2009 – An Outlook

December 31, 2008 · Posted in General Economics · Comment

Consumer Spending will collapse throughout the entire year as consumer credit continues its contraction

Commercial real estate and consumer credit will be the next sub-prime crisis and companies from those industries will get in line for massive bailouts

The stock markets will drop to new lows, the S&P 500 will test new lows around 600 and bottom out some time between the end of 2009 and mid 2010

Home prices will continue to decline constantly

Government spending will soar beyond levels that Americans wouldn’t have dared to dream of in their worst nightmares

A new massive government public works program will spark an initial euphoria that will soon be disappointed by progressively worsening unemployment data

All measures taken by the government to stabilize consumer credit, home prices, domestic auto sales, employment and other things will turn out to be miserable failures and aggravate and prolong the crisis

New municipal bankruptcies will add to the ongoing credit contraction

Banks will remain unwilling to lend so long as credit keeps contracting

The savings rate will keep rising

Gold and silver will rise continuously but not excessively

Big unknown: What will foreign central banks, in particular in Japan and China do? Will they keep lending money to the US by buying their bonds. Recent events indicate that foreigners are slowly beginning to cut the US off. China has embarked upon a huge domestic stimulus package over $600 billion and Japan is injecting $110 billion for bad loans. This means that less money will be available to lend to the US. Kuwait just pulled out of a deal to buy a stake in Dow Chemical. So long as foreigners keep loaning money, the US will not yet plunge into a complete depression.

Tags: outlook 2009

Municipal Bankruptcies Expected to Surge in 2009

December 31, 2008 · Posted in General Economics · 4 Comments

Muni Bond Sales Drying Up as States Face $42 Billion Shortfall:

The worst year for municipal bond investors since 1999 may further reduce demand for tax-exempt debt just as state governments face the biggest budget deficits in at least a quarter-century.

State and local borrowers sold $385 billion of long-term bonds through yesterday, down 9 percent from 2007, according to data compiled by Thomson Reuters. Next year, sales will drop more than 6 percent to about $364 billion, the least since 2004, based on an average of estimates from London-based Barclays Plc, Merrill Lynch & Co. and Loop Capital Markets LLC.

The combination of the worst financial crisis since World War II and the collapse of the $330 billion auction-rate debt market will leave 41 states and the District of Columbia with shortfalls just as financing sources diminish. Merrill Lynch’s Municipal Master Index, which tracks 14,000 bonds, fell 4.6 percent this year, the first decline since a 6.34 percent drop in 1999. The biggest underwriters are merging or leaving the business.

“It’s been an absolutely horrible year,” said Robert MacIntosh, a money manager at Eaton Vance Management in Boston, who oversees $17 billion in tax-exempt bonds. He said he’s never seen such turmoil in the $2.67 trillion municipal debt market during more than 25 years in the business.

A freeze in global credit markets this year drove municipal borrowing costs to unprecedented levels. Yields on AAA general obligation bonds due in 30 years rose to a record 2.2 times Treasury yields from the historical average of about 0.96 times, according to Concord, Massachusetts-based Municipal Market Advisors. That represents an extra $2.93 million a year in interest on every $100 million of debt sold.

Lowest-Rated Borrowers

The lowest-rated borrowers were hit hardest. Merrill Lynch’s index tracking debt ranked BBB, the bottom tier of investment-grade, fell 22.3 percent, the most since the firm began compiling the data in 1989. Five of the 12 largest municipal-bond underwriters, including New York-based Merrill Lynch and Zurich-based UBS AG, agreed to merge or have exited the business.

Budget analysts are increasing their estimates of state deficits as the U.S. economy enters its second year of recession. The Center on Budget and Policy Priorities in Washington, a non-partisan budget and tax analysis group, said last week that states faced a combined budget shortfall of $42 billion this fiscal year, up from $8.9 billion on Oct. 10.

“It’s going to be very hard to get refundings done, at least in the first part of the year,” said Evan Rourke, part of a team that manages $7 billion in municipal bonds at New York- based M.D. Sass Associates.

Harvard Penalized

This month, top-rated Harvard University in Cambridge, Massachusetts, sold tax-exempt bonds due in 2036 at a yield of 5.8 percent, or 1.31 percentage points more than similar securities it issued in June.

New York City offered investors 6.25 percent on bonds due in 20 years, up 1.65 percentage points from December 2007. Cascade Healthcare Community’s yields shot up more than 3 percentage points in seven months to 8.5 percent, as the Bend, Oregon-based hospital’s ratings were cut, in part because of higher debt costs.

