The Road: Where we are, How we got here, and Which way to go

(Originally posted on Mises.org:   https://mises.org/wire/current-crisis-has-its-roots-central-bank)

            We have been locked down for weeks.  Classes have been cancelled.  Only essential activities are allowed.  While there is so much to cover and analyze, I want to focus on the economics of the situation.

            To understate it, the situation today is simply not good.  The Covid-19 crisis has caused the world to lock down the population, which essentially ceased most commerce.  While all businesses are affected in some way, a report by the US Chamber of Commerce shows that 24% of businesses are completely unable to conduct business in the emergency state, and further states that 43% of all small businesses are less than six months away (and 10% are less than one month away) from permanently closing their doors.  From their highs in February, the DJIA is down approximately 20% and the Nasdaq is down about 15%.  The initial claims for unemployment insurance since the US Department of Labor’s March 19^th report totals in excess of 22 million people.  A rough calculation places the current US unemployment rate above 17%.  Yes, the situation is not good.

             

How did we get here?

            The obvious answer is that a virus has swept across the globe and caused all of our woes.  While this is the proximate cause of the current recession, it is not the only cause.  In other words, our economic weakness didn’t start in February or March; it has been building for years. 

The most recent recession was over a decade ago.  Here is a quick history beginning with the 2007-08 recession.  In the period that is now called “the housing bubble,” banks bought assets that were backed by mortgages.  These mortgages were driven by politics and an expansionary monetary policy.  People were loaned mortgages that were simply beyond their means.  Eventually reality hit and borrowers started to default on the loans.  As the defaults piled up, the mortgage-backed assets lost value, resulting in the banks’ balance sheets showing that they were in the red.  (The value of their assets fell while their liabilities didn’t, which caused their net equity to plummet and in some cases even turn negative.)  This crisis generated a political response in the form of the Troubled Asset Relief Package (TARP) and the Federal Reserve’s secretive bank bailout was conducted through its facility accounts.

The lesson learned by the banking system was that even though profits are private, losses (if you are too big to fail) could be socialized (i.e., covered by the tax payer).  The consequence of this lesson was to continue to engage in riskier investments on larger margins and make oneself so large in the process that if anything happened, one would be deemed essential and bailed out.

A banking bubble is precisely what has happened since the end of the last recession.  In the years after 2009, the larger banks grew and acquired smaller banks.  Meanwhile the economy grew at an anemic annual rate of 1.6% between 2009 and 2016.

It was against this backdrop that the political winds shifted in 2016.  After Trump was elected, the Congress pushed through a cut in the corporate tax rate (from 35 to 21%).  While this repatriated some overseas profits and stimulated economic growth (averaging 2.5% annual real GDP growth since January 2017), it was not enough to overcome the underlying fragility built up by the previous malinvestments.  Over the summer and fall of 2017, corporate profits began to soften and lose steam.  In nine of the ten quarters since QIII:17, nonfinancial corporate business profit returns fell.  As a result, the value of the banks’ assets softened as well.

At this point, the profits weren’t negative in absolute terms, but they were shrinking from what they were just a year prior.  In other words, the economy was still growing, but it was slowing down.  As profits lessened, we saw y-t-y Real Private Fixed Investment fall from 5.2% in QII:18 to 0.1% in QIV:19. 

Making profits, retaining earnings, and reinvesting these funds into companies is a form of savings.  This fund of savings supports the investments made in the structure of production.  Without these savings, the economy falters.  An alternative way to temporarily prop up investment and consumption (without a firm foundation of savings) is through credit expansion.  However, the problem is that credit expansion creates the malinvestments which we have been building since the end of the previous recession.  At some point, the expansion has to give way to a crunch.  The economy was on the path towards this crunch long before Covid-19 became a reality. 

            Furthermore, a general slowing of the economy also occurred as Real GDP y-t-y growth fell from 3.2% in QII:18 to 2.3% in QIV:19.

