The Dollar's Demise: The Coming American Default
The Dollar as Toxic Asset: The Coming American Default
By: Dr. Peter E. Chojnowski
May 5, 2009
If the saying is true that, “The greatness of a depression is commensurate to the government’s efforts to prevent it,” we can assuredly say that we are in the greatest downturn ever to threaten the prosperity of our civilization. As of this writing, the United States Treasury and the Federal Reserve Bank has committed $13 trillion to bailouts and “stimulus” packages. To put this “injection of liquidity” into perspective, we can say that the United States government has spent more money propping up the financial system since August of 2008, as it spent, with inflation adjusted dollars, on all the wars in its history put together. To make another illustrative comparison, the entire gross domestic product (GDP) for the year 2008 (i.e., the total amount of goods and services produced in the nation) totaled $14 trillion. This tally works out to $42,105 for every man, woman, and child in the United States and some 14x the $900 billion of currency in circulation. Not desiring to “cry wolf,” Dana Johnson, chief economist for Comerica Bank in Dallas, said, “The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets.”
This attempt to “stabilize the credit markets” has taken two forms in the United States, “stimulus” and “bailout”.
A) “Stimulating” a Zombie Economy
The most basic, and seemingly inconsequential, aspect of the attempt by government to “increase liquidity” and “demand” within the economy is the $787 billion dollar “stimulus” package offered by the Obama administration. To use the adjective “inconsequential” seems fitting on account of the fact that the package would pump a mere $185 billion into the economy this year. The very partisan legislation, having received only 3 Republican votes in the Senate and none in the House, includes extra-spending, a large increase in the debt limit, and some small-scale tax cuts. With regard to the tax cuts, millions of American workers can expect to see about $13 extra in their weekly paychecks beginning in June; this tax credit, in the year 2010, will result, on average, in $7.70 more in the typical American’s pay-packet per week. Not, seemingly, having learned from catastrophic indebtedness of the American family, which caused the worst financial crisis since the Great Depression, first-time homebuyers will be eligible for a $8,000 tax credit and those who buy a new car before the end of the year can write off the sales tax. In this regard, can we assume that all the borrowers who “earn” these tax credits, are “credit worthy” or is the government simply encouraging borrowing for the sake of pumping up the GDP? We seem to be simply attempting to “re-inflate” the credit-bubble here.
With regard to the new spending portion of the “stimulus package,” some of the money goes for worthwhile projects, like development of alternative energy sources and infrastructure projects that have been put off for decades. Even the “positive” aspects of the spending allocations, however, demonstrate that this legislation is truly nothing more than an attempt to “stimulate” and not to repair a national economy that began to realize in September 2008 that it was primarily a “phantom” economy; the appearance of life, without the substance. The $90 billion to be spent on the nation’s infrastructure, for example, is only a meager down payment on the repairs needed to fix the problems with the bridges and highways. The $9.2 billion earmarked for environmental projects and the Environmental Protection Agency (EPA) will only, according to reports, make a dent in the backlog of cleanups facing the EPA and the long list of chores at the country’s national parks, refuges and other public lands. This expenditure too can be considered to be a mere down payment on a much bigger problem.
What many of the expenditures in the “stimulus package” do is to federalize projects and programs that have been cut back by near-bankrupt state governments. Of course, with federal money comes federal control. For example, for those who lose their jobs and who want to extend their health insurance coverage for 18 months (the COBRA program), the federal government will now pick up 65% of the total cost of that premium for the first 9 months. With regard to education, the package allocates some $54 billion of federal money to compensate for state budget cuts over the next 3 years. This means that the federal government will try to ensure that the potential 600,000 elementary and secondary school teachers that would have been laid off on account of state budget cuts, will not need to be laid off.
B) No Banker Left Behind
“Quantitative Easing” is the term being used to describe the Treasury’s and Federal Reserves injection of trillions of dollars into the financial system in order to keep it afloat and prevent “deflation.” It has been these regular injections of trillions of dollars into the banking system, which has dwarfed the relatively paltry hundreds of billions allocated by Congress for the purpose of “stimulus” and buying “toxic assets” from the 5 largest banks. In describing this “quantitative easing” policy, the Federal Reserve, on March 21, 2009, said, “In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to ¼ % [N.B., the European Central Bank has just lowered this same interest rate to 1%, a record low] and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”
What you have in the above is a summary of the unprecedented intervention in the financial system. Traditionally, the key number that the Fed would vote on and that they would communicate to the public with a statement like the above, would be a target interest rate that the Fed had settled on for the Fed funds rate, an interest rate charged on overnight interbank loans. The Fed, however, has recently found that keeping the fed funds rate at near zero has not helped to bolster and stabilize the banks and the equity markets. That is why they have reverted to buying US government securities (i.e., monetizing the debt) and trying to get the credit flowing by relieving the banks of risky assets like mortgage-based securities. All of this, of course, occurred only 2 weeks before Treasury Secretary Geithner new Public-Private Partnership Investment Program (PPIP) to price and remove toxic assets from banks’ balance sheets to the tune of some $500 billion to $1 trillion.
