The Immediate Important Lesson From Europe

We can learn many lessons from what is happening in Europe and what will be happening over the next decade or two. We will see in very explicit detail that democracy is at root a destructive system as it attempts to consume very productive asset it can get its hands on. We shall see that borrowing to spend and consume is inherently a dead-end. We shall see again that government controls do not stop destructive behavior and that few know what good behavior is then. Etc.

But we are now witnessing something that I didn’t expect. We are seeing how not to achieve a turn around in an economy. “Austerity” is a failed program.

Okay, first let’s consider what “austerity” is. It is not actually austerity. The term was first picked up from the context of an over-indebted person. If he wanted to get out of his situation, without going back on his word to pay those people who lent him money, he had to reduce his spending and pay off his debts. Then he would be financially healthy and could begin building wealth.

So, the idea went, governments could reduce their spending, too. Except they failed to remember two different aspects of the individual’s context: first, that the individual had to continue to work, i.e., produce. Production is still the key. Second, they failed to remember that the individual had to spend less than his income. Governments regard “austerity” as merely spending less than they were or perhaps spending less than they were planning, although still increasing their spending. I haven’t seen any of the European governments talking about a budget surplus and paying off their debt.

But, the most important lesson to be learned is the first: Production is the key. What I mean is that just spending less in those countries has no positive effect on the economy, only less of a negative effect. What has a positive effect is the creation of goods and services, i.e., production. Those countries aren’t producing more. Actually, since they have grown the government so much, less spending translates immediately into less purchases and a constriction of business. Business has been forced to depend upon government spending. When that spending disappears, businesses do less business, are less profitable and tend to fail. That is what we are seeing across Europe, especially in the countries with the worst situations.

Those economies haven’t gotten to where they are because of the government spending by itself. The major cause of the poor performance of those economies is government controls. Controls limit what businessmen can do and their ability to produce. Government controls are the lid on man’s productive capacity.

As long as the government controls the economy, and the European Union has a staggering level of controls, those economies are going to suffer. In fact, what we see today is the simultaneous reduction of government spending with the increase in numbers and degree of control. We see tighter and tighter restrictions being placed on business and finance, further weakening their ability to produce while the governments are trying to at least slow the rate of their indebtedness. It won’t work.

This is a lesson for us all. We need to realize that as bad as the debt situation is, and as bad as it can get, and that by itself debt can destroy our economy, that it is not the primary issue and should not be our primary target. At least it shouldn’t be.

We must also recognize that if we only talk about debt and the need to reduce spending as our immediate objective we will not succeed in moving any society towards our viewpoint. They see what “austerity” achieves. No one should want any part of that, including us.

No, our focus should be on production. Our campaign should be to unleash the productive abilities of the United States, to reverse governmental economic controls. to free our businessmen. Freedom. That should be our program.

I do not want for a minute for you to think that I am the originator of this insight. As in most all of my understanding of the world, I learned this from Ayn Rand. She did not write about this issue, but she was asked about it more than once in public forums. It is to our benefit that we can read today what she said in response to those questions in Ayn Rand Answers, pages 46-50. Also look at her answer regarding unemployment benefits on page 124. She isn’t in favor of government spending or any activity that isn’t directly protecting individual rights. She wants to stop inappropriate government spending. But she recognizes that what must be done first is to free the economy. Without that first step, and giving it the time to begin producing (probably shorter than we might think), we will see our economy contract just as the European economies are.

My position in this article isn’t new, but I hadn’t realized until recently that the European “austerity” program was exactly that being proposed by my critics. These are the people who argue that the US government spending had to be stopped as soon as possible. The immediate target of these proponents of “austerity” was Social Security and unemployment benefits. I responded that what would happen is just a lot of misery and the destruction of legitimate business, which is just what is happening in Europe, especially Greece and Spain. If “austerity” were begun in the US today, the results might not be as bad. But no good would be achieved as long as government controls were kept in place.

The only direct, economic destructive element of government spending is that it soaks up savings, which is needed for business investment. But the economy can find capital when it has potential profits in sight. We would learn that finding capital would not be an issue. Today, the drag on the US economy isn’t a lack of capital. Banks will tell you that they have plenty to lend. Businesses have plenty of money to invest if they chose. (I am not really conflating fiat money with capital.) Companies could find capital today if they were confident in the future. With all of the proposed additional controls and the fear of BO’s plans for our future, they are wise to avoid the crazy risk inherent in our political situation. And thus the economy stalls. It isn’t the deficit they are afraid of, but government force.

It might be argued that the correct approach to cutting spending would include some advanced warning. Perhaps people should be given a year or two to get their lives in order in preparation for changes in government spending. Yet, that still doesn’t address the underlying problem. If there isn’t sufficient economic activity, sufficient investment, sufficient production, sufficient productive jobs, advanced warning would provide no benefit. There are no economic alternatives to prepare with. Advanced warning only is beneficial if the person affected has alternatives to what he is currently relying upon.

At this point the response that I receive is that I am evading the moral issue of the theft of the property of those who are paying the taxes (either direct or indirect from the borrowing and inflation). It is wrong, I am told, for the theft to continue. It should be stopped immediately.

Aside from the fact that Ayn Rand did not advance this point when she had the chance, and aside from the fact that I am not disagreeing with either the immorality of the taxes or the spending, and aside from the fact that I vehemently argue that the spending and borrowing has to stop, and aside from the fact that I recognize the moral hazard from the dependency upon government spending, I reject the argument that the morality requires us to act without considering the immediate consequences and how very bad ones can be avoided.

I would argue that Objectivist morality is fundamentally a morality of consequences, that is, of causes and effects, of ends and means. If implementing a moral decision means the destruction of those who are the intended beneficiaries, the innocent and the productive in this case, then there is something wrong with the reasoning. And destruction of the productive and innocent is definitely a result of “austerity.” It isn’t just the person receiving the government handout who is suffering but the entire economy, the productive and innocent. Real, honest businesses are going under. People who made rational decisions within the context of their country are loosing all they possess. It is these people who a morality of self-interest and the social-economic system of capitalism is suppose to protect. It is they who should flourish. “Austerity” is destroying their lives as thoroughly as socialism itself. Therefore, “austerity” is the wrong approach.

While government spending upon anything but the protection of individual rights is automatically a violation of rights and a move toward the destruction of those rights, the spending itself isn’t a major catastrophe, in the sense of the immediate, economic consequences. Just as with a household, it isn’t the spending per se, it is the spending in relation to the income, which means the economy’s production. If the spending is higher than the production allows (not even considering the savings necessary to increase production), then there will be problems. That is true for either a household or a business or a government. It is worse when the overspending is for unproductive consumption, which is always true of governmental spending. “Infrastructure” is consumption. Something constructed by the government might sit there for a while, like a bridge, but it is not paying its own way and replacing itself, as a business investment would, is consumption.

Of course, governmental spending is often accompanied by restrictions on the population because the government wants to keep its monopoly, i.e., only the government can build roads, etc. If there was competition, the incompetence of the government would be clearly demonstrated. Look at the U.S. Post Office.

No, government spending isn’t the cause of a country’s economy failing to grow.

