The Keynesian Endgame

I absolutely despise the Keynesian school of economic thought. The Keynesians worship three gods: demand, jobs and inflation. All of which have given us the world that we live in today. A world mired in debt due to government policies designed to stimulate demand and “create” jobs. The parabolic rise in debt across the economy since the 1970s cannot go on forever. It should be obvious to anyone that anything rising at an exponential rate will eventually hit a constraint that will reverse the trend.

The constraint to hit parabolic debt is deflation. Deflation is a contraction in the money supply. Most people will say deflation is falling prices but changes in the price level are a consequence of the supply of money relative to the goods and services produced in an economy.

During the boom times, economic activity is rising and money is being borrowed. Fractional reserve banking creates a vicious cycle of rising asset prices, followed by rising levels of equity relative to debt, further leading to more money borrowed which is then used to bid asset prices higher. Eventually, this cycle is reversed as central banks increase interest rates to a point where asset prices stop rising and debts are repaid or defaulted upon. What follows is a cycle of falling asset prices and as debt is repaid, a contraction of the money supply (deflation). Central banks (CB) see this as a major problem which is solved by slashing interest rates to get people borrowing and see rising asset prices. Before you say this is crazy talk, Bernanke has explicitly said the Federal Reserve has propped up not only the housing market but the stock market in what he calls “the wealth effect”. Every major central bank has this secret third mandate of propping up both housing and the stock market (the first two are inflation and employment). It was only a few years ago that no central banker would admit to having this secret third mandate.

This model of monetary policy has worked “fine” until the demand for new borrowing evaporates and despite interest rates being cut, the economy does not return to the debt fuelled inflation boom. This is my theory of the economic cycle, which closely resembles Austrian Business Cycle Theory and it may even be the same. Eventually debt becomes too high and no matter what the CB does the deleveraging process continues.

Either the government slowly tries to reflate the economy (Japan last 20 years) or they go nuclear with continuous debt monetisation (US Federal Reserve) or threats to go all in (Bank of Japan in recent months) with seemingly outlandish policy options such as negative interest rates, nominal GDP targeting and monetising private sector assets (corporate bonds, equities etc.).

With central banks increasing underestimating the risk of rampant inflation as a consequence of their unconventional monetary policy (debt and asset monetisation), the inevitable conclusion is hyperinflation. CBs have made it clear they will not tolerate deflation. Nothing is stopping them from expanding the money supply by trillions as long as they fear the threat of deflation. This is exactly why asset prices will skyrocket and the only thing likely to destroy confidence and asset prices are an exogenous shock (natural disasters, political risks, terrorist attacks, wars, social unrest etc.).

The consequence is rising interest rates as investors realise the CBs have poured gasoline on the fire through their reckless monetary inflation. Bond markets will collapse and anyone holding long duration debt will be burned (insurance companies, banks and pension/superannuation funds). Government borrowing costs will rocket higher as rising interest rates will mean any debt that is rolled over will rollover at higher interest rates. This is very similar to the sub-prime mortgages crisis when low teaser interest rates made the mortgage affordable until the interest rate reset to a much higher rate a few years later. This will result in the government slashing government expenditure in an attempt to service the debt and appease the bond vigilantes. The current European debt crisis is a glimpse of what we can expect when governments have to make tough decisions that are very politically unpopular.

The penultimate result of the chaos will be a deep recession as unemployment rises, causing social unrest (riots and protests) as governments struggle to deal with the problem (see Greece and Spain).

Central banks will be forced to increase interest rates but I guarantee they will be too slow to act or worse remain in denial and downplay the inflation risk as “transitory”. The UK has already experienced the effects of monetisation on consumer prices.

What’s worse is there are now calls in the UK to drop inflation targeting in favour of nominal GDP targeting. This essentially means if the nominal GDP target is 4%, inflation can be 3% which means real GDP is only 1%. Another combination is a target of 3%, real GDP of -2% and inflation of 5%. There are numerous permutations but it just shows how ridiculous nominal GDP targeting is.