C) Paper Mill on the Potomac: The Marginal Productivity of Debt
Whether the extra expenditure will “grow” the economy or not, is still an open question. What is not an open question, however, is that both “stimulus” and “added liquidity” will radically boost the national debt of the United States. Forecasters expect the 2009 deficit to top 2.1 trillion dollars, which is more than 3x last year’s shortfall. The overall National Debt is now approximately 11 trillion dollars.
The thinking of the past and present administrations, Bush and Obama, and the past and present Federal Reserve chairmen, Greenspan and Bernanke, is that the more money “printed,” either through government expenditure or lower interest rates --- both of which produce more debt --- the greater likelihood of stopping both economic contraction and asset deflation. Will, however, this be the case? Can such a scenario be assumed? What seems to be the great-unasked question, in this regard, is whether greater amounts of public and private debt will in any way “grow” the economy and encourage only moderate inflation. What we are really speaking about here is the “quality of debt”. What do we mean by the “quality of debt”? The Keynesians in the Bush and Obama administrations take comfort in the fact that the total national debt as a percentage of GDP is safely below 100% in the United States, while it is 100% or higher in some other countries. According to Melchior Palyi, a Hungarian-born Chicago economist who died in the early 1970s, the significant ratio to watch is additional debt to additional GDP, in other words, the amount of GDP contributed by the creation of $1 in new debt. This is the ratio that determines the “quality of debt”. For example, if the marginal productivity of debt was ½, then $2 in debt had to be incurred in order to increase the nation’s output of goods and services by $1. An increase in total debt by $1 could no longer reproduce its cost in the form of an equivalent increase in the GDP. In this situation, debt would have lost whatever justification it may have once had.
To chart the “quality of debt” historically, we can say that in the 1950s, when the dollar was still redeemable in the sense that foreign governments and central banks could covert their dollar balances into gold at the fixed statutory rate of $35 per ounce, the marginal productivity of debt was 3 or higher, meaning that the addition of $1 in new debt caused the GDP to increase by at least $3. When, in 1971, Richard Nixon defaulted on the international gold obligations of the United States, the marginal productivity of debt fell below the critical level of 1. If the marginal productivity of debt is ½, then $2 in debt had to be incurred in order to increase the nation’s output and services by $1.
As long as debt was constrained by gold, deterioration of debt was relatively slow. It took the economy 35years after Nixon’s taking the US off the gold standard for the capital of society to erode and be consumed through a steadily deteriorating marginal productivity of debt. The year 2006 was a watershed. Late in that year, the marginal productivity of debt dropped to zero and then went negative for the first time ever. Here a red light warning of an imminent economic catastrophe was set off.
If Palyi’s theory is correct, being supported by such economists as Peter Warburton and Antal Fekete, when there is a negative marginal productivity of debt, it indicates that any further increase in debtedness would necessarily cause economic contraction. In view of the fact that the marginal productivity of debt is now negative we can see that the damage-control measures of the Obama administration, which are being financed through creating unprecedented amounts of new debt, are counterproductive. It could, moreover, be the direct cause of further economic contraction of an already prostrate economy, including unemployment. This is, perhaps, what the head of the European Union and Czech Prime Minister Mirek Topolanek meant when he publicly characterized Obama’s plan to spend nearly $2 trillion to push the US economy out of recession as the “road to hell.”
D) Dumping the Dollar: America’s Stealth Default
If many Europeans and American economists worry about deflation, its seems as if the Chinese government is definitely worried about inflation. They have good reason to worry. “A policy mistake made by some major central bank may bring inflation risks to the whole world,” said the People’s Central Bank in its quarterly report. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing major currencies’ devaluation risks may rise,” it said. Premier Wen Jiabao, at the Communist Party summit in March, left no doubt that China was extremely irritated with Washington’s response to the credit crisis set off by the AIG (i.e., American International [Insurance] Group) and Lehman Brothers collapse. The Chinese have come to suspect that the United States is engaged in stealth default on its debt by driving down the dollar. Premier Wen continued, “We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries.” A few days later, the Chinese central bank chief wrote a paper suggesting a world currency based on Special Drawing Rights issued by the International Monetary Fund (IMF). This call to replace the US dollar as the world reserve currency was recently echoed by a United Nations panel of economists. The panel was led by US economist Joseph Stiglitz, the 2001 Nobel economics laureate, who told a press conference that there was “a growing consensus that there are problems with the dollar reserve system.” Such as system was “relatively volatile, deflationary, unstable and had inequity associated with it.” “Developing countries are lending the United States trillions of dollars at almost zero interest rates when they have huge needs themselves,” Stiglitz noted. “It’s indicative of the nature of the problem. It’s a net transfer, in a sense, to the United States, a form of foreign aid.” A new global reserve currency, however, “is feasible, non-inflationary and could be easily implemented.” Feeling that the Bretton-Woods Agreement of 1944, which established the US dollar as the world’s reserve currency --- and the United States as the beneficiary of the world-wide need to possess the dollar and dollar-denominated assets, is coming to an end, the Kremlin’s chief economic advisor, Arkady Dvorkevich, has publicly stated that Russia would favor the partial return of the gold standard, as part of a system of a new world currency based on Special Drawing Rights (SDR) issued by the IMF. The Kremlin has already instructed the its central bank to gradually raise the gold share of foreign reserves to 10%.