Rising bond expenses are forcing municipalities to postpone projects. Merrill Lynch estimates the backlog of offerings to fund public works has grown to more than $120 billion.

The school district in Fort Bragg, California, a town of 6,600 located 170 miles (273.5 kilometers) north of San Francisco on the Pacific coast, put off construction at its high school and delayed a solar-power project after shelving a $7 million bond sale when interest rates jumped following the collapse of Lehman Brothers Holdings Inc. in September.

‘Really Crazy’

“It got really crazy right about the time we wanted to sell,” said Kathryn Charters, the district’s business manager, who hopes to issue the debt next year.

A total of $390 billion of bond sales are anticipated in 2009, said analysts Ivan Gulich and Chris Mier of Loop Capital, a Chicago-based underwriter. “Interest rates are the most important predictor of municipal bond volumes,” they said in a Dec. 18 report.

This year’s turmoil is a reversal from 2007, when sales reached a record $430 billion as hedge funds, banks and other institutions borrowed money to buy municipal securities and boost returns, according to Thomson data.

Analysts at New York-based Citigroup Inc. led by George Friedlander estimated in a Dec. 19 report that the amount being used by investors in that type of strategy fell to about $12 billion from a peak of $120 billion.

Auction-Rate Collapse

Losses started in February, when the auction-rate market collapsed as dealers who supported it for two decades abandoned the weekly and monthly sales where rates were set on the long- term bonds. Interest costs soared to 20 percent for issuers such as the Port Authority of New York & New Jersey when dealers stopped buying securities that went unsold.

At the same time, bond insurers that guaranteed more than 50 percent of all new municipal debt began suffering credit rating downgrades after standing behind the same subprime mortgage-related securities that have triggered $1 trillion in losses and writedowns at the world’s biggest financial institutions.

Instead of selling bonds to finance public works, issuers from California to New York were forced to refinance auction- rate and other adjustable-rate securities with fixed-rate debt.

With demand drying up among institutions, state and local governments are turning to individual investors.

A marketing campaign by California, the biggest municipal borrower, helped draw a record of more than $3.9 billion of orders from retail investors in a $5 billion short-term note deal in October, according to the state treasurer’s office.

California Downgraded

“Issuers should not presume that market access will necessarily be available on demand,” underscoring the need to cater to individuals, Phil Fischer, a municipal strategist at Merrill Lynch, said in a Dec. 8 report.

California officials said Dec. 11 the state’s shortfall will reach a record $41.8 billion over the next 19 months, and the state may run out of cash as soon as February.

A day earlier, Standard & Poor’s said it may lower the rating on California’s $46.6 billion of general obligation debt and $7.8 billion in bonds backed by lease payments. S&P reduced to “SP-2” from “SP-1” its ranking on $5 billion of short- term notes that the state sold to cover its tax shortfalls.

Public officials are pinning their hopes for a turnaround on a stimulus plan of as much as $1 trillion being developed by President-elect Barack Obama. New York Governor David Paterson wrote in a Dec. 29 letter to Obama that he “strongly” supported spending $300 billion for “ready-to-go projects to rehabilitate and construct” infrastructure.

“We have got a huge infrastructure problem that will start to be funded in 2009,” said Kevin Giddis, a managing director of fixed-income trading with Morgan Keegan Inc. in Memphis, Tennessee, in a Dec. 29 interview with Bloomberg Television.

The fiscal insanity behind these plans is staggering. The mayors and state governors are getting in line for bailouts. They, too, appear unwilling to simply do what is asked of every single individual in society: Live within your means, cut your expenditures, consolidate your finances. Vallejo in California already declared bankruptcy in May this year way before the bailout surge spiraled out of control. Several more are expected over the next years:

After a disaster of a year, 2009 isn’t shaping up to be a walk in the park either. Sure, Option ARM resets will wreak havoc on defaults and foreclosure rates, but that’s the least of our concerns.

Now, the accountant (who predicted the 1994 Orange County bankruptcy) believes we’ll see up to 10 municipal bankruptcies in 2009. And if that happens, we could watch as the $2.7 trillion market for state, county and city debt is shattered.

In 1994, John Moorlach warned that Orange County, California’s investing strategies could wreck its finances. And he was right. Six months later, the county went bankrupt after losing $1.6 billion.

And he now believes that four cities in California and six others nationwide could seek court protection under Chapter 9 of the bankruptcy code in 2009.

But Moorlach may be too optimistic. Richard Ciccarone, a research officer, for example, believes we’ll see 36 bankruptcies over the next two years; 12 defaults in 2009 and at least 24 in 2010.

