Is Austerity a “Recipe for Disaster”?

December 26, 2010 · Posted in General Economics · 5 Comments

Let’s say you are stranded on an island for a week and you climb trees every day to pick up and eat coconuts, and also set aside one coconut a day.

Then over the course of the next week you don’t climb trees at all and just eat 7 out of 7 coconuts that you have stored up.

So the next week you have none left. So now you need to do with fewer coconuts during that week (=austerity) and climb some trees again (=work) to get some more.

Is it a recipe for disaster for that week to have no coconuts left to consume? Maybe it is. But the question is meaningless …

Is there anything you can do about it other than consume less and work more (= generate savings) again?

When you jump off a cliff, is the existence of gravity a recipe for disaster? Sure it is. Is there anything else you can do other than take the fall?

When you are shot in the foot and the infection is about to creep up your leg, is that a recipe for disaster? You bet it is. Is there an option to keep your leg without amputating the foot?

Unfortunately, in any of those cases, you’re SOL, my friend … and you need to accept reality in case you care to try and make the best of it.

The good news is … falling off a cliff is a lot worse than restoring discipline and prudence in your financial dealings. =)

Tags: austerity, savings

The Great Credit Contraction & Deflation

July 12, 2009 · Posted in General Economics · Comment

Lew Rockwell posted a piece by Bill Bonner which strongly supports the deflationist view:

“In a fundamental shift, consumers are saving rather than spending,” notes the Los Angeles Times.

This is the shift we’ve been talking about for months. The great credit expansion of 1945–2007 is over. Now cometh the great credit contraction.

During the bubble years, more and more credit produced less and less real prosperity. It was as if you were borrowing more and more, to invest in your business or merely to increase your standard of living, but your income didn’t rise fast enough to keep up with the interest payments.

In 2005, Americans saved nothing. Not even aluminum foil or string. Now, the savings rate is approaching 5% of disposable income – a big turnaround.

We know from logic and experience that saving money – not spending it – is the key to getting wealthier. Saving money gives you capital. And it’s capital accumulation – in the form of factories, roads, ships, buildings, machines…and raw savings – that gives people the ability to produce more. It may take a man with a shovel a whole day to dig a decent grave. Give him capital – in the form of a backhoe – and he can bury everyone in town. That’s why capitalism works. It rewards the fellow who saves his money.

Yet every yahoo economist in the year of our Lord 2009 takes news of rising savings rates like the death of Michael Jackson. If households don’t consume, they reason, how can a consumer economy grow?

The problem is that you can’t really grow an economy by borrowing and spending.

Recent history proves it. Despite the biggest splurge of borrowing and spending in history, the US consumer economy barely grew at all.

“In the five years to December 2007,” reports Grant’s Interest Rate Observer, “America’s credit market debt climbed by nearly 57%, to $18 trillion. However, in the same half-decade, nominal GDP was up by only $3.3 trillion.”

For every five dollars people borrowed, they only increased their incomes by $1. Imagine that the borrowing had an average effective interest rate of 10% (credit card debt can be much more expensive). At that rate half of the additional income earned between 2002 and 2007 had to be used just to pay the interest.

“Companies, households and banks all want to pay down debt and…prefer to hold cash rather than assets, partly because the outlook for those assets is poor and partly because after a decade of excess, everyone now looks a bit over-extended.

“This is exactly what happened in Japan during its lost decade, when a balance sheet recession, one characterized by the paying down of debt and liquidations of assets, was self-reinforcing and very difficult to stem.”

And now this from David Rosenberg:

“The ultimate question is where all this cash is going to be deployed, and we believe it will ultimately be diverted toward debt repayment.”

Let’s see. We can figure this out from the numbers above. American consumers must have added about $7 trillion in extra debt during the Bubble Epoque, 2002–2007. Now, instead of buying things, they use their money to pay it down. The average household has about $43,000 worth of income. Let’s keep the math simple by saying there are 100 million households in the United States…and that they save 5% of their income. And let’s say they use every penny of savings to pay down debt. Hey…it will only take about 30 years to pay it off! Get ready for a long, long slump.

