P., I speculated that we would come to this point:
The inability of politicians to say no or not play Santa Claus appears to be universal. It has every welfare state headed for bankruptcy. It is unlikely that politicians will act to head off this problem, but markets will eventually put these states out of their misery.
Lack of action is not necessarily a sign of ignorance amongst the ruling class. We got here as a result of their cowardice and Santa Claus politics. That is not about to change. The brighter politicians surely understand the situation as well as I have tried to explain it and probably better. Refusal to act is dastardly but likely "good" politics. Initiating cuts of the magnitude necessary to avoid Armageddon would precipitate our version of an Egyptian rebellion. In the political mind, even a benevolent dictator with virtually unlimited power could not solve the mathematics of this problem. Given this attitude, it is rational for politicians to pretend ‘til the end. In effect, they are faking their way to sovereign bankruptcy. Even though it is useless, they will do anything to keep the economy afloat for as long as they can. Once the true condition is known, we will be indistinguishable from Egypt. Apparently that will be fine with President Obama who stated that what was happening in Egypt was democracy at work. Will he feel that way when the US population realizes what has been done and reacts? Monty Pelerin originally posted this article on American Thinker