On the other hand, the best any of the commentators that I have read have made only the slight suggestions that regulation has any effect on production and prosperity. It is recognized that regulation has a cost in time and money, but not on an economy’s ability to produce and grow. This is a complete blind spot. I attribute this lack of knowledge to the general rationalist trend found in economics and business schools. Looking at how things actually work is not an acceptable practice. At least at one point in time efficiency studies were all the rage. If there are still such studies they most likely don’t question government mandated business practices. They just treat regulations as acts of nature.

However, the point is that government regulation is treated as just a part of life and is not questioned and its consequences are not considered. This last point is true in a wider scale than you probably realize. Few look to see if the supposed good consequence of government regulation actually happened. No follow up studies are done to evaluate the success of the regulation. Those consequences are assumed and bragged about but never proved or evaluated. Recently, I received an email from Ending Big Government, the website set up by Yaron Brook and Don Watkins in connection with their new book, Free Market Revolution: How Ayn Rand’s Ideas Can End Big Government. This email was entitled “Story about Stories” in which people who were impacted by government regulations explained what was happening (See here). This is a great idea. The consequences of regulations have to be concretized for people. They have to see in detail that regulation is destructive in order to understand that it has to be stopped. For example, people don’t know how extensive, intrusive, expensive, and anti-productive the FDA regulation is. These details need to be made public. The media won’t do it. The Republicans won’t do it. Who will?

So, let me suggest that you continue to watch Europe attempt to practice “austerity” and how they go into recessions. I think that Spain is already in a depression, or will be soon. Greece certainly is. Think about the consequences as the government just spending less. Think about why their economies can’t seem to grow. What is stopping them?

Next week I hope to finish up a post that will be more specific about Europe and the backlash against “austerity.” I think that we will see another lesson there as well.

Comments on Richard Salsman Review of Objective Economics by Northrup Buechner

Richard Salsman wrote an extensive review of Dr. Northrup Buechner’s book, Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics (OE) that appeared in the recent issue of The Objectivist Standard, Vol. 7, No. 1.

Salsman doesn’t like what is in Objective Economics – any of it. He says, “That which is true in the book is not new, while that which is new in it is not true.” (SR 10)

The review, which goes on for ten pages, comments upon many different aspects of the book. In fact, the approximately 50 paragraphs contain almost as many different points. One might think that the review is offered for people with a background in academic economics, however it is offered in a journal with a broad audience.

It might have served Salsman’s purpose better if he had selected a couple issues and focused on explaining his positions and how he differed from Buechner. Taking my own advise, instead of plodding through all of Salsman’s comments, I will restrict myself to only a few points.

Buechner’s focus is on the development of his own theory and its underlying justification, but Salsman doesn’t state what Buechner’s theory is or how he proves it. Salsman’s review ignores 90% of Buechner’s book, its theme, and its purpose.

Salsman is very upset that Buechner rejects a lot of “contemporary, academic economics.” (SR, 1) Salsman thinks that modern economics has improved significantly over the last decades – Buechner doesn’t. Buechner explicitly rejects the venerable theory of the law of supply and demand as a true theory of economic prices and proceeds to create his own, which he calls The Theory of Objective Price (Chapter 8, OE). Since Salsman insists on the importance of the law of supply and demand, I will start there.

Salsman says on page 2, “in crucial areas [Buechner] strips modern economics of its more rational doctrines… the law of supply and demand….” (Salsman mentions several other “rational doctrines”). Page 3: “Modern economics does have a theory of objective prices (i.e., the law of supply and demand)….” Page 5: “But Buechner insists that there is only a law of demand, and, strictly speaking, no law of supply – hence no unified law of supply and demand. Buechner disintegrates this law, insisting that supply somehow is less crucial than demand, which is equivalent to insisting that one side of a coin is less important to the whole than the other.” And: “…the law of supply and demand is one of the more magnificent, integrative achievements in the history of economics.” Salsman then goes on to quote John Locke and Jean-Baptiste Say who say that the law of supply and demand is important. Page 7: “Since at least Alfred Marshal, economists have said that prices are determined jointly and equally by supply and demand, that our desires coupled with our purchasing power (supply) (sic) entail our demand for goods and services whose attributes yield utility (satisfaction) for us, and that profit-seeking supplier try to offer products with utility-yielding features. In [Alfred] Marshall’s famous metaphor, it takes both blades of the scissors (supply and demand) to cut the paper (establish price). …this depiction captures the relational aspect of the economic valuer and what is economically valued, of mind and reality, of consciousness and existence. This is the essence of a valid theory of objective economic value.” (Italics in original; SR, 7) The quotations are only the spots where Salsman uses the term “the law of supply and demand”.

But in spite of all of these statements, Salsman does not tell you what the law of supply and demand is, what it does, or how it is proved. You might say that this is a review and not a place proof. Nevertheless, when he is denying that Buechner has proved his theory, Salsman should at least say something about the law’s proof. It is as if Salsman regards the law as self-evident. He should tell you where you can find a full discussion and a proof. Actually, I have never seen a proof. At best you can find descriptions, which is what you find in Adam Smith’s initial discussion.

For references purposes, here is what Wikipedia says this about this law:

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity.
The four basic laws of supply and demand are:
5. If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity.
6. If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity.
7. If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity.
8. If supply decreases and demand remains unchanged, then it leads to higher equilibrium price and lower quantity.

This is total demand and total supply, not just what is in front of you in the grocery store and not just what a certain manufacturer produces, but everything. Thus, the idea is that, generally, prices move according to changes in the total supply and total demand. This happens regardless of the knowledge or understanding of any or all of the participants in the market. Not every theorist holds that the changes in price are immediate or worldwide at any particular time or situation. Actually, these issues are rarely covered or acknowledged. The forces of the market are considered impersonal and unaffected by individuals or individual firms.

The point in the law of supply and demand is not that there has to be a supply, which seems to be Salsman’s thought in places, but that the amount of total supply directly affects the price. You can see something like that in certain auction markets or produce markets in which the product moves swiftly from the field to the store. The immediate supply of limes, for example, immediately affects the price. Gasoline prices also closely follow the international supply. But that is misleading since the international price, or what is called the Light Sweet Crude Oil priced in the Oklahoma market reflects the oil that is offered at that time at that market of that quality and not the total supply.

I want to point out two things about the law of supply and demand. First, it has no mechanism for explaining the prices of new products. And not just new products for which there is no demand, but no knowledge of it in the marketplace. We have seen hundreds of new products offered in the past decades that no one has thought of before and for which there was no demand. In order to get a demand people had to be educated (one of the functions of a sales force). Yet when these products reached the consumer, they had prices.

Salsman says, “…Buechner finds the first method [of how prices are set] ubiquitous [the method in which someone sets the price], even though it entails the oxymoron of solo price determination, in direct defiance of the basic fact that every price is an exchange ratio and that it takes (at least) two people to arrive at a price.” (SR, 5) That is obviously not the case. It does take two people for an exchange to take place. But in our every day experience, including what we read in the papers, etc., prices are set by individuals all the time.

Consider the initial public offering of the stock in a company that is going public. The price is set by the owners, with advice from experts in the equity markets. The stock is sold and immediately goes on to the secondary market, the stock exchange, and then the price fluctuates. On what we call the secondary market for stocks, price is set not by the total demand or the total supply, but the marginal supply and demand, that is the number of shares supplied at that time and the demanded at that time. If the numbers, the shares and prices, do not balance, a “market maker” steps in and either holds them or fills from his own account.