What is noteworthy that in light of this interest rates for new issues have recently actually dropped sharply and now appear to be approaching lower treasury multiples. This indicates that the market expects a significant decline in demand for new funding on the part of municipalities due to consolidation and more bankruptcies, and/or that investors no longer find municipal debt risky since they are expecting a bailout from the Obama administration. Most likely it is a little bit of both that is pushing yields down at this point. This is in line with phase 8 of the business cycle.

Tags: municipal bankruptcies

Home Prices Drop Further in October 2008

December 30, 2008 · Posted in General Economics · Comment

Today the new Case Shiller home price index values were published:

Top 3 annual declines:

1. Phoenix 33%
2. Las Vegas 32%
3. San Francisco 31%

Top 3 monthly declines:

1. San Francisco 4.18%
2. Minneapolis 3.42%
3. Tampa 3.39%

On average home prices are still around 2004 levels. The way toward 1999 levels is wide open and there can’t be any doubt that home prices will keep falling throughout 2009 until they reach pre-bubble levels, before the most recent business cycle was started by excessive credit expansion.

Tags: case shiller, home prices

Holiday Retail Sales Down

December 29, 2008 · Posted in General Economics · Comment

Reuters writes Retailers’ holiday sales plummet 4 percent:

Retailers’ sales fell as much as 4 percent during the holiday season, as the weak economy and bad weather created one of the worst holiday shopping climates in modern times, according to data released on Thursday by SpendingPulse.

The figures, from the retail data service of MasterCard Advisors, show the 2008 holiday shopping season was the weakest in decades, as U.S. consumers cut spending as they confront a yearlong recession, mounting job losses and tighter credit.

“It’s probably one of the most challenging holiday seasons we’ve ever had in modern times,” said Michael McNamara, vice president of Research and Analysis at MasterCard Advisors.

“We had a very difficult economic environment. Weather patterns were not favorable toward the end of season, and that resulted in one of the most challenging economic seasons we’ve seen in decades.”

The figures exclude auto and gas sales but include grocery, restaurant and specialty food sales. Although SpendingPulse did not exempt the food prices, McNamara said the decline would have been steeper without them.

“There’s a lot of food that provide a buffer for the total retail sales numbers,” he said.

SpendingPulse tracks sales activity in the MasterCard Inc payments network and couples that with estimates for all other payment forms, including cash and checks. It has been tracking holiday spending figures since 2002. Exact comparisons beyond that year are difficult because of changes in measurements.

The holiday shopping season typically runs from the day after U.S. Thanksgiving, which occurs on the fourth Thursday of November, until Christmas Eve. But this year Thanksgiving was a week later than last year.

To benchmark a comparison, SpendingPulse measured the season from November 1 through December 24. Sales fell 2 percent in November and 4 percent from December 1 through December 24, according to SpendingPulse.

The holiday sales season can account for up to 40 percent of a retailer’s annual revenue.

It is rather amusing that Michael McNamara mentions unfavorable wether patterns as part of the reason for this slump. If anything, it is surprising that sales aren’t down by much more. Consumer credit will inevitably keep contracting. 2009 will forever be remembered as the year where the American consumer finally capitulated.

If the holiday sales season can account for up to 40% of the annual revenue, then a 4% drop during that season would approximately contribute a 1.6% drop to overall annual sales. If sales during the rest of the year were bleak, the number will be much worse. Add to that a significant drop in profit margins, due to slashed sales prices, and several retailers could easily see their free cash flow wiped out over the next years.

More mid to high-end retailers, such as Best Buy, Gap or Neiman Marcus will have to close down stores nationwide or at least trim down their existing stores. I expect that in 2009 commercial real estate will finally be recognized by the wide public as the disaster it is. Amercia doesn’t need any more Malls. Companies with high exposure to commercial retail properties will suffer. Stocks of Simon Properties Group (SPG) and Federal Realty Trust (FRT) will follow General Growth Properties (GGP) and tumble.

Tags: consumer credit, consumer spending, retail sales

Savings and Investment

December 26, 2008 · Posted in General Economics · Comment

The following scenario shall explain the significance of savings on any market system:

P1 produces A, P2 produces B, P3 produces C, all 3 produce these goods by transforming previously untouched land
Each of them can produce 3 units of their respective goods within 1 time unit
The period of exchanging goods is 1 time unit
Each of them trade 2 units against the other two goods and keeps one unit to himself
Each of them can last 2 time units without consumption after consuming 2 unis of any good

As long as they produce for immediate consumption only, the cycle would look like this:

Period	Person 1	Person 2	Person 3	Event
1	AAA	BBB	CCC	Production
2	ABC	ABC	ABC	Exchange
3	-	-	-	Consumption
4	AAA	BBB	CCC	Production
5	ABC	ABC	ABC	Exchange
6	-	-	-	Consumption

After producing, exchanging, and consuming the goods obtained, the 3 individuals return to their initial state and produce the same amounts again over the next production cycles. No raise of anyone’s standard of living occurs.