With declining profits, a slowdown in investment for future growth, and a slowing economy, the banks’ asset values continued to decline, assets which were highly leveraged.  By law, a large bank must maintain 10% as required reserves.  As the value of the assets depreciated, the banks had to make up that difference to maintain the balance on their balance sheet, resulting in borrowing from other banks.  As we see in the figure below, the short-term rates started to climb in 2015/16, but accelerated their climb in 2017 and 2018.  Part of this climb was due to Federal Reserve monetary tightening, but a large part of it was coming from the banks looking to shore up their crumbling accounts by borrowing funds.

The result of this scramble for funds was a brief semi-inverted yield curve in the summer (June – Sept) 2019.

Today, an inverted yield curve is a financial sign of a forthcoming recession.  As I have shown in my Sept. 5^th article “Inverted Yield Curves, Recessions and You,” a recession was projected to take place between October 2020 and April 2021. 

To counteract and stop the yield curve from fully inverting, the Fed took an unusual step and did something it had not done since October 8^th, 2008.  In September 2019, the Fed injected massive amounts of liquidity into the repo market.  These injections continue today. 

Furthermore, the Fed declared (on March 26^th) that banks no longer needed to maintain a 10% reserve ratio.  The reserve ratio was waived entirely and set to zero.  The combined result of these two actions was intended to make the banks financially sound.  Instead these actions signal an underlying fragility of the fractional reserve system based upon a fiat money.     The bottom line is that, in this crisis, the banks are being bailed out yet again.  What is wrong with the current policy is that by bailing out the banks, they have not learned the correct lesson that investment contains risk.  If these risks are transferred to the taxpayer, the banks will simply continue to build up malinvestments as they get new cash infusions.

The current path is wrong

            Austrian Business Cycle theory explains that for the economy to establish a sound foundation, it must get rid of the malinvestments which have built up in the market.  Simply put, the economy requires a liquidation of the malinvestments.  If there are a lot of malinvestments to be liquidated, then collectively that process is known as a recession.  In an economic downturn, companies go out of business.  This step is unfortunate, painful and sadly necessary.  A person with a cavity needs to see a dentist and have the tooth drilled before a firm foundation can be established.  No one likes to get their teeth drilled, but if they don’t go through the short-term pain, the long-term problems fester and grow. 

            The method of converting from a recession to a recovery is through the liquidation process.  Imagine a store that is unable to sustain itself.  What happens?  It closes, of course, but the story doesn’t end there.  What happens next is the liquidation process, best illustrated through an example.

            Imagine a boutique cupcake shop that has a weekly shortfall of $1,000.  (I am just using $1,000 as an example, the real number would be much larger.)  If the company has a gross margin of 25%, the store would have to sell an additional $4,000 in total sales to make up the shortfall.  If the government is going to stimulate demand by giving money to consumers, then the government would have to give these customers $4,000 per week to prevent the store from closing.  As we can see, demand-side stimulus is expensive.  If, instead, the government cut the store’s taxes by $1,000 per week, it could achieve the same result.  Thus, tax cuts are better policy than demand-side stimulus.

            However, let us suppose that this cupcake company still fails.  The next step is that the bank (and other creditors) foreclose on the shop.  The company has a liquidation sale.  The ovens, tables, chairs, and even the curtains are sold to whomever might purchase them.  The money is allocated to the claimants (creditors and equity holders) in accordance with Chapter 7 of the Federal Bankruptcy Reform Act of 1978.  The claimants are paid according to the absolute priority rule where the common stockholders are the last in line.  (It should come as no surprise that the lawyers always get paid first.)

            Notice that the equipment—the ovens, tables and the chairs—don’t simply disappear.  They are sold to other users.  In these liquidation sales, the buyers are not paying top prices.  In fact, during the economic downturn, prices tend to fall (deflation).  When these new buyers purchase this liquidated capital equipment, they are converting malinvestments into proper investments.  The more flexible the capital is the faster it can be added to other parts of the economy and the quicker the economy can recover.  If, however, the capital equipment is very specific and specialized, then those tools might simply be thrown away and their total value is lost.  To simplify our cupcake store example, suppose that a single buyer purchases the whole store.  Since this buyer has purchased this store for a fraction of the original price, the new owner can make the very same products, sell them at the previously listed prices, but instead of losing $1,000 per week, the store could very well make a profit because its cost structure is much lower.