When I was a general manager of a small retail chain and responsible for setting our prices, I used a standard markup. I didn’t go into the shop and bargain. I didn’t do a survey. Sometimes, if we had gotten a good deal on an item, I would use a higher markup. I set prices. I practiced solo price determination. Buechner stresses that the businessman tends to have significant experience in his market. He knows his customers, his total costs, and his competitors and then uses his judgment to set a price that will in the long term maximize his profits. Certainly he could adjust the price if he doesn’t get the result he wants. But still, in any circumstance, the price is set by the actions of a human consciousness.

Consider what someone does who wants to buy something. The buyer, whether he is a consumer or the purchasing agent for a company, goes to the source of the product and asks what the price is. Price is not some disembodied thing, but a real concrete that is known by the seller or the person who facilitates the transaction (broker, market maker, etc.). The market may be such that the buyer may bargain or negotiate a different price, but starts with what the seller has decided. If there is a negotiation, the seller has to agree to the final price. Price is not a separate thing from the actions and decisions, conscious decisions, of the people involved in the transaction.

What is your experience? If Salsman, and by extension modern economics, is right, we should all experience influence on prices daily. Salsman is wrong, there is no such “basic fact.”

Second, the law of supply and demand as a determinate of price does not have a mechanism to explain how prices change. It says that when the total supply or total demand changes the price changes. How? Exactly how does that happen. What concrete steps does the total supply impact the market price? Buechner’s explanation is that businessmen keeps informed about his market. When conditions change, demand changes for example, in order for the price to change some businessman has to decide to change his price. He does not consider total supply. He considers his costs, his profits, and his competitors and then he makes a decision. There are no other actors but human beings who are the producers who are buying and selling. There are no disembodied forces.

But Salsman is interested in defending not just the law of supply and demand, but “contemporary, academic economics.” (SR, 1)

I wonder why. As an academic discipline, economics in the last century has been impacted by the same influences as every other academic pursuit and aspect of our culture. The Twentieth Century was the century of nihilism (except for Ayn Rand). It was the century of constant attacks on civilization, reason, man’s rights, everything we hold dear. It is the century that produced the slow disintegration that we see in theoretical physics, for example, as described in David Harriman’s The Logical Leap. It is the century that has seen the growth of American government without interruption regardless of which political party was in power. It was the century that has seen the nearly complete disintegration of all art forms. We do live in a wasteland, again except for Ayn Rand and her followers. Yet, Salsman wants us to understand that economics is mostly solid.

Buechner does comment on this issue, “The philosophical overview of my book is this: Modern economics is the product of modern philosophy. Since on every important issue, Objectivism is the opposite of modern philosophy, Objectivism changes everything about economics. This includes economics’ method, the conception of the economy, the meaning of competition, the concepts of supply and demand, the theory of price, the role of scarcity, and the theory of aggregate production. Overall, as the result of all the preceding, Objectivism confirms the practicality of capitalism.” (OE, 3)

At the beginning of his review, Salsman lists several influences that he credits with the positive intellectual results in economics, i.e., Austrian economics, Supply-side economics, monetarism, rational expectations, and public choice (and he includes all of their Nobel Prize winners!) (SR, 1). Yet none of these people are advocates or practitioners of reason, induction, rational self-interest, or even of introspection. None of these influences are advocates of laissez-faire capitalism. All that Salsman offers to support his contention is that economics has improved is that some contemporary, academic economists are willing to consider less regulated markets rather than government activity in certain circumstances. Certainly that is better than being an outright socialist. But Salsman’s favored economists do not understand or accept the absolute necessity of individual rights and the use of reason for the survival of man as man.

In fact, these people are the appeasers of the progressives and leftists who wish to destroy capitalism and freedom. They need to be swept aside. Ultimately, Salsman’s favored economists are not valid alternatives for the Objectivist. (Go listen to Yaron Brook’s talk, “Why Bad Economics Won’t Go Away”)

What is vitally important in considering economics, and any science studying some aspect of man, is the initial view the science takes of what a man is and what is the proper method of studying the subject. You will find in Buechner explicit answers to both questions. Salsman does not address the first issue at all. He makes only minor references to induction and objectivity. Salsman declares, “Moreover, contrary to his pledge to proceed inductively, Buechner’s alternative theories are not proved inductively….” (SR, 2) Salsman does not tell you Buechner’s method of induction or why Salsman believes it to be invalid, or even that Buechner does have a method. For that matter, Salsman does not tell you what a valid method of induction within economics might be or where to find it. This vital issue is ignored and replaced with repeated statements about the law of supply and demand and “contemporary, academic economics.”

At points it seems that Salsman dislikes this book sufficiently to make amazing claims, amazing to someone who has read Objective Economics. Amazing in that the book does not say what is being claimed. I want to show you examples of Salsman’s criticisms that seem to me to be incomprehensible. I will limit myself to two examples. The one I am offering first comes in a very confusing paragraph (SR, 6), Salsman argues “…, on Buechner’s own account, even in the normal case no general theory of price, objective or otherwise, can hold.” (Italics in original) Salsman sites pages 283, 277, and 278. I’m sorry, that is wrong. These pages come from Appendix A, “The Theory of Price in Modern Economics: A Critique,” in which Buechner has placed his discussion of modern economics’ theory of supply and demand. It is Buechner’s conclusion that the entire modern theory is wrong, and founded on concepts with no relation to reality. The quotations Salsman used are clearly about modern theory and not Buechner’s. Buechner presents his own theory in Chapter 8, pages 139 to 152. Buechner states unequivocally that he holds his theory to apply to all exchanges within an economy.

But Salsman also says that “[Buechner] contends that his theory of objective price-setting is valid and applicable only in that unique context, and (by implication not in the mixed economy.” (Italics in original) Salsman quotes Buechner, “The general context in which my theory applies is laissez-faire capitalism, this political-economic system”…”defines the surrounding conditions” for the theory. (SR, 4; OE, 16; the formulation here is how Salsman wrote it) But, at the end of that two page section, Buechner says, “In fact, the study of economics has to begin, and always has begun, with the assumption, more or less fuzzy, that men are free to act on their best rational judgment. It is not possible to begin with a system in which the government initiates physical force, intervening, regulating, controlling, and usurping countless details of economic activity and then ask a question such as “Why do prices rise?””
Buechner continues, “One has to begin by seeing how capitalism would work when there are no government controls or regulations. Once that is clear, it is possible to project government action or regulation and consider how it changes the free market result. But first one has to have the free market result. That is what I provide in this book.”

How did Salsman fail to see that statement?

The second example is Salsman’s reference to Leonard Peikoff’s Objectivism: The Philosophy of Ayn Rand (OPAR). Salsman suggests that “The best account of how Ayn Rand’s philosophy undergirds and further integrates economics – including the objectivity …of the law of supply and demand” you should read chapter 11 (Capitalism). (SR, 10) Well, yes, of course you should. But chapter 11 doesn’t help Salsman. There is no attempt to establish economic laws in that chapter. Dr. Peikoff is not an economists and doesn’t attempt to be.