What was, perhaps, the most surprising aspect of the very public call by the Chinese for a new global reserve currency to replace the US dollar was the lack of any real objection to this proposal coming from the US Treasury Secretary Timothy Geithner. When speaking at an event hosted by the Council on Foreign Relations in New York, Geithner was asked about China’s Central Bank Governor Zhou Xiaochuan’s call for a new international reserve currency. Geithner said that he had not read Zhou’s proposal, but that “he understood it was a plan designed to increase the use of the IMF’s special drawing rights. And we’re actually quite open to that.” Having just, nonchalantly, thrown into question America’s 65 year commitment to the enshrinement of the US dollar as the world’s reserve and commodity trading currency, Geithner was subtly given the heads up that he had driven the value of the US dollar down some 1.3% against the Euro, since his remarks about the Chinese proposal began. This occurred when Roger Altman, who worked with Geithner as deputy Treasury secretary in the Clinton administration, asked Geithner if he wanted to “clarify” his comments. “I’d like to ask one final question, in effect on behalf of the market” [hint: you are causing months of dollar appreciation to disappear], said Altman, founder of Evercore Partners, Inc., “Let me ask the question this way. Do you see any change over the foreseeable future in the basic role of the dollar as the world’s reserve currency?” Apparently catching the hint, Geithner responded, “I think the dollar remains the world’s dominant reserve currency.”
E) Obama’s Multi-lateral New World Order: The End of the Americanist Paradigm
If Secretary Geithner is “open” to the idea of the end of the United States’ domination of the economic and political processes of the world, which would result from the toppling of the dollar as the world’s reserve currency, Barack Obama seems to be acting as if that “toppling” has already taken place. In the context of holding a press conference with Angela Merkel in Baden-Baden after the G-20 meeting in April, Obama was asked about his “grand designs” for NATO and said simply, “I don’t come bearing grand designs,” instead, “I’m here to listen, to share ideas and to jointly, as one of many NATO allies, help shape our vision for the future.” When asked by two American reporters for his response to the claim by Gordon Brown (referred to as “Crash Gordon” in Britain) that the “Washington consensus is over,” meaning the uni-lateral American exceptionalism, Obama did not object, but seemed, rather, to agree, noting the term “Washington consensus” had its roots in a set of economic policies that have been shown to be defective. Obama’s vision of the world as a consortium of “enlightened” nations fighting the remnants of religious militancy and exclusivism, won the appreciation of Nicolas Sarkozy, when the French leader praised this new post-Americanist global system and the man that made it happen, “It feels really good to work with a US president who wants to change the world and who understands that the world does not boil down to simply the American frontiers and borders….And that is a hell of a good piece of good news for 2009.”
A concrete manifestation of this new New World Order, was the activation of the IMF’s power to create money and to begin a global “quantitative easing”. The leaders at the G-20 summit literally tripled overnight to $750 billion, the IMF’s ability to provide credit to national economies on the edge. The move is akin to a national central bank such as the Federal Reserve creating the money out of thin air, except this is on a global scale. A list of the countries that the IMF has already “bailed out” are Latvia, Iceland, Pakistan, Hungary, Belarus, Serbia, Bosnia, and Romania. In April, Mexico became the first G-20 nation to ask the IMF for immediate help. Along with providing the IMF with plenty of national “bailout money” and the world with the basis for a global currency (N.B., the SDR), the G-20 leaders, with the support of Barack Obama, established a international Financial Stability Board, which appears to be meant as a global financial regulator. Obama appears to take it for granted that the post-WWII United States dominated and determined world has ceased to be and that another one is emerging. At the end of the G-20 conference in April, he stated, “I think we did OK.” Bretton Woods in 1944 was a simpler affair, “Just Roosevelt and Churchill sitting in a room with a brandy, that’s an easy negotiation, but that’s not the world we live in.”
F) Hyperinflation or Deflationary Spiral? Possibilities for 2009
That what we have witnessed since the September collapse of Lehman Brothers has been an unprecedented intervention in the banking and economic sector on the part of the government and central banks of the world, is not the issue which is being currently debated. What is being debated is the ultimate consequence of such a “injection of liquidity” (i.e., printing of money) into the financial system. As Peter Schiff has recently stated, what we are suffering from now is an overdose of past stimulus. A larger dose will only worsen the condition. According to Schiff, “The Greenspan/Bush stimulus of 2001 prevented a much needed recession and bought us seven years of artificial growth. The multi-trillion dollar tab for that federally-engineered economic bullet-dodging came due in 2008. The 2001 stimulus had kicked off a debt-fueled consumption binge that resulted in economic weakness, not strength. So now, even though the recent stimulus administered a much larger dose, we will likely experience a much smaller bounce. One can only speculate as to how much time this stimulus will buy and what it will cost when the bill arrives.”