Yesterday, stocks went nowhere. Oil went nowhere. And the dollar went down as gold went up.

The reason for the dollar’s decline and gold’s rise was given in the front-page headline of yesterday’s Financial Times. China launched a “new dig” at the dollar, it says. As near as we could tell, China merely stated the obvious – that the world is going to have to find a better monetary system. The US dollar won’t be king of the hill forever. And China, which is up to its neck in dollars, would like to find a solution sooner rather than later – that is, before the dollar goes the way of all paper.

The dollar will eventually give way to inflation and devaluation, but probably not soon.

“I’m absolutely worried about inflation,” says John B. Taylor.

But it is not inflation that worries us…it’s the lack of it. Making a long story short, as long as the feds see no inflation they will continue trying to create it. In the end, they will get more than they wanted.

Though, right now, instead of inflation, we have deflation. Yesterday’s New York Times tells us that deflation in Ireland has reached 5.4% – the highest since the Great Depression of the ’30s.

You know the reasons for deflation as well as we do. The world suddenly has too many people who borrowed too much money to buy too many things they really didn’t need and really couldn’t afford. This caused the world’s producers to greatly over-estimate the “real” demand. Their customers began to disappear in 2007. Their factories are still standing.

I may add: Who says that Americans will only want to pay down the recently amassed $7 trillion in debt during this downturn. As I explained in Inflation & Deflation Revisited, the total debt load in the US is at around $60 trillion, if one includes unfunded government obligations it is more like $120 trillion. That is not to say that all that debt needs to be paid off as part of this contraction, but it is reasonable to assume that a more significant portion will have to be paid. On the other hand, his estimate of an ongoing saving rate of 5% is a bit too low.I believe US households will be saving a lot more in the decades to come, more like 10% which is a historical average.

But in general this piece is consistent with what I wrote a while ago in Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

And how much less we will have to consume to support such level of savings I explained in True Consumption as Percentage of GDP:

…the red line is the average over the past decades to which we will have to return during this contraction, maybe consumption will go even lower since corrections always undershoot regular levels.

Tags: credit contraction, credit crunch, household debt, personal saving rate, savings

US Saving Rate Highest in 16 Years

June 26, 2009 · Posted in General Economics · Comment

The US Personal Saving Rate just hit 6.9%:

The last time it was higher was in December 1993:

Savings are crucial to economic progress and prosperity. For the first time in decades Americans have realized this and are turning the tide. This is in line with ongoing Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving.

Tags: personal saving rate, savings

The End of Consumerism

March 1, 2009 · Posted in General Economics · Comment

In a free society where individuals are allowed to make choices by themselves so long as they don’t infringe upon their fellow men’s life, health, and property, entrepreneurs use natural resources, transform them and/or combine them with previously produced factors of production, and turn them into either consumer goods or other factors of production. They employ workers in the process who provide the production factor labor.

They exchange consumer goods on the market against money obtained from consumers. They exchange factors of production against money obtained from other entrepreneurs.

Factors of production, once completed at some point in the future, enable entrepreneurs to produce more consumer goods during the same amount of time. But while factors of production are being built, workers and natural resources are being used in processes that don’t turn out any consumer goods. It is thus necessary to only employ workers and resources in the production and maintenance of factors of production to the extent that during this process individuals in society are willing to not consume the full output of their labor, and hence generate savings.

On top of that, it is necessary to maintain the existing stock of productive factors, lest their wear and tear cause a decline in the output of consumer products. Thus a continuous level of savings needs to be maintained by individuals in society.

Interest rates on the market give entrepreneurs an indication of the market participants’ time preference, meaning how much immediate consumption people are willing to forgo in exchange for the prospect of more future consumption. In other words, interest rates give an indication as to how much people are ready to save and thus contribute to the maintenance and new developments of factors of production.