Dr. Peikoff first discusses the relation between philosophy and economics. What is interesting in this context is that Dr. Peikoff’s discussion closely approximates what Buechner had to say (OE, 18-19). Salsman castigates Buechner because the book has no ethical argument for capitalism. (SR, 3) Peikoff and Buechner see that there is a division of intellectual labor. Apparently Salsman doesn’t. Buechner says, “In the preceding discussion, I have made no attempt to give the moral justification for laissez-faire capitalism. In particular, I have not defined man’s rights nor explained why men have rights. I have not explained what is wrong with the initiation of physical force and why it is only such force that violates men’s rights. I have not tried to argue that capitalism is the ideal social system, though I believe it is. Proving these things is the responsibility of political philosophy, not economics. Here, I have been concerned only to identify what laissez-faire is. That it should exist is another subject.” (OE, 18-19)

Peikoff also affirms that, “The dominant view today is that economic value (like every other kind) is not objective, but arbitrary. Monopolists or other “exploiter,” subjectivists claim, charge any amount they feel like charging….” (OPAR, 399) Buechner uses the concept of objectivity throughout the book, and identifies errors involving the subjective and intrinsic. Salsman denies that modern economics is stuck with the subjective and criticizes Buechner for saying so. (SR, 3)

What Peikoff has to say about the law of supply and demand isn’t very helpful either. “The economic value of goods and services is their price (this term subsumes all forms of price, including wages, rents, and interest rates); and prices on a free market are determined by the law of supply and demand. Men create products and offer them for sale; this is supply. Other men offer their own products in exchange; this is demand. “Supply” and “demand,” therefore, are two perspectives on a single fact: a man’s supply is his demand; it is his only means of demanding another man’s supply. The market price of a product is determined by the conjunction of two evaluations, i.e., by the voluntary agreement of sellers and buyers. If sellers decide to charge a thousand dollars for a barrel of flour because they feel “greed,” there will be no buyers….” (OPAR, 399). This is hardly a ringing endorsement of the economic theory that total supply and total demand converge to establish and change prices. It is the philosophical point that demand is not a floating governmental creation. It is also the point that an exchange occurs when both the buyer and the seller decide the price to be good for them individually. That Dr. Peikoff (or Ayn Rand, in her own writing) did not go out and personally evaluate the theory of price that is the law of supply and demand is not an endorsement.

Even more disappointing is the lack of discussion of Buechner’s understanding of objectivity and his application of that understanding to the actions of the producer (businessman), buyer, and economist. In his discussion of a businessman’s attempt to calculate his cost of production, Buechner says, “Objectivity is an issue of method. There is no way to determine the objectivity of a result other than by looking at the method by which that result was reached. If the method is based on facts, if it reflects a rational attempt to grasp reality, if nothing relevant is deleted or evaded, and nothing extraneous is introduced, then the resulting unit cost is objective.” (OE, 83)

Buechner also focuses on production and the producer as the driving force in an industrial economy (See, e.g., “Producer sovereignty?, OE, 204). In discussing capital goods and factors of production he says, “The original factor of production is the reasoning human mind. In the fundamental sense, there is no other factor.” (OE, 153) It is for this reason that Buechner holds that businessmen do not consider supply when setting their prices. Supply is what they create and control. That is what a businessman, an industrialist, a producer does.

What Salsman’s review amounts to is a ringing endorsement of “contemporary, academic economics” (SR, 1) and an attempt to stop you from reading Objective Economics without mentioning what is in the book. It is disappointing.

Inflation Update: First Quarter, 2012

I have been writing this since the turn of the year. It has been subdivided already several times. A couple parts have appeared as other posts and several pages are just sitting around in this file, orphaned! I have again divided it so that I can get something out and the length will not evoke cursing. This section is my inflation update. Maybe some of the rest will appear in the future.

I realized recently that my most “favorite” group that constantly announced the coming of hyperinflation has only made one such announcement in the last several months, and that one was somewhat less frantic than normal. (Recently, they have been touting stocks.) In their last prophascy of doom, they did touch on issues that are important, but since they have only one economic note, hyperinflation, they don’t consider other, equally nasty, potentials, of which there are several. But apparently, hyperinflation is not the immediate threat they have often claimed. They haven’t said why they have changed their tune.

Yet, there is plenty of good reasons to be concerned about inflation in the next few years. For the fun of it, let’s divide up the issue into two separate (but certainly related) questions:

If by inflation you are asking about the money supply and its impact on asset prices and the economy: just look at the stock market! There is plenty of made up money sitting around that comes out and bids up assets when given even a glimmer of hope. True, company profits are healthy. My question is about the source of those profits. Is it just savings from leaner operations, or is it return on growing business. I fear that it is the former, which means little for future economic improvement. What reasons do we have to suggest that businesses are investing in the anticipation of growth?

There is new, made-up money floating around, for example, our balance of payments for last year was again a large deficit, perhaps smaller that in 2007, but still large. That means that a lot of electronic dollars left the country, billions of them ($110B in the third quarter, 2011; $124.7B in the second quarter, 2011), and didn’t return, won’t return (for those dollars to come back other currencies would have to be better than the dollar, and that isn’t happening). At the same time, notice that our money supply did not shrink by hundreds of billions. Think about this. We sent over $400B dollars out of the country last year, and didn’t notice it. Where did it come from? (Hint: International trade is done entirely on credit!)

The money supply within the country, in the broad measure that I use, MZM, shows the resumption in the upward trend continuing. The graph available, and widely used, is hard to read and the current trend is still only a few of months old. So what it means is unclear. What appears to be the situation at this point is that the increase is on the same growth line as before the meltdown. But since the base is larger, the growth will have less impact. Think of the difference it means to you to have a $10,000 raise when your income was $30,000 vs. $200,000. So, an additional $100B means more when the money supply was $1T in the 80s vs. today’s nearly $11T. The rate of growth in the money supply would need to be a lot steeper to be really important. The growth we see isn’t good, mind you, just not frightening.

Another important measure of the money supply is new loans made by banks. This is the method by which the Fed puts money into the economy. The Fed has been trying to push new made-up money into the economy since 2007 with little success. Recently, however, loans are beginning to increase again. Just new loans would not be an issue. After all, business needs credit, and amount would fluctuate over time. Further, with the deep recession, the amount of loans would have declined. A healthy economy would need credit to grow. If that new credit reflected new savings we would be seeing real growth soon. Of course, it doesn’t. Savings is being sucked into the Federal deficit. So, the growth of bank loans tends to indicate new made-up money being pumped into the economy, which could lead to another round of asset price inflation. The recent upward trend of new bank loans is worrisome, and needs to be watched. Again, the graph is too small to give good detail, but the slant of the upward movement isn’t too steep.

We are still sitting on a time bomb. If you look at the reserves (deposits) of banks who are members of the Federal Reserve (nearly all banks), you see that the amount of reserves they have is amazingly high. This is the Bernanke plan. Notice the last big jump to about $1.8T. That was QE2. That is to say that much of the massive amounts of money that Bernanke and his gang pushed into the economy is actually just still sitting at the Fed. It really didn’t do much except keep interest rates at stupidly low levels. It did help push commodity prices up, which is another type of asset boom. Does anyone believe that the interest rates actually reflect any element of the real economy? Low interest rates have not sparked new investment. They have merely given an unearned bonus to holders of federal debt and kept BO thinking that his deficits don’t really cost anything.

