Clause 61: The Pushback Blog

Because ideas have consequences

Posts Tagged ‘inflation

The July Crisis

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The diplomatic crisis that began World War I played out 101 years ago this month. On 28 June, the casus belli occurred, when the Austro-Hungarian heir and his wife were murdered by Serbian nationalists. By 31 July, Austria-Hungary and Serbia were at war and Russia and Germany were mobilizing.

One of the most interesting features of the crisis was that, reading the accounts of the various participating governments, no one believed that they started the war. Everyone spoke as if they had no choice to do what they had done:

  • Austro-Hungarian leaders believed they could not allow their neighbor to instigate assassination without reprisal;
  • Russian leaders believed that they could not abandon their brother Slavs without losing credibility;
  • German leaders had predicated all their plans on the slowness of the Russian mobilization, and therefore believed that they could not allow it a head start.

People went to war saying, “Home before the leaves fall.” They were cavalier about the risks of the actions that they were taking. Few had any notion of the character of the war they were beginning.

I do not expect the current July crisis, centered on the Greek economy, to result in a shooting war. But what it will result in is serious enough. Like its forerunner a century ago, it features people who don’t understand the consequences of their actions and who see themselves as having no choice but to do what they are doing.

The Greek voters have not helped matters. While poll results had been predicting a close result, the actual vote was a thumping 61-39% result in support of Alexis Tsirpas and his hard-line approach. One ray of hope appeared in the form of the resignation of his finance minister, Yanis Varoufakis, who had made ill-considered remarks comparing the Greek creditors to terrorists last week. But the horse is out of the barn now, and Tsirpas can be sure of his political backing as he resumes negotiations.

Many of the Mediterranean countries are shot through with corruption and clientelism. Favored political groups have become dependent on state handouts. The fact that the state can no longer afford them doesn’t enter into their reckoning. Under these conditions, attempts at reform from above are political suicide missions.

Greece was able to gain admission to the Eurozone in 1999 by showing data meeting the European Union targets, including annual budget deficits below 3% of GDP and public debt below 60% of GDP. By 2004, it had become apparent that the Greek government had cooked the books and these targets had not been met in reality. However, there was no framework in which to handle this.

The Eurozone had been dedicated to expand for expansion’s sake. The dream was of a unified economic entity of 500 million people — larger than the United States — with a single currency and free movement across internal political borders. The European Central Bank would prevent the politicians from inflating the currency in order to hand out candy to their clientele. Within this structure, each country could pursue its own political preferences, but their politicians would have to take the heat for economic consequences of those preferences.

It hasn’t worked out that way. Since 2008, Portugal, Spain, Italy and Greece have all gone through debt-driven troubles. Greece is the worst of the lot, but Spain is not in great shape either. Spanish voters are watching what happens in Greece with great interest.

The referendum now looks like a shrewd calculation by Tsirpas. He now can be sure of his political situation at home as he attempts to shake down the IMF and Germany for yet another bailout and a debt haircut. Tsirpas can point to the result and say that he has no choice; he is only doing what his voters want him to do.

Now we will see what the real consequences of the Eurozone are. Did they leave the central bank in charge of the currency, forcing the elected officials to face the music for their policies? Or did they change the central bank into a fire brigade, committed to do whatever it takes to save the Euro?

The choices now faced by the creditors are all bad. Caving in to the Greeks will encourage the other Mediterranean countries, who don’t want reform either, to push back all the harder. Angela Merkel will face all kinds of heat at home; the Germans are not eager to prop up these other nations at their expense.

However, a hard line position by the creditors has problems of its own. It could force Greece out of the euro. While that in itself might seem desirable, it opens a door in what was meant to be a solid wall. Given the expansive nature of the intent of the euro, there was never a plan to have countries leave. No one knows how it would work. Worse for its proponents, it is a move in a direction opposite to their goals. What becomes of the euro if it is not a permanent arrangement?