            In this liquidation process, the banks would lose a part of the value of their loans.  Through these liquidation sales, they will only get a fraction of the value loaned out.  These losses should be made painful to the banks due to their miscalculations.  However, the recent actions taken by the Federal Reserve has protected the banks from these painful lessons.

A new path

            The takeaway points are these: the bubble was caused by massive credit expansion.  The recession was inevitable, and the proximate cause was the forced closures due to Covid-19.  As the economy falls into recession, a continual inflating of the money supply bubble will not create a foundation for future economic growth.  Expanding the money supply will only delay the inevitable and ultimately make the situation even worse.  Furthermore, demand-side stimulus will not produce the “V-shaped” recovery.  Economic growth is generated by saving, investment and capital formation. 

            A three-pronged recipe emerges to quicken a solid and sustainable recovery.   The first ingredient is to build up savings relative to spending.  Savings are the cushion for a falling economy.  It is savings that bidders use to buy the liquidating businesses.  Without buyers of the liquidating capital, the recession cannot be converted into a recovery.  Thus, policies that can quicken a recovery are those that stimulate savings (not spending).

            One troubling point is how little Americans save.  In February 2020, the personal savings rate in the US was 8.2% of disposable personal income.  One of the most prominent features of the CARES Act of 2020 was the personal cash injections directly into people’s accounts.  The argument was that people needed that money to pay for rent, food and other basic necessities.  In contrast, the 2000/2001 tax rebate, as argued by President Bush, was for consumer spending.  In fact, the Bush stimulus was considered a failure because so few people spent the money on consumption.  Unfortunately, neither the 2000/1 nor the 2020 policies help to build up our savings fund.  The better approach is for the government to reverse its spend-and-inflate policies.  The cutting of taxes on activities that defer consumption will ultimately lead us out of the recession more quickly.

The second ingredient is deflation.  Economists have correctly associated deflation with recessions, but they have wrongly concluded that if we avoid deflations, we avoid recessions.  If a deflation is artificially created by a government, then yes, a recession will be the result.  However, deflation is the natural way in which an economy repairs itself.  It does so on two fronts.  The first is through the liquidation process.  In our example, the store had an oven.  Suppose that it was originally purchased at a price of $5,000.  If the new buyer spends $3,000 to acquire it, he has $2,000 which he could allocate to other factors of production.  Thus, as capital equipment prices fall, it becomes easier for new entrepreneurs to get started in the recovery process.  The second way in which deflation is beneficial is for the consumers.  As prices fall, their purchasing power grows.  This increase in purchasing power is especially important for those who are now unemployed.  If the weekly grocery budget was $300 per week, now the same amount of food can be purchased for less.

            The third ingredient is anything that can expedite the liquidation process.  Laws should be reformed to make the bankruptcy process easier.  Additionally, mergers and acquisitions should also be made easier. 

            During this crisis, it is unfortunate that many people are using this opportunity so advocate for socialism, nationalization, and the adoption of modern monetary policy.  Every time socialism has been tried, it has failed to produce enough wealth for its people.  The nationalization of industries have failed because bureaucracies simply cannot engage in economic calculation.  And while modern monetary theory may seem new and novel, it is nothing more than the repackaging of the ideas of the “monetary-cranks” of the nineteenth century.  It is now more critical than ever to return to what we know works—free markets.  History shows us time and time again that free markets generate sustained economic growth.  Adam Smith found the formula as early as 1755.

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

It is not a coincidence that when nations liberalized trade and opened markets, there was an explosion of wealth for all—the rich, the poor and everyone in between.  This simple insight set off an upsurge of growth that has had a greater impact on humanity than any virus, natural disaster, or war.  It is time to simply let individuals be free.

Business Cycle Talk at Furman University by Cwik

Recently, I had the pleasure to give a talk at Furman University to the group, "Conservative Students for a Better Tomorrow."  The talk was, "It Didn't Have to Be This Way: From the Great Depression to Financial Meltdown."

There were about 70 students in attendance and several sat without chairs.  I commend the group for gathering so many students to listen to an economics lecture on the night that competed with the first Presidential Debate.

As you can see, they are a good looking group...

Additionally, the lecture was recorded.  It was split into two parts.  Here is Part 1...

Here is Part 2...