If, however, P1 decides to save good A and only consumes B and C he will hold good A after the first consumption cycle is over. He can repeat the cycle twice and then hold three units of A. This will now enable him to last over 2 time periods during the first of which he can produce a machine M, a factor of production that enables him to produce twice the amount of A within 1 time unit. During the next time unit he can again exchange two units of A and consume all thee goods A, B, and C which leaves him with M. He has invested his savings in capital. From hereon he will be able to produce 6 units of A per time unit. He can now afford to consume more units of A or exchange more. His real income rises. He has accumulated capital:

Period	Person 1	Person 2	Person 3	Event
1	AAA	BBB	CCC	Production
2	ABC	ABC	ABC	Exchange
3	A	-	-	P1 only consumes B & C, saves A throughout next steps
4	A AAA	BBB	CCC	Production
5	A ABC	ABC	ABC	Exchange
6	AA	-	-	P1 only consumes B & C, saves another unit of A throughout next steps
7	AA AAA	BBB	CCC	Production
8	AA ABC	ABC	ABC	Exchange
9	AAA	-	-	P1 only consumes B & C, saves another unit of A
10	M AAA	BBB	CCC	Production, P1 this time produces M instead of 3xA
11	M ABC	ABC	ABC	Exchange
12	M	-	-	Consumption
13	M AAAAAA	BBB	CCC	Production, P1 uses M which doubles production output
14	M AAA ABC	ABC	ABC	Exchange
15	M AAA	-	-	Consumption, P1’s output per time has increased

Instead of producing M himself, P1 could also have provided the goods to P2 or P3 in a credit transaction if one of those had had a better investment idea, have one of them build a machine that increases their output, and then get his goods back plus interest which could be financed out of higher production output. However this is arranged, the concept of savings and investment is not changed in the slightest.

If P2 and P3 do the same thing, their real income rises as well and as a result the society’s standard of living rises as a whole.

This is the essence of all wealth generation. If some countries enjoy a higher standard of living than others it is precisely due to the fact that the amount of capital per individual is higher than in others and as a result the output per unit of labor is higher. Thus savings are indispensable to an increase in everyone’s standard of living. Without savings, there would be no investment and hence no capital accumulation. Without capital accumulation the output per unit of labor remains the same.

But all capital that has been accumulated requires maintenance. The machinery, tools, computers, and other productive factors require repair, replacements of parts, and routine checkups, lest their output per unit of labor shrink. Hence, even in order to just maintain an existing stock of capital, continuous savings on the part of individuals on the market are necessary. If the government discourages people from saving, the necessary uphold of existing capital will fall short, what ensues is called capital consumption. The productivity of existing capital will diminish rapidly and the workers’ real income will drop. Thus capital consumption is the inevitable result of policies such as credit expansion or taxation of incomes derived from interest, dividends, and capital gains. The business cycle irrefutably shows how credit expansion precipitates capital consumption.

History has shown that no one single country is ever safeguarded against the blunder of capital consumption. It has lead to the decay and demise of the most powerful and wealthiest empires, and plunged their inhabitants into decades if not centuries of pauperism. On the flip side, rapid capital accumulation has helped the poorest and most underdeveloped nations rise to the ranks of industrialized nations within a matter of years.

Hence there is only one way to continuously and progressively raise the standard of living for the common man. If politicians are truly interested in attaining this objective, they need to encourage savings, capital accumulation, and investments inside the country. The best means to this end are an unconditional abandonment of the policy of credit expansion, a sound monetary policy, and a significant lowering if not an outright abolition of the taxes levied on incomes derived from interest, dividends, and capital gains. Any policy that aims at the opposite, is bound to progressively lower the standards of living of working men and women.

Tags: Investing, savings

Freedom, Liberty, Peace, Happiness and Prosperity

December 25, 2008 · Posted in General Economics, Interventionism, Philosophy, Politics · 4 Comments

Freedom is the degree to which a thing can move without obstruction from other sources, while in itself not obstructing other things’ freedoms.

Liberty is directly derived from freedom. It is the concept of freedom applied to society. A society in which every individual is able to do what he wants with his body and his property while not infringing upon other people’s freedoms, that is their bodies and properties, can be called a society that has endorsed the concepts of liberty.

