Tuesday, March 31, 2009

Live Poor and Die: Debt Slavery for a New Generation

The title says it all: Financial Rescue Approaches GDP as U.S. Pledges $12.8 Trillion. That there is what they call a punch to the gut. My entire generation is being sold down the river by Washington politicians and the Federal Reserve's board of directors. We were running record deficits before this spending spree started. How do our parents and grandparents ever expect us to pay this back? How do they expect us to pay this back, and pay for their Social Security, Medicare, and Medicaid benefits!? How does President Obama expect me to pay this back, and pay for my parents' and grandparents' Social Security, Medicare, and Medicaid benefits, and pay for universal heathcare?!

Well, the Federal Reserve has a cute little trick to try and muddle the issue. The Fed has the power (by act of Congress) to print up new money. In the United States we have a "fiat" currency, so this new money doesn't have to be backed up by anything. They can just print as much as they want, no strings.

Now, let's say Congress and President Obama decide to go on a $12,800,000,000,000 spending spree (Yes, that's how many zeroes there are: $12.8 trillion = $12,800 billion = $12,800,000 million = $12,800,000,000,000). I'm going to go out on a limb here and say that it's going to be hard for the government to find buyers for $12,800,000,000,000 in bonds. Washington has another option though--the Federal Reserve.

The Federal Reserve can print up a bunch of cash at will, and use it however it likes...including buying government bonds. So if the government needs to borrow X dollars and no one will lend it to them, the Fed just prints up the money. The result is that the base money supply--ie, the total number of dollars the Fed has printed--increases by X, and the government's debt increases by X.

So how much has the Fed printed recently? I'm glad you asked. Here's a chart from the St. Louis branch of the Fed. Go take a peek. I'll wait.

Back? Ok. Did you see the nearly vertical jump starting around September 2008? The base money supply has more or less doubled since then. Ok, so if the money supply has doubled, why doesn't everything just cost twice as much as it used to? The answer is that base money doesn't tell the whole story. When the economy--especially the banking part of it--operates normally, a small change in base money will lead to a large effective increase in the money supply, because banks don't have to keep all of their deposits on hand--they can lend most of a deposit out to be spent by someone else and eventually deposited again by the person who ended up with the money that had been loaned out.

But the economy isn't operating normally. Banks are barely lending at all. To understand why, I need to digress for a while, beginning with a quick parable.

Let's say that last year, you had found a buried pirate treasure estimated to be worth a cool $1,000,000 dollars. The trick, however, is actually converting it from pirate treasure to dollars. Finding a buying for things like pirate treasure can be hard. Stuff that you own that isn't easy to convert to cash is called an illiquid asset. However, you don't want to wait around to convert your pirate treasure into dollars. You found a pirate treasure, by golly, and you want to be cruising around in a yacht and a new sports car. So, you take out a loan and buy yourself some cool stuff. You figure you're sitting fine. Sure, you've just run up $500,000 in debt, but your pirate treasure will cover it and then some.

Then, disaster strikes. A large portion of your pirate treasure is actually fool's gold. Instead of being worth $1,000,000, your pirate treasure is only worth $300,000. Uh oh. You can't cover your debts any more, even if you convert all of your pirate treasure into cash.

This, in a nutshell, is what happened to the banking system. They woke up to discover that their pirate treasure was worth a fraction of what they had assumed. A large number of banks discovered that the value of their assets (their pirate treasure) was worth less than the amount they owed (their debt).

So when a government official tells you that a bank "has a liquidity problem" or "needs an injection of liquidity," a very large portion of the time they're simply wrong. Liquidity isn't the biggest issue facing the bank at all; the bank is simply insolvent.

Presidents Obama and Bush and their advisors have refused to accept this. They insist that banks aren't lending because the things they own are difficult to convert to cash. If the government would just help out, they say, the banks could get cash for their assets at a fair market price, and start lending again.

There is a major flaw with this plan. Even if all of the banks' illiquid assets were turned into cash at market prices, many of them wouldn't have enough cash to pay off their debts, let alone start lending again. The only way Obama's plan can work is if he can get people to pay real-pirate-treasure prices for pirate treasure that is mostly fool's gold.

I don't want to get into the various nefarious ways that President Obama and Treasury Secretary Geithner have schemed up to get people to do this--it involves sticking the taxpayer with the bill if things go badly for the buyer--because it simply can't possibly work without totally destroying the economy.