Meanwhile, what happens to Greece outside the euro? They would be free to inflate their own currency at the expense of pauperizing themselves in real terms. Exporters would gain, but anyone on a fixed income would lose, as would anyone with money in the bank. The worst-case scenario is a Zimbabwe on the doorstep of Europe.

Events of July 2015 will go far to decide how this mess will play out. Your grandchildren will be reading about this in their history books.


Written by srojak

July 6, 2015 at 8:32 am

Voting Ourselves Rich

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A former co-worker sent me a link to a polemic on Social Security by Michael Goodwin, the author of Economix. Since the material is presented as a series of drawings, I have to include the drawings in order to quote them. All the drawings on this page are the work of the author, Michael Goodwin, and the illustrator, Dan Burr.

There is a lot of misinformation on this site, so let’s dig in.

The Pay-As-You-Go System?

"pay-as-you-go" system, from Economix
They way Social Security was advertised to the GI generation was as a pay-as-you-go system: your Federal Old Age Benefit payments (some pay stubs used to have a column F.O.A.B.) went into a fund to pay for your retirement. The first year anyone actually received Social Security benefits was 1940.

In fact, such a system would be unimplementable. What would the government do with such an enormous pile of money, anyway? Stick it in a vault? It would never keep up with normal economic growth. Invest it? The position would be impossible to manage and would swamp competing private investments.

Meanwhile, there would be this enormous pile of money in the Treasury, and somehow politicians were going to be able to keep their hands off it?

So what Mr. Goodwin describes, a pay-as-he-goes system, is actually closer to how the system worked than was the story that was sold to people who were voting adults back in the day. However, there is a fundamental problem with this. If you were to set up a private investment fund along this model, paying earlier participants out of the proceeds from later entrants, it would be called a Ponzi scheme and you would be slung in jail.

And Reagan Screwed Us All, Right?

Reagan borrowing, from Economix

Actually, no. This was getting out of control before Ronald Reagan ever came to town. Howard Ruff was calling Social Security a Ponzi scheme back when Jimmy Carter was still president.

Any fund that a government sets up to collect taxes now and pay benefits in the future is going to have a hard time keeping up with normal economic growth. Government is not a wealth-producing entity. You can’t “invest” in government, because there is no wealth production from which to obtain returns. It is just one big cost center.

Some of those costs are unavoidable and necessary, such as law enforcement, road repair, diplomats, soldiers and food inspectors. You may not agree with the levels at which they are funded, but they are necessary. However, their necessity doesn’t change the fact that none of them are producing wealth, and therefore none of them can contribute returns to an investment designed to provide for citizens in their old age.

But the event that really put Social Security underwater was the inflation of the seventies. Given that there was nothing in which the government could invest a fund of that size and keep up with normal economic activity, there was absolutely no chance of the government being able to keep up with the currency inflation it was driving back then.

By 1980, mortgage rates were pushing 13% and the prime rate for commercial borrowing was near 15% (See this New York Times article). This was completely unsustainable and a threat to the proper function of the economy. Business managers were beginning to question their ability to extend 30-day payment terms. Banks were starting to get interested in workarounds to avoid state usury laws, which would change the credit card business forever.

There are only 3 ways to finance government operations:

  • Levy taxes;
  • Borrow;
  • Print the money.

Taxes were off the table, because they would have pitted some voters against others. Uncle Feelgood didn’t want that. States were already experiencing tax revolts, such as the one led by Howard Jarvis in California that passed Proposition 13 in 1978. Having pushed inflation to the apparent limit, borrowing was the only unexplored avenue. Well, other than not spending — what do you think of that, Mr. Goodwin?

I’m Entitled

Social security entitlement, from Economix

Apparently not much.

Hey, wait — previously, you said that our social security payments were paying for current retirees’ benefits. So how, exactly, does this entitlement thing work?

This touches on another idea that periodically lumbers out of the woods to be beaten to a bloody pulp: means-testing Social Security. Every so many years, somebody floats it, and you will hear it trotted out again before long. But it never goes anywhere, because politicians know that means-testing Social Security will be the death of large-scale political support for the program. If a significant number of voters never expected to receive Social Security benefits, it wouldn’t be long before a revolt against Social Security started. However, with all of us in the system, expecting to receive benefits if we live long enough, there are payoffs for everyone. We can vote ourselves rich!