Since liberty, by that definition, requires absence of aggression from anyone against anyone, liberty cannot exist without peace. Peace is the indispensable precondition for liberty. Liberty can’t do without peace and peace can’t do without liberty.

Happiness is a subjective aim. It is that goal that every individual, with every action and every step he takes, seeks to attain. So long as one can pursue his desires in an unobstructed manner he becomes happier every step of the way. He might make false decisions once in a while, but this doesn’t in the slightest change the overall direction towards happiness. He will change course if he realizes that something doesn’t make him happy, seek advice with his fellow men, and get on the path he considers right again.

But when someone forces him down a path that he doesn’t approve of, it will be completely impossible for him to pursue happiness. Nobody can possibly tell someone else what it is that will make him happier. If one finds happiness in infringing upon other individuals’ liberties he has to understand that his lifestyle could not possibly be one that is applicable universally. For if he is to be allowed to infringe upon others’ freedoms, what keeps someone else from doing the same to him? Thus happiness, freedom, liberty and peace are inextricably linked.

At times one may seek material wealth and at times indulge in spiritual/intellectual activities. But before one gets to enjoy the delightful beauty of a Monet painting or the subtlety of a Kafka novel, he needs to provide for the means of bare subsistence for himself and his family. To blame capitalism for a lack of cultural or spiritual progress, or to blame it for negligence of the poor and the weak is thus an utter mistake. It is precisely in those countries that have later than others embarked upon a policy of destroying the accomplishments of the Age of Enlightenment and their corollary, free market capitalism, where people got to enjoy an abundance of art museums, opera houses, philosophical lectures, and the like. It is in those very countries where the vast lot of the poor and unemployed have been able to find employment in factories, behind desks and elsewhere and raise their standards of living beyond levels that a Croesus or the Medici would have envied them for. It is in those very countries where a dynamic market has provided for an ever rising supply of health care and pharmaceutical products to improve the lifes of the unfortunate, instead of casting them off a cliff. It is in those very countries where an indispensable network of churches and voluntary charities has been able to appeal to their affluent countrymen’s compassion and raise sums of money that dwarf all governmental welfare programs, quantitatively and most importantly qualitatively, in taking care of those few who were still falling through the cracks.

We are in the process of a complete destruction of all these accomplishments in the United States. We are returning to a state of mass poverty, pauperism, and militarism. But capitalism is not to blame for this unfortunate development. It is the rise of interventionism and the radical expansion of government intrusion that used to be unthinkable up to 100 years ago.

Prosperity is a direct outcome of the pursuit of happiness. To say that money or material wealth alone do not make one happy is to utter a rather pedestrian truism. There is no one thing in the universe that makes one attain a state of complete happiness. But every action voluntarily taken aims at getting closer to that state. It is what Thomas Jefferson had understood long before he chose his words for the Declaration of Independence:

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

Government, by definition, is an obstacle to the pursuit of happiness. Its very essence consists in the infringement upon its subjects’ liberties through compulsory taxation. If it weren’t for this modus operandi, government would not pose such an obstacle.

If the past millennia have shown us one immutable economic law it is this: That governments always and everywhere grow and grow and grow in the long run, to the point of a complete and utter social collapse, only to start the cycle anew. The youngest and probably best example is that of the United States. Founded in 1776 as arguably the smallest government that has ever existed, it only took a few hundred years for it to turn into the biggest, most armed, most powerful, and most bellicose government in the whole world, along with a crushing public debt that will inevitably cause the demise of the current system within the coming decades.

These facts are not arcane or hidden. They are right before us. It doesn’t take the precision or smarts of a brain surgeon to grasp this. Quite the opposite: It takes really hard work and strenuous effort to ignore them and to delude yourself into believing anything else. The root causes for this deliberate self-delusion can be found in scar tissues from our childhoods and until one deals with one’s own personal childhood depredations and mental/physical abuses and corruption from authority figures, one is never going to accept such seemingly simple ideas.

For those who have understood the truth behind the concepts outlined above, it is obvious that there can only be one proper solution: The elimination of that institution commonly referred to as government, aka voluntaryism.

But all these realizations are worth nothing if the people who are subject to the government’s depredations and propaganda are not educated accordingly. In today’s world there is an overwhelming, though fading, compliance on the part of the public with the depredations of interventionism. It is thus my intention to spread the word about these truths wherever I can. Anyone who agrees should, if it doesn’t cause him major discomfort, do the same. It is in conversations in bars and restaurants, in the announcements in the news media, in town halls and on public squares, in quick chats with neighbors and friends where public opinion is formed.

Without an educated public, all the concepts that stand behind liberty and peace are meaningless. It is thus the duty of every one of us to take the word to those around us and show them the right way towards a better world.