Whatever the consequences, clearly the response of the governments of the world to the current financial crisis reveals, unequivocally, the extent of the crisis. The talk about “green shoots” coming from the “in the pocket” economists employed by the mass media and their corporate and financial sponsors must be a siren song that causes us to tie ourselves to the mast and plug our ears. The IMF in the “green shoots” month of April was saying that the world had entered “by far the deepest global recession since the Great Depression.” A recession which would cost the nations of the world “trillions of dollars in lost business, millions of people thrust into hunger and homelessness and crime on the rise.” This assessment of the current downturn as “the worst since the Great Depression,” was further confirmed by a recent statement of Professor Tim Congdon of International Monetary Research, in which he stated that company bank deposits in Europe have begun to contract at rates not seen since the early 1930s, threatening severe damage in the coming months. “It’s a catastrophe. Company bank deposits have been falling at 1% a month since December. It is what happened in the US during the Great Depression, and it is why we are seeing such a horrific recession in Europe.”
The word “since” the Great Depression is even somewhat deceptive in this context. Mark Twain said, “History does not repeat itself, but it does rhyme.” The current financial and economic crisis is both “like” the Great Depression and, yet, distinctly different. The “distinctly different” here should not, however, be an occasion for comfort. Even the IMF has pointed out the differences, saying, “While the credit boom in the 1920s was largely specific to the United States, the boom during 2004-2007 was global, with increased leverage and risk-taking in advanced economies and many emerging economies. Levels of integration are now much higher than during the inter-war period, so US financial shocks have a larger impact,” it has said. This should engender a great concern since, “Synchronized world recessions striking all major regions are ‘historically rare’ events. They last one and a half times as long as typical downturns, and are followed by painfully slow recoveries.” Leap/Europe 2020 has given 3 reasons why this current crisis is distinctly more dangerous that was the Depression of the 30s. First, “today’s world is far more integrated than in the 1930s so this crisis is definitely the first truly global crisis ever. The 1930s one was essentially limited to the US and Europe. Second, our societies depend much more on the financial sphere than 80 years ago. Credit (especially consumer credit) has been the key tool for our GDP growth in the past decades; so the impact of the financial meltdown is going to affect more deeply and durably our societies than it did 70 years ago. Finally, the US, which is the epicenter of the current global crisis, was an ascendant world power in the 1930s when now it is a decaying one. So the impact of the crisis will reinforce the downward trends affecting the US today when, in the 1930s, the crisis impact was strongly diminished by the upward trend affecting the US at that time.” This leads to the conclusion that, “this crisis will be much stronger and last much longer than in the 1930s, especially in the case of the US which is at its epicenter.” All Lollipop Guild economists aside. In regard to those “green shoots” of recovery that we hear about on CNBC, let us apply to them what Dr. Samuel Johnson said about second marriages, they are “the triumph of hope over experience.”
Although many economists make the conclusion that the only result of the inundation of the economy with trillions of fake dollars by the Fed and the Treasury will inevitably produce an unprecedented hyperinflation, especially when the Chinese stop buying US Treasuries and begin bringing their $1.4 trillion reserve back to the United States by spending it on American commodities, if what Melchior Palyi said is true concerning the marginal productivity of debt, it is rather a deflationary spiral that ought to concern us now. Clearly there has been a sharp decline in the amount of US debt that the Chinese are willing to take on; because of the “policy mistake” --- to quote the Chinese, of “quantitative easing,” they are clearly showing signs that they view the US dollar and US Treasuries as “toxic” due to the increasing likelihood of a US default, whether officially or by stealth. Could this debasement of the US currency lead to deflation, rather than inflation, however? Could our currency become worth too much and become scarce, rather than being worth too little and overly plentiful?
The trajectory for a future downward deflationary spiral is clear enough. While prices for primary products such as oil and food may, initially, rise, there is no purchasing power in the hands of the consumer, nor can they borrow as they once did, in order to pay the higher prices. The flood of newly created money has gone to bail out banks. Very little will trickle down to the ordinary consumers who are still squeezed by the debts that they have contracted in the past. Price rises are, then, unsustainable, insofar as the consumer is unable to pay them. When consumers become squeezed, merchants become squeezed; when merchants become squeezed they are forced to retrench and lay-off people and this rise in unemployment put less cash into the hands of the consumer --- and so the vicious cycle goes. For the “stimulus” money that does get into the hands of the people, it is fair to assume that it will be used to pay off the debt that, in spite of all the transference from banks to government of “toxic debt,” are still the unaltered obligation of the consumer. Switzerland has been the first Western nation to tip into deflation. Swiss consumer prices fell .4% in March (year-on-year). The Swiss Consumer Price Index will be at –1% by July. This tipping into the deflationary spiral described above is, says Philipp Hildebrand, a governor of the Swiss National Bank, “something that we must prevent at all costs. The current situation is extraordinarily serious.” All are concerned that Switzerland is entering an economic situation resembling that of Japan. “We don’t fully realize in the West what a catastrophic collapse Japan has suffered,” says Albert Edwards, global strategist at Société Générale. Japan’s industrial output fell 38% in February (year-on-year), mostly concentrated into the last 5 months. No economy imploded at this speed in the 1930s. If America enters this type of deflationary spiral, the word “depression” will seem a bit too optimistic.
