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One of
the most famous quotations of Austrian economist Ludwig von Mises is
that “There is no means of avoiding the final collapse of a boom
brought about by credit expansion. The alternative is only whether the
crisis should come sooner as the result of a voluntary abandonment of further
credit expansion or later as a final and total catastrophe of the currency
involved.” In fact, the US
economy is in a downward spiral of debt deflation despite the bold actions of
the federal government and of the US Federal Reserve taken in response to the
financial crisis that began in 2008 and the associated recession.
Although the vicious circle of debt deflation is not widely recognized,
precisely what von Mises described is happening before our eyes.
A variety of
positive economic data has been reported in recent months. Retail sales rose 0.4% in April 2010
as consumer spending rose and the US
gross domestic product (GDP) grew at a rate of 3%.
In May 2010, home sales rose to a five-month high and consumer confidence rose 17% (from 57.7
to 63.3). Industrial production rose 0.8% and durable goods orders rose 2.9%, more
than had been forecast. However, the modest gains reported represent
the continuing adaptation of economic activity at dramatically lower levels
compared to the pre-recession period and most of the reported gains have been
substantially manufactured by massive government deficit spending.
Despite the
widely reported green shoots, in May, the unemployment rate rose to 9.9% while
paychecks in the private sector shrank to
historic lows as a percentage of personal income, and personal bankruptcies rose.
Roughly 14% of US mortgages are delinquent or in
foreclosure, credit card defaults are rising and consumer spending hit 7 month lows.
To make matters worse, the reported increase in consumer credit, in
fact, points to a further deterioration because consumers appear to be
borrowing to service existing debt. Outside of the federal government,
which is borrowing at record levels and expanding as a percentage of GDP, and
outside of the bailed out financial sector, debt deflation has continued
unabated since 2008.
Money
Supply vs. Debt Service
A contraction of the broad money supply
is taking place because the influx of money into the US
economy, i.e., lending to consumers and non financial businesses, has fallen
below the rate at which money is flowing out of general circulation as a
function of debt service (interest and principle payments on existing debt),
thus a net drain of money from the broad US economy is taking place. As
a result, additional borrowing, as consumer spending falls, appears to be servicing
existing debt in a pattern that is clearly unsustainable and that signals a
further rise in debt defaults in coming months.
The estimate of
the broad money supply (the Federal Reserve’s M3 monetary aggregate) is
crashing and the Federal Reserve’s M1 Money Multiplier, a measure of
how much new money is created through lending activity, fell off of a cliff
in 2008, and remains practically flat-lined.
The contraction
of the broad money supply points to a potential slowing of economic activity
and indicates that consumers and non financial businesses will be less able
to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain
near 10% over the next year and mortgage delinquencies, are currently at
a record highs, and these dismal predictions
implicitly assume a stable or growing money supply.
A tsunami of
eventual mortgage defaults seems to be building and loan modifications have
been a failure thus far. There have been only a small number of permanent loan modifications (295,348)
under the Home Affordable Modification Program (HAMP) in 2009, out
of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.
Although it has
been reported that American consumers are saving at a rate
of 3.4%, the contraction of the broad money supply suggests
savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the
increase in non-mortgage consumer loans indicates that consumers are
borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating
financially as their total debt grows, thus as they
approach insolvency.
The increase in
non-mortgage consumer loans has not prevented an overall decline in total
household debt attributed to ongoing deleveraging by consumers.
While deleveraging (paying down debt) has been interpreted as caution on the
part of consumers, or as low consumer confidence, the decline in outstanding
credit reflects a reduced ability to borrow, i.e., to service additional
debt. This suggests that the recovery of the US economy may be illusory
and that the economy is likely to contract further in coming months.
Commercial
borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has
not been matched by debt financed expansion in the private sector.