What is the solution? Over the years I’ve realised it’s usually the politically unpopular decision that is the correct decision. The only way we can address the debt issues not only on the public balance sheet but also the private balance sheet is to embrace sound money and back currency with gold or at the very least some other commodity. This stops the limitless expansions of the money supply and links it to a steady growth rate. There will be pain initially as people realise of the features of a gold backed currency is an end to the continual debasement and the end of rising prices economy wide.  

This solution is unlikely to happen because firstly, the mainstream pundits support the current monetary system and secondly, moving to a gold backed currency will be politically unpopular as vested interests scream and shout in protest (banks will probably the most vocal opponents given their mortgages denominated in the old currency and because the new system limits their ability to lend).

It will usually take a crisis to change people’s perceptions but even then, there’s no guarantee that perceptions will change for the better. I will strongly support the minority that adopts the new system first because it will take the minority view becoming the majority view before we see real change for the better.

Downfall of the US Empire

The fall of an empire is usually caused by war. Just like the wars of ancient history, the wars of modern history have caused empires to go bankrupt and lose their superpower status. One only has to look back to World War 2 to see how war bankrupted the British empire. Britain was once the superpower of the free world but the war placed an enormous economic toll on Britain from which it never recovered and led to the isolationist US usurping Britain as the world superpower.

Once again we witness the fall of one empire (the US) and the rise of another (China). There is no doubt that the US stock market bubble of 2001 and the 911 terrorist attacks were massive shocks to the economy and confidence. The US Federal Reserve (Fed) then lowered rates to 1% and kept them there, for some time, to guarantee a recovery. What central banks fail to realise is that economic activity caused by lowering interest rates is an artificial boost to the economy. Money becomes cheap and the market reacts by borrowing more and accumulating more debt. Is this really economic growth? Was the NASDAQ bubble valuing companies accurately? In 2005, were US houses valued correctly? No and No. Central bank fuelled debt and the old cliché of "irrational exuberance" are to blame for the bubbles.

The great idea to invade Afghanistan and Iraq added more debt onto the US empire. Funding unwinnable wars with debt is how empires go into decline. The US government is now forced to use "quantitative easing" or printing money to fund their government expenditure. Imagine how much money would have been saved if Iraq had not been invaded or more importantly the thousands of lives that would have been saved on both sides of the conflict. These costs are now placing a huge strain on the US economy and will severely delay its recovery.

The government funded its wars with paper dollars. You can see that debt levels increased rapidly after Nixon closed the gold window. This is what happens when governments fund wars with debt. Eventually an economic crisis will hit government tax revenues hard and if the government had already been running a deficit then the deficit will become larger and eventually governments will print money to fund the war and to stimulate the economy.

Clearly after 2001, the price of gold accelerated upwards from $200/oz and has been growing exponentially since then.

The only way wars of aggression can be beneficial is if the resources that are captured are greater than the resources expended in fighting the war. Since Afghanistan had little economic importance and more strategic importance, we can say that this war had a purpose with no expected economic gain. On the other hand Iraq has major economic significance as an major oil supplier and posed little threat to global security (WMDs did not exist and the intelligence community knew this). We can therefore say that Iraq was war based on economics which secured future oil supply for the US.

Despite this gain, the war has no end in sight and every day the US military operated in Iraq is another US$ 150 million gone. Perhaps the strategists have worked out the future cost of oil being so expensive that the cost of the Iraq war is worth the gain in oil supplies secured. This is the only economic justification for the war and whether it is true will only be known years from now.

The only other economic justification for war is in self-defence, which should be self-explanatory.

We have looked at how the events of 9/11 set the US on a warpath that has bankrupted the nation. Osama Bin Laden's goal was to inflict terror on the US and send a message to the world. But he may have contributed to the downfall of the US.