The time bomb will be the consequence when banks begin to think that they should move those reserves to their banks and expand their loan portfolios. Then we have a real inflation as the money supply explodes (once put into the economy, under current rules, each dollar moved from the reserve could become ten, or the $1.8T of excess reserves could become an additional $18T (our current money supply using MZM is almost $11T). The Fed actually knows that is a bad thing. When they first expanded the reserves with QE1 in 2008, there was a lot of talk about what they would do to sop up the excess reserves, which were then about $1T. That talk has completely disappeared as the economy failed to improve. But the problem remains and has gotten bigger. If the economy begins to grow the Fed will have to do something. Any action the Fed takes to sop up that money will raise interest rates, perhaps dramatically, and that would put a lid on the economy. That would also send interest rates up around the world and make things in Europe much worse. So ignored everywhere right now is this time bomb that will go off if the economy does begin to grow.

If you are thinking of prices as an indication of your cost of living (quality of products is often forgotten), the news is mixed. For example, the costs of health care and health care insurance is going to continue to skyrocket, especially if the quality of care is considered. (This increase in cost is only partly due to ObamaCare. Wait until that really begins to kick in!) Government interference in healthcare has never lowered cost or improved care. It has only made people feel like they were getting something for nothing.

Gas prices have risen, and will remain at higher levels until various international issues have been resolved. The last few years the pressure on prices has been due to new demand from countries that actually were developing. The current problem is due to the threatened supply because of Iran’s level of irrationality, Iran being a major oil producer. Again, the West’s willingness to allow its technology and industriousness to be hijacked by local warlords and savages becomes the source of economic shocks.

(The problems with higher food commodity prices that we had a while ago have abated, mostly due to higher crop results, e.g., the end of the draught in Russia. There are countries that are still seeing lower supply and thus more expensive food supplies. Most of these countries have governments who are controlling the markets. I can’t help but wonder if their problems are due to their governments inability to continue to subsidize food distribution.)

Reports from some U.S. food processors report that they have had to raise their prices from between 5% and 7% in the last year. No doubt we will see some upward movement in prices and no upward movement is good. Even price inflation rates of 2% are damaging. But there is no indication on the horizon that we are moving toward hyperinflation.

I just read another of Peter Schiff’s monologues. Among other things, he claims that price inflation is running at 10% (He just said inflation, but I assume he meant prices, in his writing he often switches back and forth.). He and others have constantly asserted that the CPI has been politically corrupted and that actual prices increases have run much higher. I do think that the CPI has been manipulated in many ways, and a lot of it was politically motivated, at least implicitly. But I have a problem with rates of price increases much higher than a few percent. Why? Let’s say that prices were going up at the rate of 7% a year, which is in the ballpark of many such claims. That would mean that prices today would be double what they were ten years ago (rule of 72, see below). Is that your experience? It isn’t mine. Some have argued with some justification that the quality level in many products has improved at the same or nearly the same price and that lots of technology prices have dropped. As I suggest in my review and comments of his books, I think Schiff often shoots from the hip, which I don’t find admirable. He has been right on some important things, but I’m not sure that it was because of good insight or just accident.

I did say that the situation is mixed, didn’t I. What I meant is that the news is that mixed in with the reports that prices are generally drifting upward are some reports of some really bad spots. In December, I would have said that foodstuff commodities prices had dropped, but the thinking that loosening of credit in China and Europe was going to stimulate demand has run them back up a little.

As I see it, the problem that could most affect us immediately is a financial crisis brought about by the European governments. The finance ministers in Europe are saying that they aren’t sure that this bailout will succeed. The Greeks have shown that they fail to live up to their promises, and curse others when that is pointed out. The other tottering European economies are very dependent upon low interest rates and the availability of massive amounts of made-up money. Remember, the euro zone’s long-term plan is a “fire wall” of several hundred billion euros. Where is that money going to come from?

So, my expectations for the next year or so is that our economy will continue to totter along. If unemployment moves up, or people become to understand the figures that are before them, we could see a big pull back in equities and consumption slow. That would lead to QE3 and more of a mess.

Prices will continue to inch up. Commodities will continue to have upward pressure. Basically, we will have more of the same.

There are two other considerations to watch for: The implimentation of the new rules for banks and derivatives and the actions that BO might take in anticipation of the election latter this year. Neither of these will be good for us and will be inflationary.

Having said that I should also say how reliable I regard my expectations. (Do you notice that nearly all of today’s prognosticators never look at how they did in the past?) Reliability of economic predictions is dependent upon two separate issues: One – how reality oriented is the analysis; Two – lack of omniscience. There is also one other point to keep in mind, good economic events require rationality, at least to some extent, and productivity. As good economic events are in short supply, for obvious reasons, the question is then how far off on the down side are my comments. I noted the areas that I thought that we could have major problems. There could be problems coming that I, or anyone, has not noticed. The most recent example, aside from people missing what is under their noses (the residential real mortgage meltdown), is 9/11. Another major terrorist strike could upset everything, and we would have a hard time recovering, too. So, I have tried to cover the economic bases that I can spot. But there could be others. Just keep on your toes.



P.S. I just read an article about investments in Turkish companies by venture capitalists, Now I don’t know how true the article was, although it did make Turkey sound like a much better place than I would have imagined. What I thought was so amazing about the article was that it didn’t mention the Turkish government or nationalized companies once! (Except to imply that the government wasn’t an issue!)

Europe Money Flood

As a follow up to my recent comments about the sovereign debt crisis in Europe, I want to comment briefly about the flood of money that has just been released by the European Central Bank (ECB). Today, February 29, 2012, the ECB allowed any bank that is in a Common Market country to borrow unlimited funds at nearly zero interest rates for three years (see http://finance.yahoo.com/news/second-cheap-money-round-hard-171320240.html). The total taken was 529B euros ($710B, @ 1 euro = $0.7450). This is the second such offering. Last November, the ECB loaned about 479B euros ($650B). The grand total is now 1.02T euros. Someone suggested that there was some shorter-term debt owed ECB that the banks paid back and that the net new made-up money amount was close to 600B euros ($805B).

Much of the money from last February was just put back into accounts with the ECB. That’s right, when the banks had billions sitting around doing nothing, they took billions more. What the hell, the money was nearly free.

The justification for this exercise in Disney finance was that the banks were no longer willing to make loans to. The banks were not sufficiently confident to risk making loans to nearly anyone. Interest rates for the debt of many European governments was going up, loans to businesses, especially small businesses were declining, and loans to other banks had essentially stopped, even the overnight loans. That’s right. Overnight loans to other banks were deemed to be too risky.

So now, European banks have lots of money. Lots.

What have we seen since November?

Interest rates and the availability of money to governments, even to countries with severe problems like Italy, Spain, and Portugal, has vastly improved.

Commodity prices have begun moving up again. The spot price for copper has climbed over 15% in the last couple months (when it looks like the Greek bailout would go through the copper price would go up, when not, down).

The euro has fallen against the dollar. (The euro would fall against the yen, but the Japanese are doing all they can to make the yen fall. This is the called world competition.) We can count on prices in the euro zone to begin climbing.

These are the more obvious consequences of this flood of money. I am sure that more will surface as time go by.