The broad US
money supply is no longer being maintained or expanded by normal lending
activity. If federal government deficit spending ($1.5 trillion annually), debt monetization and emergency actions by the
Federal Reserve (totaling an estimated $1.5 trillion
since 2008) to recapitalize banks are considered separately, there remains a
net drain effect on the broad money supply. The scarcity of money
hampers economic activity, i.e., money is less available for investment, and
directly exacerbates debt defaults as consumers and businesses experience
cash shortfalls, while at the same time being less able to borrow.
Since unemployment is a key indicator of recession, then if the US economy
were contracting, it would be evident in unemployment statistics.
Structural
Unemployment
Unemployment and
labor force data suggest that the US labor market is in a structural decline,
i.e., millions of jobs have been and are being permanently eliminated,
perhaps as a long term consequence of offshoring, outsourcing to other
countries and the ongoing deindustrialization of the United States.
However, the immediate meaning of the term “structural” has to
with the fact that jobs created or sustained during the unprecedented expansion
of debt leading to the financial crisis that began in 2008, e.g., a
substantial portion of service sector jobs created in the past two decades
now appear not to be viable outside of a credit expansion.
Officially, the
US unemployment rate rose to 9.9% in April 2010, which represents the
percentage of workers claiming unemployment benefits. However, the total number of unemployed or underemployed
persons, including so-called “discouraged workers” (Bureau of
Labor Statistics U-6), rose to 17.1%. Using the same methods that the BLS had
used prior to the Clinton administration, U-6 would be approximately 22%,
rather than the official 17.1% statistic.
With official U-6
unemployment of 17.1% and a workforce of 154.1 million there
are roughly 26,197,000 people officially out of work. Using the
pre-Clinton U-6 unemployment calculation of approximately 22%, there would be
33.9 million unemployed. If the average US household consists of 2.6
persons and if 33% of the unemployed are sole wage earners, then 55.5 million
US citizens currently have no means of financial support (17.9% of the
population).
While it has been
reported that the labor force is shrinking, the
characterization of workers permanently exiting the workforce by choice may
be inaccurate. While a shrinking workforce could reflect demographic
changes, the rate of change suggests that tens of millions of Americans are
simply unemployed.
Setting aside the
question of whether or not those “not in the workforce” are, in
fact, permanently unemployed, the workforce, as a percentage of the total US
population, is currently at 1970s levels. Since many more households
today depend on two incomes to meet their obligations, compared to the 1970s,
a marked drop in the percentage of the population in the workforce points to
a decline in the labor market more significant than official unemployment
statistics suggest. What is more important, however, is that structural
unemployment suggests structural government deficits, e.g., unemployment
benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP
(roughly 70%) consists of consumer spending, a sustainable recovery from
recession seems improbable if unemployment is worsening or if the labor force
is in a structural decline, since that would imply unsustainable government
deficits, whether or not they are masked by nominal GDP gains thanks to
economic stimulus measures.
Government
and GDP Growth
The US federal
government is a growing portion of GDP, thus reported GDP growth is largely a
byproduct of government deficit spending and stimulus measures, i.e.,
reported GDP growth is unsustainable. Total government spending at the
local, state and federal levels accounts for as much as 45% of GDP, thus
nominal gains would be expected when government deficit spending
increases. According to some measures, reported gains in GDP are a
byproduct of relatively new statistical methods and, using earlier methods of
calculation, GDP remains negative.
Government
borrowing and spending may have offset declines in the private sector but
only to a degree and only temporarily. The resulting growth in US
public debt has an eventual mathematical limit: insolvency. Of course,
the actual limit to US borrowing remains unknown. The continuing
solvency of the US depends on the ability and willingness of governments,
banks and investors around the world to lend to the US, which in turn depends
on the tolerance of lenders for the US government’s profligacy and
money printing by the Federal Reserve, e.g., quantitative easing and
exchanging new cash for worthless bank assets. US Treasury bond
auctions will fail if lenders conclude that a sufficiently large portion of
their investment will be diluted into oblivion by proverbial money
printing. In that event, the US dollar will surely plummet, despite
deflationary pressures within the domestic US economy, and the cost of
foreign goods, e.g., oil, will rise causing high inflation or triggering
hyperinflation.