Again, I want to thank Furman University and the student group, Conservative Students for a Better Tomorrow, for their hospitality.

Moore Nonsense on Taking and Giving

To start the new year, I have been receiving free movie channels through a promotion.  On one of them, Michael Moore's movie, "Capitalism: A Love Story" came on.  Since there is no way that I'd ever pay to watch one of his movies, free was about the right price.  I soon discovered that even free was too much.

Either the first or second sentence out of Moore's mouth was this, "[Capitalism] is a system of taking and giving."  It is mind-numbing how completely wrong this is.  Capitalism, or rather the free market, is a system of giving and giving.

Suppose you go to the store because you want to buy a snack for a dollar.  In order for you to give up the dollar, which do you have to value more: the snack or the dollar?  The answer is the snack.  In order for a trade to occur, what does the guy behind the counter have to value more: the snack or the dollar?  His answer has to be the dollar.  If both sides of the exchange value the dollar more, there would be no trade.  Also if both sides value the snack more, again there would be no trade.  We trade because each side values what they gain more than what they are giving.  Trade requires unequal valuations.  Since value is in the eye of the beholder, meeting this requirement is not difficult.

When we trade both sides say, "Thank You" because both sides are giving and benefiting. 

A system where one side gives while the other side takes also has a name: it is called stealing.  It is a system where one side has no choice in the matter while the other side has all the power.  An example of this relationship is the one between the individual and the state.  The individual must give whenever the state decides to take.  Try not paying your taxes and see what happens. 

The relationship of giving and taking is between unequal parties.  The relationship between giving and giving is necessarily between equals, since both sides can walk away from the trade at any time.  The ability to refuse and say, "No" is the most fundamental power that an individual has in expressing one's individuality.

In his movie, it's clear that Michael Moore thinks that we were harmed by the national bail-outs of the large banks and corporations.  I completely agree that this was a disgrace and that it never should have happened.  These banks and corporations should have been left to fail.  However, the bail-outs weren't market phenomena, rather they were the actions of the state repeatedly intervening in the economy.  The government took tax money and gave it to these institutions. 

Furthermore, the underlying cause of the economic crisis wasn't too little government, it was that there was too much.  The free market has a system of natural checks and balances that prevent massive business cycles.  It is when the government disrupts this system, that bubbles form and burst.  Those that cannot see the past the immediate and are unable to look at deeper causes blame "capitalism" in a knee-jerk reaction. 

Michael Moore's movie was just that—a classic case of haphazard economics and laziness.  He could learn much from Henry Hazlitt's single lesson:

[T]he whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence.  The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Recessions and Recoveries

Two weeks ago the National Bureau for Economic Research (NBER) announced that we are out of the recession and have been since June 2009.  So, how does this recession compare to previous recessions?

The earliest date that the NBER uses is 1854.  The average length of a U.S. recession between 1854 and 2010 is 17 months.  If one uses post-WWII data, the average length of a business contraction is 10 months.

If we compare the current recession, which started in December 2007, with that of previous recessions, we see that the duration is longer than either average.  Now that the NBER says we hit bottom in June 2009, we have had 19 official months of recession.

We are now entering the 34th month since the beginning of the recession and many are questioning whether we have truly hit bottom.  While I believe that we have stopped falling, I think that the so-called recovery has started yet.  In fact, there are signs that the recovery is still far off.  For example, private investors are unwilling to make a move until they have a clearer understanding of the government's next regulatory moves.  This situation precisely mirrors investors' sentiments in the 1930s.

The Bush administration reigned over the first 14 months of this recession.  By historical averages, we should have been recovering by inauguration.  What does this tell us?  It says very clearly that the Bush administration made the wrong move by bailing out banks and propping up failing businesses.

It  is now more than 20 months since the Bush administration has left office, and the current government has also done much to hamper any prospect of recovery.  The Obama administration has not unleashed the economy (and reverse the Bush agenda), but instead, it has further shackled it.  By supporting TARP and the Bush bank bail outs and adding to the situation the GM bail out, the ineffective stimulus package, a new health care burden and more financial regulation, the Obama administration has set us on a path towards economic stagnation.  The looming fear is whether the stagnation will be coupled with Jimmy Carter style inflation.