Tags: freedom, happiness, liberty, peace, prosperity

Consumer Spending Update, Savings Update & Other Data

December 24, 2008 · Posted in General Economics · Comment

Consumption on Non-Durable Goods Down:

Savings Up:

Savings Rate Up, it was obviously unsustainable below 0:

Personal Income Peaking:

All in line with an ongoing consumer credit contraction. All in line with phase 8 of the bunsiness cycle. Be prepared for much worse.

Tags: consumer spending, savings

Orangutans Smarter than US Politicians

December 24, 2008 · Posted in Global Economics · Comment

BBC writes in Orangutans learn to trade favours :

Two orangutans – Bim and Dok – who live in Leipzig Zoo, Germany, were especially good at helping each other.

Initially, they were given several sets of tokens, and learned the value of the different types.

An animal could exchange one type for bananas for itself, another type could be used to gain bananas for a partner, and a third had no value.

Initially, Dok, the female, was especially good at swapping tokens to get bananas for Bim, the male. Sometimes Bim would point at the tokens to encourage her.

But he was less interested in trading tokens that would win bananas for her.

As she became less willing to help him out, Bim responded by trading more and more, until their efforts were more or less equal.

Bim quickly realized that he will not receive favors anymore unless he starts giving back. He was amassing debt while Dok was generating savings. This is a charming simplification of the process I outlined in The US Current Account Deficit. Just as Bim realized that he needs to consume less and start giving back more, US politicians need to realize that the same applies to their countrymen.

It shouldn’t be too much to ask of our politicians: Have the courage of a orangutan and abandon the policy of credit expansion and fiscal irresponsibility!

Tags: current account deficit, orangutans

Welcome to Krugmanland

December 23, 2008 · Posted in General Economics · 2 Comments

The science of economics is still young and full of clueless pundits. A perfect example is Nobel Price winner Paul Krugman and this article about fiscal stimuli:

I’ve been on the warpath over Germany’s refusal to play a constructive role in European fiscal stimulus. But what does the math look like? Here’s a simple analysis — well, simple by economists’ standards — of the reason coordination is so important for the EU.

We start from the proposition that Europe is, or soon will be, in a position where interest rates are up against the zero lower bound. This means both that fiscal policy is the only game in town, and that we can use ordinary multiplier analysis.

OK, I hope Krugman understands that interest rates are low because we are in phase 8 of the business cycle. That phase where people finally realize that too much has been consumed, while not enough has been saved so as to make available enough factors of production that produce those consumer goods. I hope he realizes that in order to accomplish the objectives of economic policy, viz. the maximization of every one’s well being in society, the government needs to do what is possibly can to let the market return to the state that the consumers are asking for in their value preferences and time preferences expressed in the form of interest rates and prices, respectively. We shall examine whether or not his recommendations even remotely accomplish this objective.

Let m be the share of a marginal euro spent on imports — either for an individual county, or for the EU as a whole (I’ll explain in a minute). I’ll assume that m is the same for government spending and for domestic demand. Let c be the marginal propensity to consume. And let t be the share of an increase in GDP that accrues to the government in increased taxes or reduced transfers.

Consider the effects of an increase in government purchases dG. This will raise GDP directly, to the extent that it falls on domestic goods and services, and indirectly, as the rise in GDP induces a rise in consumer spending. We have:

dY = (1-m)dG + (1-m)(1-t)c dY

or dY/dG = (1-m)/[1 - (1-m)(1-t)c]

Without any further analysis or detail Krugman implies that an increase in the nominal GDP is the ultimate objective of economic policy. He doesn’t go into any detail whatsoever. He passes in silence all the flaws that come with this figure and he certainly doesn’t ponder for a second what a true GDP measure should look like.

But all these amateurish shortcomings taken aside, let’s examine what the formula above really tells us. The idea behind the GDP is to approximate the total sum of the prices paid for all consumer goods and factors of production produced inside the country and consumed or used subsequently. The GDP Y is defined as Y = I + C + G + X – M, where
I = Private Investment (purchases of factors of production by domestic non government individuals),
C = Private Consumption (purchases of consumer goods by domestic non government individuals),
G = Government Expenses (purchases of consumer goods and factors of production by domestic government individuals),
X = Exports (purchases of consumer goods and factors of production by foreigners),
M = Imports (purchases of consumer goods and factors of production that were produced abroad)

Now Krugman tries to quantify the effect of additional government purchases dG on Y. dG(1-m) is that portion of government expenses that falls upon domestic consumption by the government. But for some reason he commits the unfortunate blunder of adding to that a mystical (1-m)(1-t)c dY. Where does that come from? He doesn’t even attempt to explain it. He simply assumes that the additional government purchases for some obscure reason also lead to more consumer demand due to an increase of the GDP which is … due to the increase in government expenditure. This is complete utter amateurish kindergarten nonsense.