One interesting thing to look forward to is the time when these loans need to be paid back. Some of the bonds that the banks are buying have a longer time to maturity than three years. How are they going to get their money out? If all the banks are selling bonds at the same time what will that do to the markets and interest rates? Do the banks think that the European economy is going to be robust enough for the banks to be making money or to acquire capital? I did see that one governor of the ECB was concerned with the bank’s ability to pay back these loans. He suggested that the governments be ready to bail out the banks in three years. Which would mean more made-up money or higher government debt.

The banks also have to improve their balance sheet to meet the ECB’s new equity to loan requirements of ten percent. Where is that capital going to come from?

The ECB is prohibited by charter from buying government bonds directly from the government auctions, i.e., financing the debt of the euro zone governments. But that is what they have done by giving the banks cash. In fact, before the first set of loans had been taken, the French President suggested that the banks should put the ECB money immediately into bad bonds. It is such a bad idea. Letting interest rates come down for the problem countries makes it seem as if there isn’t much urgency for them to spend less or engage in economic reforms that are necessary if people are going to find jobs and survive. This exercise is counter-productive. The Europeans have not learned anything.

There is such a fixation with the immediate short-terms that you wonder if people have been surgically altered. To solve problems that they created a little while ago (which they aren’t willing to admit to – except for the excessive government debt to a limited extent) they engage in actions that will create greater problems just a few months later. The process is a spiral, and it is becoming tighter.

It is amazing that they think that putting 600B euros into their economy will have only good consequences.

So, everyone:

Short the euro. Go long on commodities and European stocks, as there will most likely be an equity boom. But be careful. Who knows when that bubble will bust. And, if you plan to go to Europe, you can plan on not having to spend as much. The dollar will be able to buy lots of euros, at least as long as the money that the Fed tried to put into the economy, which is twice the amount the ECB created in Europe, still sits as deposits at the Fed.

Germany and the Euro Problems

I think that there is one interesting aspect to the turmoil in Europe. Well, okay, two. The one I am not referring to here is the revenge of reality. Borrowing to consume, especially as a national policy is stupid. It can only be done as a direct result of determined evasion of the fact that you are still going to be alive, or be a country, in the next minute. We should be very familiar with this trend. It is what is happening in Washington today.

What I want to discuss here is what is happening within and toward Germany: what the Germans are thinking and doing, and how people are acting toward Germany as Europe grapples with Greece’s very high government debt.

In more than one news article Germany has been called the paymaster, that is, ultimately, it is Germany who will provide the funds for bailing out every stupid government, that includes not just the Greeks, the Irish, the Spanish, and the Portugese, but also, when their time comes, the Italians and the French, although even German isn’t wealthy enough to save them all. In fact, the French have pushed policies recently that would have required the ECB, the European Central Bank, to fund recapitalizing the banks in France and elsewhere. That really means that Germany would be the source of the capital. The Germans said no, do it yourself.

There are other European governments besides Germany that have been more responsible in their fiscal habits that would have money to offer, but they are all small. Combined, the other governments would be dwarfed by problems in Greece. No, only Germany is large enough and wealthy enough to have the capacity to bail out a small country like Greece.

This recognition also includes the understanding that it isn’t just money that is required. This understanding comes from Germany. Others, many others, both within and outside of government, are calling for the ECB to just inflate their way out of the current mess. On some level Germany understands that doing so would destroy their wealth, and they aren’t willing to do that. So far, the ECB has been controlled by the Germans.

Then we have the people who explain the entire problem in terms of Germany’s scheme when the euro zone was established to construct it for their own benefit. The most consistent and clear statement of this view that I have seen comes from Stratfor, a private “intelligence” firm in the U.S. In a report, “Germany's Role in Europe and the European Debt Crisis”, published January 31, 2012, Stratfor argues that Germany engineered the agreements setting up the bloc and the common currency to make them wealthy.

[a cause] relates to Germany's status as the world's second-largest exporter. About 40 percent of German gross domestic product comes from exports, much of them to the European Union. For all their discussion of fiscal prudence and care, the Germans have an interest in facilitating consumption and demand for their exports across Europe. Without these exports, Germany would plunge into depression.
Therefore, the Germans have used the institutions and practices of the European Union to maintain demand for their products. Through the currency union, Germany has enabled other eurozone states to access credit at rates their economies didn't merit in their own right. In this sense, Germany encouraged demand for its exports by facilitating irresponsible lending practices across Europe. The degree to which German actions encouraged such imprudent practices -- since German industrial production vastly outstrips its domestic market, making sustained consumption in markets outside Germany critical to German economic prosperity -- is not fully realized.
True austerity within the European Union would have been disastrous for the German economy, since declines in consumption would have come at the expense of German exports. While demand from Greece is only a small portion of these exports, Greece is part of the larger system -- and the proper functioning of that system is very much in Germany's strategic interests. The Germans claim the Greeks deceived their creditors and the European Union. A more comprehensive explanation would include the fact that the Germans willingly turned a blind eye. Though Greece is an extreme case, Germany's overall interest has been to maintain European demand -- and thus avoid prudent austerity -- as long as possible.

This explanation is pure Maciovellan real politics and Marxist economics thinking that have been standard for a couple centuries. Supposedly, Germany could only become wealthy by sucking the wealth from others. Never mind that its best trading partners are other wealthy countries (or countries that are developing, like China). Never mind that the Greeks (and Spain and Italy, etc.) choose to borrow based on their own social welfare goals (that was the first cause that Stratfor mentions, but then ignores completely in its focus on Germany).

Also, in the same report, Stratfor states clearly that Greece and any of the others must stop this spending binge, without any hint of the supposed consequence to Germany. If they were consistent, they would be selling Germany short.

The Germans are well aware that they are going to be the paymaster. Even the man in the street understands the situation well enough to consider the wisdom of going ahead with the bailouts. The Greek bailout is especially irksome because the Greeks have pushed their wage rates above those in Germany (the monthly, legal, minimum wage in Greece is much higher than Germany’s, and all the other European countries), the Greeks have failed to follow through on the promises they made for the first round of the bailout, and the protestors in Greece have called the Germans names that no German can tolerate.

Which brings us to the attitude of the Greeks, themselves. A few have shown that they understand the situation. That seems to include a few politicians. To begin to move the government toward policies that Germany would accept, the Greeks had to make a man prime minister who was not a politician. When Germany demanded a lot more than promises, the politicians dithered for days. And when the vote was actually taken, many politicians in the largest parties voted against the bailout.

The Greek technocrat government does recognize that the country is bankrupt. The bailout offered by the other European countries is not to actually make them whole, but to give them the time to put themselves right. This isn’t a free lunch, just a little support. The support gives them the cash necessary to redeem debt falling due in March and the money to meet payrolls and continue operating without resorting to adding more debt to their total (and nationalize the banks). The Greek government must still find ways to spend less and income sources to pay off more debt. By 2020 it is suppose to reduce its debt from 160% GDP to 120%. For a country that does not produce much, in which the government accounts for about 40% of the economy, which has a culture of avoiding work and accepting corruption, and sees no connection between receiving money and production, getting the government to change its budget from a big annual deficit to a surplus is an overwhelming task. I don’t think that it can be done in a few months or a few years.