Only one problem: what happens when we go to collect our entitlement and the cupboard is bare?

The New Dealers never believed that there was enough wealth to make everyone above average. That is why they allowed unfavored groups, such as blacks and Asians, to be shoved to the back of the line. That mentality did not survive the sixties, and I can’t say I’m sorry about that. Nevertheless, the mentality that replaced it was that we were so rich, cool and smart that we really could vote ourselves rich. All of us.

And, yes, you’ll get your entitlement — sort of.

Furthermore, we have the capacity under the Constitution, the Congress does, to coin money, as well as to regulate the value thereof. And therefore, we have the power to provide that money. And we are going to do it. It may not be worth anything when the recipient gets it, but he is going to get his benefits paid.
— Senator William Proxmire, Senate hearings, 1976

Sure, you can have your $2,000/month Social Security benefit. Of course, a gallon of gas might be $1,000 and a gallon of milk $500. Remember that the Core Consumer Price Index does not include food or energy. The feds are never going to overtly default on federal obligations. They are going to constructively default by inflating the currency to the vanishing point.  The process is already under way:


Monetary Base 1979-2014. Federal Reserve Bank of St. Louis.

Monetary Base 1979-2014. Federal Reserve Bank of St. Louis.

The right side of that graph shows a 5x increase in the monetary base since 2008. Ultimately, that means more dollars chasing the same amount of wealth. Why do you think there are all these people advertising to buy your gold?

You can be entitled to something, but you still can’t get blood out of a stone. Imagine how much fun it is going to be when five people with competing claims to a dollar meet in the public square to fight over 35 cents. What do you think all that rioting in the Club Med countries was about? People there had made life decisions in the expectations of receiving benefits, and suddenly the government pulls out its pocket linings. Coming soon to a nation uncomfortably near you.

So Can’t We Default on Someone Else?

So here is Mr. Goodwin’s solution:

Components of debt, from Economix

OK, let’s think about this practically and realistically. Our plan is to flip off the people who are lending us the money to live beyond our means. That won’t cause a problem, will it?

The politicians are hooked on vote buying. Wall Street is their connection that makes it possible. Both Wall Street and Washington believe that Wall Street has the federal government by the short hairs.

As of 2012, $5 trillion in federal debt was to mature within 36 months (see this Wall Street Journal article). It’s not like the feds have the means to pay it off; they have to roll it over. And over. And whose co-operation do they need to do that?

Without the active assistance of Wall Street, elected officials have no chance of buying the votes they need to stay in office. In 2008, we had an election that sent the Senator with the most progressive voting record to the White House. And what changed in the financial sector? The heavens opened up — and a feather fell to earth. Yes, we can … keep on going just the way we have been.

You’ve heard it on the radio all your life:

Meet the new boss
Same as the old boss
— Pete Townshend

By the way, the foreigners are all too familiar with the concepts on these panels. When the wheels really start to come off, you will see foreigners dumping both government debt and dollars.

But Everything’s Cool

Social Security trust fund, from Economix

Try this simple experiment: Apply for a home mortgage. Write yourself an IOU for $1 million and list it as an asset on your mortgage application. Note the reactions of the mortgage originators. Do they laugh? Make rude gestures? Call the men with nets?

Remember the plan to stiff the rich people who lend the money? The intended suckers are the holders of government bonds. The Social Security trust fund is a very large rich person, weighing in at about $2.6 trillion as of mid-2012. When — not if — the government can’t keep with the vote-buying treadmill, the value of those bonds will be significantly impaired. As in a 99% haircut. The kind of haircut that leaves you with a razor through your throat.

An Economic Stimulus Parable

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Imagine yourself as a Renaissance prince or princess, ruling a small city-state. One of the your princely possessions is a granary, where you can store grain you purchase in years of abundant harvests and release it in years of famine.