Krugman is an intelligent person. He must have missed something here. If he wants to figure out whether or not an increase in government expenses leads to an increase in GDP then how can he commit the blunder of assuming an increase of GDP in that very same formula. This is something that not even an elementary class student would get away with. If he wants to apply the questionable GDP formula to calculate the effect of government expenses on the well being of society he should at least do that right.

First of all one has to understand, as most people hopefully do, that dG does not simply grow out of nowhere. Additional dG will have to be funded out of additional taxes. Taxes are funded by taking money from private individuals. If money is taken from private individuals it will either reduce private consumption C or private investment I or both of them by precisely the amount spent. The basic culprit is that Krugman uses variables that are dependent upon each other in the same formula. When one starts calculating derivatives for such a formula one must take that into account. Thus the following calculation is the only correct one:

Y = G + (I + C ) + X – M
<=> dY = dG(1-m) + (dI + dC - dG(1-m)) + dX – dM
<=> dY/dG = 1-m + 0 + 0 – 1 + m + 0 – 0
<=> dY/dG = 1-1
<=> dY/dG = 0

Of course he has to resort to complicated and sophisticated looking mathematic formulas because if he were to explain his hideous theory in words it would break down immediately. Even if we give Krugman the benefit of the doubt, the growth in GDP, if the government spends dG, would be exactly 0. This is the one and only correct way to calculate a change dY/dG if one understands basic elementary school mathematical concepts and if one applies simple logic and reason. Paul Krugman needs to come forward and apologize for his terrible blunder.

Even if an individual were to work and save 50% of his earnings in cash in his matress, he would not inflict the slightest harm upon his fellow men. All he does in working and saving is make available more productive capacity to everyone than he in return withdraws via consumption. By withdrawing his money and saving it for future consumption he steps back and voluntarily leaves factors of production or consumer goods available to others by not participating in the bidding process on the market. The prices for those goods would thus be lower than had he participated, but they still render the same benefit to the consumers. If the government steps in and buys the good in question, it does nothing but snatch it away from someone else and employ it in bureaucratic uses. The Trouble With Bureaucracy explains what will inevitably ensue. No one is helped in this process, only harm is inflicted.

Now, I know that a Keynesian such as Krugman would now object that the additional government expenses would not necessarily have to be funded out of taxes but rather via deficit spending. OK, let’s say the government borrows additional money from one of the participants on the market. Again, this would require that someone who would have loaned the money to someone else now loans it to the government in a credit transaction. The money will thus not be available to that marginal entrepreneur who would have borrowed it. Private investment is reduced while government expenses go up. From the kindergarten GDP formula’s point of view, the effect is 0. To those who understand bureaucracy, the effect is negative.

The diligent pseudo economist, who has meticulously studied all of Keynes’s shallow theories, will then reply: “But since we are approaching 0% interest rates, no one will lend the money, everyone will hoard it. We are in a liquidity trap!” Then we would have to reply that since we are in phase 8 of the business cycle, of course people are hoarding money. The reason being a reckless monetary and fiscal deficit spending policy. And the only way to get out of it is to swiftly abandon that policy and let phase 9, the correction, occur. But even that taken aside, what I said two paragraphs above, applies just as much in this case again. There is no way around this causality, no matter how much one tries to deny it.

Then the Keynesian will reply that the added government expenses could also be funded by having the government print money and buy goods on the market. And of course the response to that would have to be that in that case, money prices for the good purchased with the fiat money will go up and, again, will force the marginal consumer to forgo consumption of that good, while it is re-allocated to the government. The Keynesian would then reply that no one would have purchased the good if the government would not have purchased it. To that we would again have to explain to the Keynesian the basic concepts of he function of a price and that a good will be demanded at a certain price, so long as that price represents the involved parties’ value preferences. If it doesn’t then the seller needs to lower the price until it does.

But even if the price for the good was 0, what good does it do if the government prints money and gives it to someone who in return has produced a good that nobody needed? He will be the first to receive this money and bid up the prices of goods that would then not be available to other marginal consumers who would have bought it in exchange for money earned from useful labor. They will then abandon their operations which the consumers deemed useful and also begin producing that same useless good in order to obtain free money from the government. The business cycle will inevitably ensue.