By: Dr. Peter E. Chojnowski
May 5, 2009
If the saying is true that, “The greatness of a depression is commensurate to the government’s efforts to prevent it,” we can assuredly say that we are in the greatest downturn ever to threaten the prosperity of our civilization. As of this writing, the United States Treasury and the Federal Reserve Bank has committed $13 trillion to bailouts and “stimulus” packages. To put this “injection of liquidity” into perspective, we can say that the United States government has spent more money propping up the financial system since August of 2008, as it spent, with inflation adjusted dollars, on all the wars in its history put together. To make another illustrative comparison, the entire gross domestic product (GDP) for the year 2008 (i.e., the total amount of goods and services produced in the nation) totaled $14 trillion. This tally works out to $42,105 for every man, woman, and child in the United States and some 14x the $900 billion of currency in circulation. Not desiring to “cry wolf,” Dana Johnson, chief economist for Comerica Bank in Dallas, said, “The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets.”
This attempt to “stabilize the credit markets” has taken two forms in the United States, “stimulus” and “bailout”.
A) “Stimulating” a Zombie Economy
The most basic, and seemingly inconsequential, aspect of the attempt by government to “increase liquidity” and “demand” within the economy is the $787 billion dollar “stimulus” package offered by the Obama administration. To use the adjective “inconsequential” seems fitting on account of the fact that the package would pump a mere $185 billion into the economy this year. The very partisan legislation, having received only 3 Republican votes in the Senate and none in the House, includes extra-spending, a large increase in the debt limit, and some small-scale tax cuts. With regard to the tax cuts, millions of American workers can expect to see about $13 extra in their weekly paychecks beginning in June; this tax credit, in the year 2010, will result, on average, in $7.70 more in the typical American’s pay-packet per week. Not, seemingly, having learned from catastrophic indebtedness of the American family, which caused the worst financial crisis since the Great Depression, first-time homebuyers will be eligible for a $8,000 tax credit and those who buy a new car before the end of the year can write off the sales tax. In this regard, can we assume that all the borrowers who “earn” these tax credits, are “credit worthy” or is the government simply encouraging borrowing for the sake of pumping up the GDP? We seem to be simply attempting to “re-inflate” the credit-bubble here.
With regard to the new spending portion of the “stimulus package,” some of the money goes for worthwhile projects, like development of alternative energy sources and infrastructure projects that have been put off for decades. Even the “positive” aspects of the spending allocations, however, demonstrate that this legislation is truly nothing more than an attempt to “stimulate” and not to repair a national economy that began to realize in September 2008 that it was primarily a “phantom” economy; the appearance of life, without the substance. The $90 billion to be spent on the nation’s infrastructure, for example, is only a meager down payment on the repairs needed to fix the problems with the bridges and highways. The $9.2 billion earmarked for environmental projects and the Environmental Protection Agency (EPA) will only, according to reports, make a dent in the backlog of cleanups facing the EPA and the long list of chores at the country’s national parks, refuges and other public lands. This expenditure too can be considered to be a mere down payment on a much bigger problem.
What many of the expenditures in the “stimulus package” do is to federalize projects and programs that have been cut back by near-bankrupt state governments. Of course, with federal money comes federal control. For example, for those who lose their jobs and who want to extend their health insurance coverage for 18 months (the COBRA program), the federal government will now pick up 65% of the total cost of that premium for the first 9 months. With regard to education, the package allocates some $54 billion of federal money to compensate for state budget cuts over the next 3 years. This means that the federal government will try to ensure that the potential 600,000 elementary and secondary school teachers that would have been laid off on account of state budget cuts, will not need to be laid off.
B) No Banker Left Behind
“Quantitative Easing” is the term being used to describe the Treasury’s and Federal Reserves injection of trillions of dollars into the financial system in order to keep it afloat and prevent “deflation.” It has been these regular injections of trillions of dollars into the banking system, which has dwarfed the relatively paltry hundreds of billions allocated by Congress for the purpose of “stimulus” and buying “toxic assets” from the 5 largest banks. In describing this “quantitative easing” policy, the Federal Reserve, on March 21, 2009, said, “In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to ¼ % [N.B., the European Central Bank has just lowered this same interest rate to 1%, a record low] and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”
What you have in the above is a summary of the unprecedented intervention in the financial system. Traditionally, the key number that the Fed would vote on and that they would communicate to the public with a statement like the above, would be a target interest rate that the Fed had settled on for the Fed funds rate, an interest rate charged on overnight interbank loans. The Fed, however, has recently found that keeping the fed funds rate at near zero has not helped to bolster and stabilize the banks and the equity markets. That is why they have reverted to buying US government securities (i.e., monetizing the debt) and trying to get the credit flowing by relieving the banks of risky assets like mortgage-based securities. All of this, of course, occurred only 2 weeks before Treasury Secretary Geithner new Public-Private Partnership Investment Program (PPIP) to price and remove toxic assets from banks’ balance sheets to the tune of some $500 billion to $1 trillion.