Then we have the Greek people. This is a democracy in the finest sense of the word. The population seems to think that it is fine for others to sacrifice and pay for the Greek life style. We have the government workers, who tend to not work, but spend their days shopping and sitting in cafes. We have the workers at government owned companies, who expect to be taken care of regardless of their lack of productivity and their willingness to cause disruption within the company and within the country. You have the employees of private companies who see government controls as the way to keep their job and income without regard to their productivity or the company’s financial health. You have the retired or the soon to be retired who were promised certain pensions and are angry that there is no money to meet those promises. These groups may not add up to the majority but they (and their relatives) are still a large enough portion of the population to be the deciding factor in elections. All of these groups have indicated they are angry about the changes required by the Euro Zone counties, led by Germany. What these elements of the Greek population think should be done hasn’t been reported that I know of. But, when interviewed, they all seem to think that their benefits should remain in place. How? Somehow!

So Germany is singled out for abuse. Memories (by people who weren’t there, for the most part) of past German sins are recalled. Ignoring the difference between sending troops to kill and providing money to maintain irrational finances, Germans are damned as dictators and Nazis. Some of the Greeks proclaim that the answer is communism, ignoring that it also failed the same way Greece is failing and that it has killed more people than the Nazis did.

One would expect that the Germans are angry about their treatment from the Greeks. I am sure that many Germans would prefer to just let the Greeks sink and be done with them. The more responsible of the Germans are not willing to do so. They do recognize that doing so would have very negative consequences for Germany for some time. I could argue that the long-run, self-interest of the Germans would be better served by unentangling themselves from their self-destructive neighbors, that their neighbors are going to continue to be problems and will require more and ever larger amounts of money. But that would be too selfish, and too painful in the short run, I suppose.

What Germany is looking at is that if Greece goes then Spain, Ireland, Portugal, and then Italy and probably France, too. They are thinking that solving the Greek problem will tend to prop up the others and they all can begin healing together. It is a pipe dream, but it is also the consequences of the premises with which Germany began. I do expect that Germany did expect the other governments to behave and control their fiscal budgets. That was a delusion and the Germans kept that delusion and tended to ignore what the other countries were actually doing. Germany is kind of an anomaly in that it is a social welfare state with a post WW2 tradition of some fiscal responsibility. It has even demonstrated how to absorb a backward country, East Germany, and grow. One has to have a certain respect for how Germany functions. Yet, they are still pretending that their own demographics problem doesn’t exist and they won’t have the same major debt problem as the rest of us. They still only pay attention to the next moment in time. They are still only a democracy that will tear itself apart under pressure. But they are holding themselves together much better than Italy or France.

So, to avoid the very nasty problems that letting Greece go to pieces, the Germans are willing to take on the obligations of bailing them out. The just completed bailout package includes sections intended to keep the Greeks on course, which the Greeks find insulting. Interesting isn’t it that the Greeks failed to follow through on their previous promises when they received money, and they are now insulted because their saviors don’t trust them.

The entire package is intended to assist the Greeks to lower their debt level from 160% of GDP today to 120.5% by 2020 (isn’t it interesting that they think that they can be so precise?). Usually, projections like this tend to have growth levels that can’t be maintained and the whole thing is fantasy. I expect that the projected growth levels in the bailout projections aren’t high at all, but I bet that the Europeans expect the Greek economy to begin growing sometime within the next couple years. I don’t know why. All of the capital within the country is either being soaked up by taxes or bonds, or has left the country. Who wants to invest in Greece? Is a Greek worker worth the effort? Has the Greek government actually made it easier or even possible for an investor to safely put his money there, let alone expect profits? According to online sources, manufacturing is only 18% of the economy. Production has been leaving Greece because of the business climate and the Greek worker. Why go back? As far as I can see, what has happened so far will not lead Greece to a growing economy and that means that it is going to continue to shrink, the government budget will not generate a surplus, debt will not decline (and will probably increase), the percentage of debt to GDP will not get anywhere near to 120%, and Greece will default with very messy consequences. Germany will have poured real money down a deep hole.

Why is it important to watch Europe now?

With so many battles to fight today in the U.S., you might wonder why I am spending time watching and writing about Europe. You could also point out that the U.S. is a vastly different sort of place. Policies and doctrines common in Europe since the fall of the Roman Empire were rejected in the U.S. We just do not have the socialist history that they have.

Unfortunately, the argument that everyone else is socialist is becoming accepted in the U.S. That was a big point in the argument for ObamaCare. We are becoming more like Europe. Our government has become a democracy in that demands for government controls and redistribution of wealth are now openly accepted as reasonable political discourse. Our government is spending like a drunken social democrat. Certainly our entitlement commitments are like what is happening in Europe. The problems they are seeing result from the same policies pursed by our own politicians of either party. The concept that made the U.S. different, individual rights, is just as unknown here today as it is in Europe.

Further, the economic policies practiced in Europe are based upon the same economic theories as is used by Bernanke, the Treasury, and the advisors of either U.S. party. Government action, focus on spending (consumption) as the power in the economy, regarding jobs only as a way to acquire income, and ignoring any real issue of production is standard everywhere.

The consequence is that the U.S. is moving toward a situation like that found in Greece, Spain, and Italy just as rapidly as France and Germany. I don’t know which large country will reach disaster first.

It is the case that our economy is not as regulated as those in Europe, although we are moving that direction rapidly. There is a lot of attention being paid to the steps required in Greece and Spain to make it a little easier to hire and fire an employee. But the controls and even the availability of capital aren’t changing much. Many core, important European industries are state owned and the labor unions have more sway than managers.

What is becoming understood, by many modern economists who regard themselves as scientists in some fashion, is that there are limits to the amount of debt that a government can sustain. This point was substantiated in a book, This Time is Different, by Carmen M. Reinhart and Kenneth S. Rogoff. For anyone who is serious about economics and the consequences of debt, I recommend this book. It is written by two modern economists, which means that their understanding and conclusions are superficial. They completely fail to recognize the difference between individual actions and those based upon force. Nevertheless, they provide important information and do offer some insight as to what the problems are in Greece, and soon the rest of the social welfare states.

The historical record is undeniable. If a government amasses debt amounting to more than sixty percent of their total production (considering only consumer goods), then they are tending toward trouble. Governments with more than one hundred percent are in trouble and there will soon be a financial crisis of some sort. The book does not mention interest rates, but certainly, if rates raise, the trouble is greater. From other sources, many modern economists seem to be convinced that the national production will be lowered by about one percent when government debt reaches ninety percent.

The U.S. will reach a government debt of one hundred percent of national production of consumer goods (called GDP) this year.

The book does not suggest what the financial crisis will be like. The world has not experienced a government debt crisis in an advanced technological country like ours, with the power that our government has amassed.

So I watch Europe to see how they are dealing with their problems and to see reality take its course. I watch to see if anyone questions their premises. I watch to see if any of the politicians choose to act intelligently or only with regard to their confused voters (see this article about the German PM) It is interesting that the Germans are now trying to put off the pending big, Greek bailout until after the April Greek elections.

I am looking to see how France and Germany confront their own fiscal/debt problems. Will they do something to actually improve their economies or not. France is headed for another Socialist government, it seems. The Socialist party is offering straight contradictions as its platform. It should be interesting.

I am not ignoring the U.S. and its impending problems. I just note that the big battle waged on the occasion of the vote to raise the U.S. government debt limit was over nothing. The amounts of the so-called cuts and what programs those cuts were suppose reduce were all inconsequential. It was all for show. A show that is now generally forgotten and ignored.