It is impossible to run away from the fact that government expenses will be wasteful and by necessity lower the people’s standard of living due to the irrefutable workings behind bureaucracy. The crucial shortcoming of applying the GDP formula is the blatant disregard of the fact that the government raises money violently and against the people’s value preferences before offering goods and thus faces the inability to calculate profit and loss.

Since governments are worried about debt, it’s also important to ask how much the budget deficit is increased by an increase in government spending. It’s not one-for-one, because higher spending leads to higher GDP and hence higher tax revenue. We have

dD = dG – tdY

Now he continues with the false assumption that GDP is growing and happily concocts new formulas based on that. He doesn’t put into context the relevance of dD and, I have to assume, does not bother to view it in light of a corresponding reduction of private investment which would necessarily occur as I already pointed out above. He blithely assumes that magically a tdY appears out of nowhere and reduces the deficit. He then takes this flawed formula and incorporates it into his other flawed formula. Everything from hereon is based on sheer nonsense and requires no further comment:

A crucial number is “bang for euro”: the ratio of the increase in GDP to the increase in the deficit. After a bit of grinding, it can be shown to be

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

OK, some numbers. The average EU country spends about 40 percent of GDP on imports, and collects about 40 percent of GDP in taxes. Let me cut corners and assume that the marginal rates are the same as the average, and also assume that the marginal propensity to consume is 0.5. That is, for an average EU country, m = 0.4, t= 0.4, c = 0.5.

We can represent a coordinated fiscal policy by looking at the numbers for the EU as a whole. The only difference is that m falls to 0.13, because two-thirds of the imports of EU members are from other EU members.

And we get the following results:

UNILATERAL FISCAL EXPANSION

Multiplier = 0.73
Bang per euro = 1.03

COORDINATED EXPANSION

Multiplier = 1.18
Bang per euro = 2.23

The bang per euro is what matters: the tradeoff between increased debt and effective stimulus is MUCH better for the EU as a whole than it is for any one country.

You can play with these numbers, but I don’t think that conclusion is very sensitive to the details as long as you keep the large intra-EU trade effects in there. The lesson of this algebra is that there are very large intra-EU externalities in fiscal policy, making coordination really important. And that’s why German obstructionism is such a problem.

Krugman can’t escape the fact that his formula fails from start to finish. It sickens me that thousands of students are probably listening to him and employing his “logic” elsewhere. To anyone who still doubts my criticism, please consider the following: If the bang per Euro of deficit spending is 2.23 Euro, then why don’t we ask all European governments to spend 1,000 quadrillion Euros on deficit. This will create unprecedented wealth in Europe of 2,230 quadrillion. Then the governments can levy a tax of 1,000 quadrillion and pay off the debt. With 1,230 quadrillion Euro, this would leave Europe wealthier than ever before for years and years to come. Welcome to Krugmanland!

Tags: deficit spending, fiscal stimulus, paul krugman

Where Has all the Money Gone?

December 22, 2008 · Posted in Politics · Comment

As I write these lines CNN runs reports on how most of the money from the TARP bill disappeared in the bank’s vaults and banks won’t report on what happened to it. It is obviously clear what happened to it: Genius Ben Bernanke announced in October that the Federal Reserve would pay interest on reserves and excess reserves. Why should a bank lend out money to an overleveraged and overstretched public which already forecloses on one loan after another? Why, especially, should it loan out one dime if it can keep it at the Fed and earn interest income at no risk whatsoever? If anyone of these deplorable fools understood the basic workings of the business cycle, in particular phase 8, they would understand that there is simply no demand for any more credit on the part of the people. Why should there be? People are sick and tired of debt. The nation is broke. People realize that they need to cut back on their consumption and begin saving and producing more.

It shall be duly noted that CNN was the #1 network beating the drums in favor of the bailout scam, asking Congress to do what is “in the nation’s interest”.

Congress and the media are acting surprised about the fact that banks won’t report what happened to the TARP bailout money. They are either fooling the public or have the intellect of a donkey. What do they expect? That within a few days you pass a 450 page bill that provides for a $700 billion bonanza to the most disastrously and unethically managed businesses in decades and everything will run through smoothly and will be accounted for?

Of course Congress will approve the second part of the TARP bailout. They will announce that this time they will do it right and oversee and regulate everything much better than they did with the first half. This bill is a complete disaster but Congress will obviously not admit it. They think that by enhancing oversight and regulation for the second check they will save the bill and make it a successful one in the eyes of the public.

The same problems will arise in a few months and Congress will once again act outraged. After all is said and done and more money is squandered on bonuses to incompetent bankers, we will all look back at a complete utter failure and ask ourselves “How could they approve that?“

Tags: cnn, congress, tarp