C) Paper Mill on the Potomac: The Marginal Productivity of Debt
Whether the extra expenditure will “grow” the economy or not, is still an open question. What is not an open question, however, is that both “stimulus” and “added liquidity” will radically boost the national debt of the United States. Forecasters expect the 2009 deficit to top 2.1 trillion dollars, which is more than 3x last year’s shortfall. The overall National Debt is now approximately 11 trillion dollars.
The thinking of the past and present administrations, Bush and Obama, and the past and present Federal Reserve chairmen, Greenspan and Bernanke, is that the more money “printed,” either through government expenditure or lower interest rates --- both of which produce more debt --- the greater likelihood of stopping both economic contraction and asset deflation. Will, however, this be the case? Can such a scenario be assumed? What seems to be the great-unasked question, in this regard, is whether greater amounts of public and private debt will in any way “grow” the economy and encourage only moderate inflation. What we are really speaking about here is the “quality of debt”. What do we mean by the “quality of debt”? The Keynesians in the Bush and Obama administrations take comfort in the fact that the total national debt as a percentage of GDP is safely below 100% in the United States, while it is 100% or higher in some other countries. According to Melchior Palyi, a Hungarian-born Chicago economist who died in the early 1970s, the significant ratio to watch is additional debt to additional GDP, in other words, the amount of GDP contributed by the creation of $1 in new debt. This is the ratio that determines the “quality of debt”. For example, if the marginal productivity of debt was ½, then $2 in debt had to be incurred in order to increase the nation’s output of goods and services by $1. An increase in total debt by $1 could no longer reproduce its cost in the form of an equivalent increase in the GDP. In this situation, debt would have lost whatever justification it may have once had.
To chart the “quality of debt” historically, we can say that in the 1950s, when the dollar was still redeemable in the sense that foreign governments and central banks could covert their dollar balances into gold at the fixed statutory rate of $35 per ounce, the marginal productivity of debt was 3 or higher, meaning that the addition of $1 in new debt caused the GDP to increase by at least $3. When, in 1971, Richard Nixon defaulted on the international gold obligations of the United States, the marginal productivity of debt fell below the critical level of 1. If the marginal productivity of debt is ½, then $2 in debt had to be incurred in order to increase the nation’s output and services by $1.
As long as debt was constrained by gold, deterioration of debt was relatively slow. It took the economy 35years after Nixon’s taking the US off the gold standard for the capital of society to erode and be consumed through a steadily deteriorating marginal productivity of debt. The year 2006 was a watershed. Late in that year, the marginal productivity of debt dropped to zero and then went negative for the first time ever. Here a red light warning of an imminent economic catastrophe was set off.
If Palyi’s theory is correct, being supported by such economists as Peter Warburton and Antal Fekete, when there is a negative marginal productivity of debt, it indicates that any further increase in debtedness would necessarily cause economic contraction. In view of the fact that the marginal productivity of debt is now negative we can see that the damage-control measures of the Obama administration, which are being financed through creating unprecedented amounts of new debt, are counterproductive. It could, moreover, be the direct cause of further economic contraction of an already prostrate economy, including unemployment. This is, perhaps, what the head of the European Union and Czech Prime Minister Mirek Topolanek meant when he publicly characterized Obama’s plan to spend nearly $2 trillion to push the US economy out of recession as the “road to hell.”
D) Dumping the Dollar: America’s Stealth Default
If many Europeans and American economists worry about deflation, its seems as if the Chinese government is definitely worried about inflation. They have good reason to worry. “A policy mistake made by some major central bank may bring inflation risks to the whole world,” said the People’s Central Bank in its quarterly report. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing major currencies’ devaluation risks may rise,” it said. Premier Wen Jiabao, at the Communist Party summit in March, left no doubt that China was extremely irritated with Washington’s response to the credit crisis set off by the AIG (i.e., American International [Insurance] Group) and Lehman Brothers collapse. The Chinese have come to suspect that the United States is engaged in stealth default on its debt by driving down the dollar. Premier Wen continued, “We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries.” A few days later, the Chinese central bank chief wrote a paper suggesting a world currency based on Special Drawing Rights issued by the International Monetary Fund (IMF). This call to replace the US dollar as the world reserve currency was recently echoed by a United Nations panel of economists. The panel was led by US economist Joseph Stiglitz, the 2001 Nobel economics laureate, who told a press conference that there was “a growing consensus that there are problems with the dollar reserve system.” Such as system was “relatively volatile, deflationary, unstable and had inequity associated with it.” “Developing countries are lending the United States trillions of dollars at almost zero interest rates when they have huge needs themselves,” Stiglitz noted. “It’s indicative of the nature of the problem. It’s a net transfer, in a sense, to the United States, a form of foreign aid.” A new global reserve currency, however, “is feasible, non-inflationary and could be easily implemented.” Feeling that the Bretton-Woods Agreement of 1944, which established the US dollar as the world’s reserve currency --- and the United States as the beneficiary of the world-wide need to possess the dollar and dollar-denominated assets, is coming to an end, the Kremlin’s chief economic advisor, Arkady Dvorkevich, has publicly stated that Russia would favor the partial return of the gold standard, as part of a system of a new world currency based on Special Drawing Rights (SDR) issued by the IMF. The Kremlin has already instructed the its central bank to gradually raise the gold share of foreign reserves to 10%.