Recent years have been relatively bountiful, but not spectacular and not for everyone. Poor people gathered around you as you traveled through the street, imploring you to help them. The pain on their faces was palpable. It was somewhat embarrassing, sitting on your horse in your silks and jewels, surrounded by these clamoring poor people in their rags. They look like bags of bones, even the children. The sight nagged at your conscience. So you released grain from the granary to feed these people. Everyone in your court praised your benevolence. They’re courtiers, so they would have praised anything you did, but still, they had a point, no?

Last year your whole region did not have good weather, and you had an inadequate harvest. This year was even worse. Famine stalks the land. So you have turned to the keepers of your granary, who report that the store is depleted. There isn’t enough grain to see the people through the winter. Starvation is staring you in the face. What are you going to do?

You write to your neighboring princes. However, they have had the same bad weather and inadequate harvests you have experienced. Everyone is hard up. The few rulers who have any surplus to sell are besieged with offers. Prices are sky-high.

You decide to try coining more money in order to pay for grain. But with more of your money in circulation, chasing the same amount of wealth, prices go up. Your neighbors aren’t stupid; they know that you have put more money in circulation, so each coin is worth less than it was before. They discount the value of your money in exchange for grain, goods or anything else of value.

Now what do you do? You watch your subjects starve. Or you hide in your palace and avoid watching, but your subjects still starve.

The Relevance

What is the difference between the United States and this fictional Renaissance ruler?

  1. The United States has so much wealth that people think there is no limit, and nothing really bad will ever happen;
  2. The United States prints the currency used in international trade, and so appears to have greater ability to debase its currency and get away with it;
  3. The economy of the United States is so complex that it is much harder for people to trace cause and effect relationships, which is the reason for this parable.

The foundation of the first belief is the fiction of material abundance.

When people think they are getting away with an action, restraint goes out the window. What was yesterday’s pushing the envelope becomes tomorrow’s baseline. The only thing that makes them stop is visible, unqualifiable failure.

When the prince gets into trouble, the obvious response is to coin more money. However, making more money doesn’t make more grain. With more money chasing the same amount of grain, prices go up. This is inflation.

There really is not a lot that the prince can do when the famine hits. The key decision was made when he reached into the granary during times of abundance.

Much like with the housing bubble that burst in 2008, you will someday hear people talking about stimulating the economy and saying things like, “It worked until it didn’t.” This is a sure sign of bad risk management.

Written by srojak

December 31, 2013 at 11:08 am

Questions for Ben Bernanke

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The American Enterprise Institute published a list of ten questions that they believe Congress should ask Ben Bernanke: The questions center on whether the Federal Reserve should adjust its rate of quantitative easing (QE), which is less euphemistically known as inflating the monetary base.

An interesting entry among the questions is:

Mr. Chairman, what does success for QE look like? First quarter GDP growth was revised downward to 1.8%. Only modest growth is expected for the next half of the year. What is your proof that QE continues to work?

This begs the question: What is QE meant to do? What is the definition of “continues to work”?

If QE is meant to stimulate the economy, it hasn’t succeeded. There has been growth in the monetary base, but because lending is constrained, there has not been the multiplier effect that would have resulted in economic expansion. This is a mixed result, as the resulting inflation would have choked off any recovery in its crib.

If QE is meant to clear the books of US lenders of toxic assets, it is a tremendous backdoor transfer of wealth from the public to the banks.

If QE is meant to monetize the public debt, it appears to be losing a race with the creation of public debt.

What is the success model here?

Written by srojak

September 30, 2013 at 12:09 pm

Posted in Economics

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Fiat Money

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Here is a simple but effective presentation on fiat money:

The problem with a gold standard is that the monetary base, which is the amount of money in circulation, can’t expand to keep up with the economy. Then there is too little money chasing the available wealth, which depresses the economy.

The problem with fiat money is that the monetary base can be expanded by the government to be anything. It need have no relation to the actual economy. Then there is too much money chasing the available wealth, which inflates the economy.

Written by srojak

May 23, 2013 at 3:59 am