According to the Bank for International Settlements
(BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2%
in 2010. Rather than being the result of one-time expenses, such as
temporary stimulus measures, much of the deficit represents permanent
increases in government spending, e.g., due to the growing number of federal
employees. If increased government spending is removed, GDP appears to
be declining significantly.
Of course,
sustainability has more to do with total debt than with deficit spending
because a deficit assumes that there is an underlying capacity to service
additional debt.
Unsustainable
Debt
While asset
prices have declined, e.g., real estate and equities, debt levels have
remained high due to the federal government’s policy of
preserving bank balance sheets, which had
ballooned prior to the financial crisis to the point that overall debt in the
US economy reached unsustainable levels.
The absolute debt
to GDP ratio of the US economy peaked in 2007 when debt levels exceeded the
ability of the economy to service debt from income based on production, even
at low interest rates. Although US GDP began to decline prior to the
advent of the global financial crisis, debt coverage had been in decline
approximately since the 1970s, coincidentally, around the time that the US
dollar was decoupled from gold.
Government
deficit spending cannot correct the situation because, for every dollar of
new borrowing, the gain in GDP is negligible and some have argued that the US
economy has passed the point of “debt saturation.”
In a growing
economy, additional debt can result in a net gain in GDP because the money
supply grows and economic activity is stimulated by transactions that flow
through the economy as a result. The debt saturation hypothesis is
that, as debt levels rise, additional debt has less impact on GDP until a
point is reached where new debt causes GDP to decline, i.e., the capacity of
the economy to service debt has been exceeded and, not only is it impossible
for the economy to grow at a rate sufficient to service existing debt (since
interest compounds), but economic activity actually declines further as a
function of additional debt.
A
Downward Spiral
The process of
debt deflation is straightforward. New lending at levels that would
maintain or expand the broad money supply is impossible for two reasons: (1)
asset values and incomes have fallen and millions remain unemployed; and (2)
debt levels remain excessive compared to GDP, i.e., real economic activity
(outside of the government and financial services industry) cannot service
additional debt. The inability to lend, actually the result of prior
excess lending, results in a net drain of money from the economy. The
drain effect, in turn, leads to further defaults as cash strapped consumers
and businesses fail to service existing debt, and as debt defaults impact
bank balance sheets, putting a damper on new lending and completing the cycle
of debt deflation.
Keynesian
economic policies, i.e., government deficit spending, are irrelevant
vis-à-vis excessive debt levels in the economy and bailing out banks
is not a solution since it cannot stop the deterioration of their balance
sheets. The process is self-perpetuating and cannot be stopped by any
government or monetary policy because it is not a matter of policy, but
rather one of mathematics.
Since the
presence of excess debt (beyond what can be supported by a stable GDP, or by
sustainable GDP growth) impacts the broad money supply, efforts to preserve
bank balance sheets, i.e., to keep otherwise bad loans on the books of banks
at full value, will ultimately cause bank balance sheets to deteriorate more
than they would have otherwise. The fact that US banks issued trillions
in bad loans cannot be corrected by changing accounting rules, nor
can the consequences be avoided by government deficit spending or by unlimited bailouts, and
the problem cannot be papered over by dropping freshly printed money from
helicopters flying over Wall Street. The major
problems facing the US economy today—a tsunami or debt defaults,
structural unemployment, massive government budget deficits, a contraction of
the broad money supply outside of the federal government and the financial
system, and a lack of sustainable growth—cannot be addressed as long as
excess debt levels are maintained. As von Mises clearly understood,
sound economic conditions cannot be restored unless and until the excess
debt, which resulted from a boom brought about by credit expansion, is purged
from the system. The alternative, and the current policy of the United
States, is a downward spiral into a bottomless economic abyss.
Ron Hera
Hera Research
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Ron Hera is the
founder of Hera Research, LLC, and the principal
author of the Hera Research Monthly newsletter. Hera Research provides deeply
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