What was, perhaps, the most surprising aspect of the very public call by the Chinese for a new global reserve currency to replace the US dollar was the lack of any real objection to this proposal coming from the US Treasury Secretary Timothy Geithner. When speaking at an event hosted by the Council on Foreign Relations in New York, Geithner was asked about China’s Central Bank Governor Zhou Xiaochuan’s call for a new international reserve currency. Geithner said that he had not read Zhou’s proposal, but that “he understood it was a plan designed to increase the use of the IMF’s special drawing rights. And we’re actually quite open to that.” Having just, nonchalantly, thrown into question America’s 65 year commitment to the enshrinement of the US dollar as the world’s reserve and commodity trading currency, Geithner was subtly given the heads up that he had driven the value of the US dollar down some 1.3% against the Euro, since his remarks about the Chinese proposal began. This occurred when Roger Altman, who worked with Geithner as deputy Treasury secretary in the Clinton administration, asked Geithner if he wanted to “clarify” his comments. “I’d like to ask one final question, in effect on behalf of the market” [hint: you are causing months of dollar appreciation to disappear], said Altman, founder of Evercore Partners, Inc., “Let me ask the question this way. Do you see any change over the foreseeable future in the basic role of the dollar as the world’s reserve currency?” Apparently catching the hint, Geithner responded, “I think the dollar remains the world’s dominant reserve currency.”
E) Obama’s Multi-lateral New World Order: The End of the Americanist Paradigm
If Secretary Geithner is “open” to the idea of the end of the United States’ domination of the economic and political processes of the world, which would result from the toppling of the dollar as the world’s reserve currency, Barack Obama seems to be acting as if that “toppling” has already taken place. In the context of holding a press conference with Angela Merkel in Baden-Baden after the G-20 meeting in April, Obama was asked about his “grand designs” for NATO and said simply, “I don’t come bearing grand designs,” instead, “I’m here to listen, to share ideas and to jointly, as one of many NATO allies, help shape our vision for the future.” When asked by two American reporters for his response to the claim by Gordon Brown (referred to as “Crash Gordon” in Britain) that the “Washington consensus is over,” meaning the uni-lateral American exceptionalism, Obama did not object, but seemed, rather, to agree, noting the term “Washington consensus” had its roots in a set of economic policies that have been shown to be defective. Obama’s vision of the world as a consortium of “enlightened” nations fighting the remnants of religious militancy and exclusivism, won the appreciation of Nicolas Sarkozy, when the French leader praised this new post-Americanist global system and the man that made it happen, “It feels really good to work with a US president who wants to change the world and who understands that the world does not boil down to simply the American frontiers and borders….And that is a hell of a good piece of good news for 2009.”
A concrete manifestation of this new New World Order, was the activation of the IMF’s power to create money and to begin a global “quantitative easing”. The leaders at the G-20 summit literally tripled overnight to $750 billion, the IMF’s ability to provide credit to national economies on the edge. The move is akin to a national central bank such as the Federal Reserve creating the money out of thin air, except this is on a global scale. A list of the countries that the IMF has already “bailed out” are Latvia, Iceland, Pakistan, Hungary, Belarus, Serbia, Bosnia, and Romania. In April, Mexico became the first G-20 nation to ask the IMF for immediate help. Along with providing the IMF with plenty of national “bailout money” and the world with the basis for a global currency (N.B., the SDR), the G-20 leaders, with the support of Barack Obama, established a international Financial Stability Board, which appears to be meant as a global financial regulator. Obama appears to take it for granted that the post-WWII United States dominated and determined world has ceased to be and that another one is emerging. At the end of the G-20 conference in April, he stated, “I think we did OK.” Bretton Woods in 1944 was a simpler affair, “Just Roosevelt and Churchill sitting in a room with a brandy, that’s an easy negotiation, but that’s not the world we live in.”
F) Hyperinflation or Deflationary Spiral? Possibilities for 2009
That what we have witnessed since the September collapse of Lehman Brothers has been an unprecedented intervention in the banking and economic sector on the part of the government and central banks of the world, is not the issue which is being currently debated. What is being debated is the ultimate consequence of such a “injection of liquidity” (i.e., printing of money) into the financial system. As Peter Schiff has recently stated, what we are suffering from now is an overdose of past stimulus. A larger dose will only worsen the condition. According to Schiff, “The Greenspan/Bush stimulus of 2001 prevented a much needed recession and bought us seven years of artificial growth. The multi-trillion dollar tab for that federally-engineered economic bullet-dodging came due in 2008. The 2001 stimulus had kicked off a debt-fueled consumption binge that resulted in economic weakness, not strength. So now, even though the recent stimulus administered a much larger dose, we will likely experience a much smaller bounce. One can only speculate as to how much time this stimulus will buy and what it will cost when the bill arrives.”