The only way that this country is going to avoid the gapping pits that Europe and the rest of the world are staggering toward is for some new group to make the obvious real to people. That means we have to do it. There is no other source for that understanding.


P.S. I watched Yaron Brook’s presentation as to why our country continues to make the same mistakes repeatedly and doesn’t seem to learn. (It was one of the videos at the bottom of the email I got from ARI. Number 191, I think.) It was excellent, and even if you know the issue, Dr. Brook’s phrasing and brevity in this complex subject is worth hearing.

A Note on Greek Banks Recapitalization

A Note on Greek Banks Recapitalization

You might have noted in the news stories about the Greek government debt problem that there was talk of needing to recapitalize the Greek banks later. What is going to happen, one way or another, is that the Greek banks, as well as other banks all over Europe eventually (and maybe a few elsewhere), will have to recognize, on their balance sheet, that the Greek government bonds that they hold are worth less than when they were purchased. It is true that the Greek government debt has been worth less on the secondary market for some time, but accounting rules do not necessarily require that that change be recognized on a balance sheet at that time. (I will let an accountant explain that issue, which isn’t necessarily corrupt.)

For the bondholder, buying the bond is the same as loaning money. The bond will pay a certain interest rate for its lifetime, and at a certain point, the issurer, which could be a government or a business, will return the borrowed amount, called a redemption. It is a timed, interest-only loan.

The bank holds the loan as an asset, just as it does all of its loans. But it does have to evaluate the loans that it has on its books. Are they performing? That is, is the borrower following the terms of the loan? Will the borrower be able to pay back the loan?

Accounting rules for banks recognize that loaning money is a risky business. Borrowers can get into trouble and fail to pay the interest and fail to repay the loan itself. In order to protect itself, a bank has to maintain reserves against potential default of a borrower. With this reserve the bank is protected from becoming insolvent and bankrupt when borrowers default. The reserve is actually capital. The more reserves a bank holds against potential loan losses the more of its capital it has tied up. That capital cannot be working and adding to the revenue or profit of the bank when it is held as a reserve. (Do confuse reserves the bank has with “reserves” required by banking authorities, such as the Fed. Those are not reserves in fact, but deposits that provide no protection or income for the bank.)

Due to the standard statist misunderstanding of how banking works, how capitalism works, and what the real benefits of government controls are, governments have established regulations as to what percentage of reserves a bank must have in its loss-loan reserves for different types of loans. Banks in the European Common Market have been heavily regulated for at least as long as U.S. banks, most likely much longer. They are well used to doing what they are told. I think that the experience and knowledge of how to properly rate the risk of most loans does not exist in Europe. Furthermore, the government decisions as to what percentage of a loan the bank must hold in reserve is heavily influenced by political considerations and populist biases. Certainly, if the ability to repay debt were a consideration, the debt of most of the European nations would be rated very low.

The developed governments of the world have gotten together over the years in Basel Switzerland to establish international standards of loan-loss reserve percentages, hence, the Basel Accords and Basel I and Basel II (Basel III is in the works, I think). They agreed that loans to sovereign, national governments required either low or zero percentage reserves. That’s right, a loan to Greece was considered safer than a loan to Apple or Microsoft or GE.

What banks did was to load up on government loans because those loans required fewer reserves. Reserves cost money, that is, reserves are idle cash. If no reserves are required, then the bank’s funds can be loaned and contribute to operating income, and maybe profits and bonuses for employees. Even European banks have some characteristics of a business.

In addition, European banks are much closer to their governments than U.S. banks. They are sensitive to the interests, biases, policies, and intentions of the ruling politicians. They have to be. The politicians have a lot of power and use it against the banks if they wish. What the politicians have wanted, in all of the European countries, is for the banks to help fund the government spending, cheaply. The banks have helped the central European bank and each country central bank to keep interest rates on government debt low by buying significant amounts of government bonds. The Greek banks have done this perhaps more than others and hold massive amounts of Greek government debt (which is a direct path of the country’s savings into the hands of the government, which spent it in a continuous, drunken shopping spree – buying votes, really). The estimate I have seen is 50B euros.

As a result of the various government actions and the way the governments have set things up, the Greek banks are now looking at losses on Greek government debt of seventy percent or more, yes, that is 70% losses. Losses for which they have little or no loss reserves. This degree of loss means that the banks’ total capital, its investment from its shareholders, whatever profits it has ever retained, and all of the reserves of any kind, have been wiped out. The Greek banks are bankrupt. They are bankrupt right now. It just hasn’t appeared on their balance sheet yet.

So, if there are to be any banks in Greece, they need to have an injection of capital. Not loans, but new ownership money. The requirement being discussed is ten percent of loans by 2013. Remember, Greece is something like five percent of the Euro zone. I have seen estimates that the recapitalization of all Euro zone banks, with all of the Euro debt problems, is one trillion euros, which is about $1.3T.

Who would want to put money into Greek banks? Not foreign investors. Not domestic investors (if there is anyone with real money to invest). No, there is only one source: the government.

Yes, the bankrupt Greek government is going to put money into Greek banks. The Greek government doesn’t have any money so it aquire the funds from outside the country, just as the government is doing for all of the other help the government is getting. The way it will probably work is that some one like the IMF, the European Central Bank, or one of the two entities that have been created to deal with the sovereign debt crisis will give/loan the money to the Greek government which will then put the money into the banks.

But, the Greek government won’t just hand over the money to the banks. No. It will “invest” the money, i.e., it will buy stock. The Greek government will nationalize the banks. There is some talk about making the stock the government buys a special, non-voting stock, thus preserving an illusion that the original owners have some standing in the bank’s ownership. But, that is what it is, an illusion. The banks will be even more tied to the Greek government than they were.

So, as an overview, here is what we have:
The Greeks (actually you can insert any European Common Market country you want because the pattern is consistent throughout) borrowed from anywhere they could for a massive spending spree.
They required the banks to be a major lender.
They required the banks to have little or no reserves against the loans to the government.
The government can’t repay the loans.
The banks are failing.
The government, with money acquired from elsewhere because it has done stupid, insane things, is going to buy the failed banks.
The banks are even more tied to government policies than before.
The government has ownership and control of the banks.
Does anyone think that the Greek banks will be better off?

Makes sense, doesn’t it. When you live by force, you “win” by force. And you all go down the tubes together. Moreover, I have seen no comment or hint that anyone writing about the European situation has anything to say about the matter. Perhaps they haven’t even noticed.

But the failure of putting two and two together is a common theme in the entire European debt crisis. It is most blatant with the Greeks.

This week there have been more “strikes,” riots, and protests against the terms required by the agencies that would bail out the Greeks. Many of the chanted slogans and posters and banners declare that the foreigners are dictators and imperialists. The protestors want the politicians to “resist”! The Greeks appear like angry four year olds who have been told that they can’t have the toy on the shelf because mommy doesn’t have the money. How and what are the politicians suppose to resist? They are suppose to resist the requirement that they do not incur more debt. They are suppose to resist the requirement that they try to pay back their existing debt. They are suppose to resist the requirement that if they are given money they spend it wisely instead of like a drunken sailor (my apologies to sailors). The Greek protestors have no contact with reality. None. They have no idea that money has some connection to real things. That real things are made by someone who wants to be paid for their efforts. That borrowing actually means that the lender expects to be paid back. The Greek country is a testament to modern education and economic “thinking.”