It is time to recognize that taxing, spending and regulating are not the instruments for economic recovery. Money creation, artificially lower interest rates and government accumulation of debt are sending us down the wrong road.

Governments at all levels are stalling the recovery and it seems that no one trusts the market enough to let it do its job.

Perhaps we should listen to our 30th President Calvin Coolidge:

“The people cannot look to legislation generally for success. Industry, thrift, character, are not conferred by act or resolve. Government cannot relieve from toil. It can provide no substitute for the rewards of service. It can, of course, care for the defective and recognize distinguished merit. The normal must care for themselves. Self-government means self-support.”

Twist and Shout

On March 18th, the Federal Reserve announced it will keep the Fed Funds rate between 0 and 0.25%, buy $750 billion in mortgage backed securities, and buy $100 billion in agency debt. While injecting $850 billion into the economy is problematic, the almost unnoticed announcement is that the Fed plans to buy $300 billion in long-term Treasury securities.

The last time the government tried to manipulate long-term interest rates was in 1961, during the Kennedy Administration. The goal of a project called “Operation Twist” was to flatten the yield curve by raising short-term rates while maintaining long-term rates. Legislators thought that higher short-term rates would reduce the flow of capital from the US, while lower long-term rates would encourage domestic investment. Operation Twist was a disaster because the result was the opposite of what the Fed intended.

Unfortunately, our economy is in a recession – the downside of the business cycle. The business cycle works something like the following. Suppose that a student is assigned a research paper that is due tomorrow at 8am. Since the student hasn’t started the paper, she is in for a long night. By 11pm, the student is getting tired but hasn’t finished the paper. What does the student do? Quite naturally, she reaches for some coffee, a sugary soda, or whatever else that has a lot of caffeine. The jolt of caffeine gets her moving again; but, around 3am, she’s slowing down. What does she do? Grab more caffeine! However, now to get the same jolt, she needs a bigger dose. Each artificial jolt cannot last, and the next jolt requires an even larger dose. Eventually, 8am arrives and the student hands in the paper. Then, she crashes! A long sleep is necessary to flush the junk out of her system and restore her to a normal state.

Our economy has been on an artificial all-nighter for the past several years. It is now time to clear the “junk” out of the system. The junk that needs to be cleared out consists of malinvestments, which were built up during the artificial boom of the last several years of expansionist monetary policy. Now, the time has come to hand in the paper and flush these malinvestments from our economy.

The only way that we can get back to a solid foundation for economic growth is by increasing saving. Savings provide the wherewithal for investment. Investment allows for capital accumulation. Capital includes better tools, better machines, and better equipment, which are necessary for workers to become more productive and raise the standard of living. This is the “Magic Formula” for economic growth; but it’s really not magic. The formula has been known and followed since the beginning of the 1800s. Following this magic formula transformed the US from a bunch of backwater colonies into the largest economy in history.

The opposite approach, the one we are currently taking, is to encourage consumption, except that method doesn’t work. We cannot consume our way to prosperity. A basic tenant of economics is that our wants and desires are unlimited; however, supply is the limiting factor. Stimulating demand alone will not increase the amount of stuff that is being produced.

Furthermore, the Fed is engaging in a policy that allows the entrepreneurs who malinvested capital to persist unnaturally. Unfortunately, those businesses must fail for the economy to recover. When they go out of business, other entrepreneurs can buy their assets for pennies on the dollar. This process allows new firms to use those very same resources (and perhaps the very same employees) with a much lower cost structure. Lower costs are good for firms and very good for consumers, especially those without jobs.

The Fed policy is propping up failing firms while attempting to keep prices high. This policy is backwards. The Fed’s action of pumping money into the economy today will force prices to be much, much higher in the future. The last thing those who have lost their jobs or suffered wage cuts need is for prices to remain high.

Every delay in the painful liquidation phase of the business cycle makes the future reckoning worse. It’s like not going to the dentist when you have a cavity. The drilling will be bad, but if we let it fester, it will become much worse.

We need to shout to the Fed, “Stop drinking those heavily caffeinated, sugary sodas! Stop flooding the market with all of this artificial credit! And let the economy wash out the malinvestments!” Perhaps the song “Twist and Shout” will always be in style; unfortunately Operation Twist is a policy that should have remained in the past.