If the the government pursues a policy of business credit expansion, the interest rate indicator is manipulated by force, as opposed to voluntary individual time preferences. The interest rate drops below the level that represents those actual preferences. If mostly consumer loans are pushed, the consumption business cycle ensues:

The Consumption Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of consumption. Examples would be car loans and home loans which made the US economy align its productive factors accordingly over the past decades. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some individuals may now enter into these new credit transactions and use the new money to consume goods that they wouldn’t have consumed before. But they didn’t do so by reducing their savings, nor did anybody else sacrifice consumption to make this money available. It was created out of nothing. No additional consumer goods have been produced.

The prices for the goods demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some additional factors of production and turn out more consumer goods instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up. Fractional reserve banks will begin to earn more interest revenue and expand their operations and resource usage.

Businesses that produce consumer goods will report higher profits, while profits for businesses producing factors of production and basic materials will lag behind. A myriad of consumer goods based businesses will spring up over time. The alignment for immediate consumption vs. more/better future consumption continues so long as individuals continue to be able to pay interest on the credit transactions performed and expect to be able to do so in future.

But as explained above, making interest payments and paying off debt is only possible in the long run if the workforce, as a whole over time, becomes more productive per unit of labor. But the opposite occurs. Productivity per labor unit will be lower than the additional consumer loans appeared to indicate, since in an unhampered system credit can only come out of savings (which means someone somewhere forgoes immediate consumption, making room for more factors of production). After a certain period, the amount of debt and interest payments will become higher than consumers can afford. In addition, due to lower interest rates, a lot of rather risky loans were made to individuals that would not have occurred in the unhampered state. Individuals will begin to default on their interest payments.

They start realizing that they need to consume less and save more in order to not have this happen again. Their demand for additional credit drops sharply. Their demand for money to pay off the debt and/or generate savings rises.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing consumer debt.

As excess consumption comes to a halt consumer prices begin to fall, businesses aligned for the production of consumer goods will see declining profits, some will start reporting losses. They realize that they will have to abandon some projects since the demand for consumer goods starts to fall back to sustainable levels that match everyone’s time preference and expectations. The desire to consolidate one’s finances takes priority over everything else.

This is what is currently happening in the United States. The end of consumerism really means the end of capital consumption. It means that people realize that they need to save more and consume less, so as to provide for economic progress and more efficiency in the future, and to restore balance to the economy as a whole. It means that people have understood that too much of the existing capital stock has been consumed and has deteriorated.

This is the causality that the majority of pundits and economics professors that one can hear talk every evening on the news simply don’t understand. All their theories and policies are ignoring this one crucial fact: That Americans are done consuming for the foreseeable future. The end of consumerism isn’t just a temporary ditch. It is here and now and it won’t go a way for a long long time. It is a once in a lifetime occurrence. This is why it is so hard to grasp and to accept. But it is very simple to understand when one approaches it with sane common sense. How many more Starbucks branches do we need in the streets of New York? How many more gas guzzling cars should each family posess? Three, four, ten …? How many more different brands of detergents, shampoos, toothpastes, and consumer electronics products do we really need?

Now, it is important that the reader doesn’t get this wrong. I do not oppose consumption. In fact, the entire material wealth of a person is ultimately determined by how much he can consume. Consumption, present or future, is what all humans ultimately work for. But if, in an environment of government induced credit expansion, people consume more than is sustainable in the long run so long as the music still plays, they need to cut back for a certain period once the music stops playing. If we had never embarked on the disastrous path of credit expansion and government intervention, if all factors of production were allocated as efficiently and effectively as possible, if the government had confined its scope to the protection of each individual’s life, health, and property, we would today be able to consume a lot more than we currently can.

Unfortunately this is not the situation we are in here and now. We do not live in a perfect free world. We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

Tags: Add new tag, business cycle, consumer spending, credit expansion, savings

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

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

Listen to Peter Schiff

November 30, 2008 · Posted in General Economics · Comment

Below please find some clips that show why one should listen to Austrian economists such as Peter Schiff, and why one should turn off the TV when he sees any of the mainstream pundits talk:

August 2006:

December 2006:

2006-2007 Compilation

Now watch Peter on a recent clip from September 2008. The guy who is trying to debate him utterly resembles the boneheads from the two clips above, doesn’t he?

Tags: consumer debt, housing market, peter schiff, savings