Whatever the consequences, clearly the response of the governments of the world to the current financial crisis reveals, unequivocally, the extent of the crisis. The talk about “green shoots” coming from the “in the pocket” economists employed by the mass media and their corporate and financial sponsors must be a siren song that causes us to tie ourselves to the mast and plug our ears. The IMF in the “green shoots” month of April was saying that the world had entered “by far the deepest global recession since the Great Depression.” A recession which would cost the nations of the world “trillions of dollars in lost business, millions of people thrust into hunger and homelessness and crime on the rise.” This assessment of the current downturn as “the worst since the Great Depression,” was further confirmed by a recent statement of Professor Tim Congdon of International Monetary Research, in which he stated that company bank deposits in Europe have begun to contract at rates not seen since the early 1930s, threatening severe damage in the coming months. “It’s a catastrophe. Company bank deposits have been falling at 1% a month since December. It is what happened in the US during the Great Depression, and it is why we are seeing such a horrific recession in Europe.”
The word “since” the Great Depression is even somewhat deceptive in this context. Mark Twain said, “History does not repeat itself, but it does rhyme.” The current financial and economic crisis is both “like” the Great Depression and, yet, distinctly different. The “distinctly different” here should not, however, be an occasion for comfort. Even the IMF has pointed out the differences, saying, “While the credit boom in the 1920s was largely specific to the United States, the boom during 2004-2007 was global, with increased leverage and risk-taking in advanced economies and many emerging economies. Levels of integration are now much higher than during the inter-war period, so US financial shocks have a larger impact,” it has said. This should engender a great concern since, “Synchronized world recessions striking all major regions are ‘historically rare’ events. They last one and a half times as long as typical downturns, and are followed by painfully slow recoveries.” Leap/Europe 2020 has given 3 reasons why this current crisis is distinctly more dangerous that was the Depression of the 30s. First, “today’s world is far more integrated than in the 1930s so this crisis is definitely the first truly global crisis ever. The 1930s one was essentially limited to the US and Europe. Second, our societies depend much more on the financial sphere than 80 years ago. Credit (especially consumer credit) has been the key tool for our GDP growth in the past decades; so the impact of the financial meltdown is going to affect more deeply and durably our societies than it did 70 years ago. Finally, the US, which is the epicenter of the current global crisis, was an ascendant world power in the 1930s when now it is a decaying one. So the impact of the crisis will reinforce the downward trends affecting the US today when, in the 1930s, the crisis impact was strongly diminished by the upward trend affecting the US at that time.” This leads to the conclusion that, “this crisis will be much stronger and last much longer than in the 1930s, especially in the case of the US which is at its epicenter.” All Lollipop Guild economists aside. In regard to those “green shoots” of recovery that we hear about on CNBC, let us apply to them what Dr. Samuel Johnson said about second marriages, they are “the triumph of hope over experience.”
Although many economists make the conclusion that the only result of the inundation of the economy with trillions of fake dollars by the Fed and the Treasury will inevitably produce an unprecedented hyperinflation, especially when the Chinese stop buying US Treasuries and begin bringing their $1.4 trillion reserve back to the United States by spending it on American commodities, if what Melchior Palyi said is true concerning the marginal productivity of debt, it is rather a deflationary spiral that ought to concern us now. Clearly there has been a sharp decline in the amount of US debt that the Chinese are willing to take on; because of the “policy mistake” --- to quote the Chinese, of “quantitative easing,” they are clearly showing signs that they view the US dollar and US Treasuries as “toxic” due to the increasing likelihood of a US default, whether officially or by stealth. Could this debasement of the US currency lead to deflation, rather than inflation, however? Could our currency become worth too much and become scarce, rather than being worth too little and overly plentiful?
The trajectory for a future downward deflationary spiral is clear enough. While prices for primary products such as oil and food may, initially, rise, there is no purchasing power in the hands of the consumer, nor can they borrow as they once did, in order to pay the higher prices. The flood of newly created money has gone to bail out banks. Very little will trickle down to the ordinary consumers who are still squeezed by the debts that they have contracted in the past. Price rises are, then, unsustainable, insofar as the consumer is unable to pay them. When consumers become squeezed, merchants become squeezed; when merchants become squeezed they are forced to retrench and lay-off people and this rise in unemployment put less cash into the hands of the consumer --- and so the vicious cycle goes. For the “stimulus” money that does get into the hands of the people, it is fair to assume that it will be used to pay off the debt that, in spite of all the transference from banks to government of “toxic debt,” are still the unaltered obligation of the consumer. Switzerland has been the first Western nation to tip into deflation. Swiss consumer prices fell .4% in March (year-on-year). The Swiss Consumer Price Index will be at –1% by July. This tipping into the deflationary spiral described above is, says Philipp Hildebrand, a governor of the Swiss National Bank, “something that we must prevent at all costs. The current situation is extraordinarily serious.” All are concerned that Switzerland is entering an economic situation resembling that of Japan. “We don’t fully realize in the West what a catastrophic collapse Japan has suffered,” says Albert Edwards, global strategist at Société Générale. Japan’s industrial output fell 38% in February (year-on-year), mostly concentrated into the last 5 months. No economy imploded at this speed in the 1930s. If America enters this type of deflationary spiral, the word “depression” will seem a bit too optimistic.
Labels: Chojnowski, depression, Dollar
posted by Dr. Chojnowski at 6:13 AM
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