Glenn Beck explains: http://www.youtube.com/watch?v=lrW6UO5Zkok.

At the peak of the housing bubble, prices were about double their historical levels. Housing prices are still very high above this level, but are falling. In fact, if the market is left alone, housing prices will probably fall below historical levels, since we overbuilt so much during the boom. Obama and Geithner think--or at least their strategy implies--that the fair market price of a house is twice the historical average market price for a house. Well all I can say to that is that they are very clearly wrong. Banks aren't having trouble getting a fair price for their assets (the price of which depends on housing prices). The market price is just substantially lower than the banks would like. Well, I'd like a billion dollars for my bellybutton lint, but no one is going to pay it.

Let's get back to the original point. The Fed is printing all this money, but it isn't being circulated through the economy. It's just papering over the giant gaping holes in the balance sheets of failed banks. Let's say that at some point in the future, we have a thriving financial sector again--the bad banks have gone under, new entrepeneurs have bought their assets at bankrupcy auctions, and we're undertaking a new economic era. Bank activity starts to rise up again to where it was before the collapse. What happens then? The trillions printed by the Fed enter the economy and start to affect price levels. If the Fed doesn't reign the money supply back in, we'll be hit with massive, crippling inflation. If the Fed reigns in too much though, liquidity really will dry up, and the recovery will be stunted. They have to figure out exactly how much to pull back, and they have to do it six months to a year ahead of when they think the effect of their policy needs to be felt (since that's about how long it usually takes for a Fed action to fully affect the economy). It seems likely that the Fed will err on the side of too much inflation. Ben Bernanke has a fear of deflation so intense that it would be risible if it wasn't horrifying. On top of that, to shrink the money supply back to normal, the Fed has to sell it's bonds in the market in echange for cash. For this to work, someone has to be willing to buy bonds. Time will tell if anyone is.

Things have gotten to the point where I just don't know what to say anymore. It money not even real to these people? We have to "save" the economy (read: give free money to the politically well-connected) no matter the cost! Even if the cost is the debt slavery of an entire generation of young Americans. Most of my classmates will be leaving school with huge debt in the form of college loans. On top of that, we're being asked to shoulder the cost--first in blood and then in dollars--of two wars. And then this bullcrap. We get to worry about the defferred cost of a spending binge equal to the nation's GDP and growing. I can hardly wait.


  1. True or false: Like belly-button lint or bandaids, ripping it all of at once (letting banks and auto makers fall apart, with large unemployment) will, in the end, be much less painful than this propping up and debt building?

    Also, estimated time till housing prices are low? I want to know when to buy a house.

  2. In response to Alexander TD...

    Short answers:

    1.) True.

    2.) When you see widespread bulldozing of vacant houses by municipalities, that's probably the bottom.

    Long answers:

    1.) The economy is suffering from a misallocation of capital resulting (at least in part) from years of interest rate manipulation by the Fed--rates were way too low for way too long. There should have probably been a much worse correction after the tech stock bubble, for instance, but the Fed tried to paper over it. We need to let the bad investments liquidate--ie, we need to allow bankruptcies--so that the tied-up capital can be put to productive use. Government intervention of the kind we're seeing creates 2 big problems. First, there's a "moral hazard" created because we're subsidizing people who messed up big time at the expense of people who were prudent. Second, we simply don't have the money to do it, and are setting ourselves up for a fiscal apocalypse. The market is trying to "rip off the band-aid," and the government is trying to put the band-aid back on. There are political incentives for the government to do this, but I don't want to get into that too deeply in a comment.
    See also:

    2.) There are something like 19 million unoccupied houses in the country. As long as that remains true, dilapidated properties are going to be dragging down the property values of all the homes around them. Also, quality of life is going to be hurt because municipalities will still be paying for infrastructure maintenance and police and fire services for areas where no taxpayers live. Mass demolitions are probably going to be more common than anyone would suspect. Lastly, keep an eye on the difference between monthly rents and monthly house payments. When that ratio is sensible again, that will be another clue that the market is nearing the bottom. I've heard Pittsburgh real estate didn't get as bad as some places, but that's just anecdotal. Definitely do your homework before buying right now.
    See also:

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  3. Question: Your thoughts on China's call for a global currency backed through (I believe) the IMF? (A post, not a comment reply, of course, there's just no other place to put it.)