Stop! In the name of the LAW!

Ask any lawyer or police officer and they will tell you that ignorance of the law will not get you off the hook. The same is true when it comes to economic laws and their consequences. Regardless of the intentions behind the legislation, the consequences of economic policies have impacts that follow economic laws.

Today’s government’s strategy is to try to stimulate the economy by increasing aggregate demand by spending more than three-quarters of a trillion dollars on anything and everything. To help put this into perspective, the stimulus package, all by itself, would be the 15th largest economy in the world. So we need to ask, “Where is all of this money going to come from?”

Governments, all governments, have only three options open to them when it comes to raising money: taxation, borrowing, and money creation. Each method not only counteracts the intention of the spending (sustained economic growth), but creates a situation that is ultimately economically worse.

It does not matter whether the law places a new tax on either the consumers or the producers; the burden of the tax is identical. The side that is less price-sensitive will end up carrying the heavier burden of the tax. Furthermore, taxes create what economists call dead-weight losses. These are burdens to all of society because some buyers are willing to buy and some sellers are willing to sell, but because the tax has increased the selling price and lowered the revenue from the sale, they walk away from the exchange undone and frustrated. The bottom line when it comes to taxes is this, it takes before it gives. If the government is hoping that its spending will create “economic stimulus,” it must first take away that economic energy out of the economy if it taxes. The net result is a wealth transfer, but not sustainable economic growth.

The second method of borrowing the money to pay for the spending package has a similar result. The government is not constrained by market forces when it comes to offering interest rates on their securities. Thus to get people to borrow from it, it can keep raising interest rates in order to get the saved dollars. When the government behaves this way, it “Crowds Out” private sector investment. Investors are looking to put their money into a vehicle that will give them a strong return. When the government starts bidding up interest rates, private companies cannot compete and they end up going without. The best possible effect of this crowding-out is a simple wealth transfer, but this is not really the case. The market is looking to put dollars into areas that send resources to their highest valued uses. However, the government does not spend money according to market signals, and as a result, it spends money in areas that do not have the highest valued uses. The net result is that instead of recovery, the economy slows further.

The third method financing the spending is through money creation. Where does the Federal Reserve get this money from? The answer is nowhere. Money is literally created out of nothingness. When this new money is put into the economy it has several effects. The first is that it changes the relationship between debtors and creditors in favor of the debtors. The second implication is that it adds static to the price signal that entrepreneurs follow. Suppose that you are an entrepreneur and you see the prices of your goods are rising by 5%. Is this because there is an increased demand for your goods? Or is it because of inflation? Or is it some combination between the two? What could that ratio be? It makes the already difficult job of the entrepreneur that much harder, thus slowing down the economy.

The most insidious implication that results from monetary expansion is the wealth transfer that occurs. Money is not neutral. When people think of inflation, they think of a price level rising. They think of the water level rising evenly across the surface of a pool. This thinking is, unfortunately, completely wrong. Money affects prices in ways that has real effects on prices and wealth.

Money is never injected into an economy equally across the entire economy. It is injected at specific points. Some people and businesses get the new money first. When they get this new money, they use it. They purchase consumer goods and services and make investments. By making these transactions, they are applying upward pressures to the prices of the items they are buying. They are literally out bidding others to attract goods and services to themselves. The specific pattern of which prices rise and by how much completely depends on who gets the new money first and what their tastes and preferences happen to be at that moment.

There is another group who are witnessing the prices rising, but they have not yet received the new money; it has not filtered to them. An example is those on fixed-incomes. As they see prices rise, their real wealth falls because their incomes have not changed. Thus, there is a real wealth transfer from those that get the new money last to those that get the new money first. The people whose real wealth is declining use their savings to maintain themselves during a recession. Savings are the key to economic growth and recovery, and inflation causes it to dry up. The result is that the economy moves two steps backwards.

Who are the people and businesses that are getting the bail-outs and the government spending? It is those companies that are inefficient and losing money. We are transferring wealth from the healthy part of the economy to the part that is inefficient and needs to be liquidated.

To all of these misguided economic policies, we need to say, “Stop! In the name of the LAW!”