Bearish News

Paul Krugman just did a piece defending deficit spending. He argues that while $9t seems like a big number, it’s very manageable as a percent of GDP. In his words:

“Right now, federal debt is about 50% of GDP. So even if we do run these deficits, federal debt as a share of GDP will be substantially less than it was at the end of World War II.”

A chart like this seems to support his case at first:

There are two glaring flaws with Mr. Krugman’s argument, however. The first is that total US debt has increased dramatically, and is far higher than any other time in history. At the end of WWII, consumers didn’t have $50k credit card balances and underwater mortgages worth 20x their annual salary. Companies weren’t nearly as highly leveraged as they remain today.

Is GDP Indicative of a Country’s Ability to Pay off Debt?

Krugman states, “What you have to bear in mind is that the economy — and hence the federal tax base — is enormous, too. Right now GDP is around $14 trillion.” (added 8/24/09 for clarity).

But does GDP really indicate federal tax base? How much does a debtor country’s GDP really say about their financial health? Fifty years ago, GDP included our strong manufacturing base. Today it includes massive government entitlement programs, war, and financial products that provide zero real value to the economy. In 2007 financial services represented 40% of corporate profits in America. Will medicare, social-security, the War on Terror, CDS, and CMBS increase productivity and pay the bills? Hell no.

Examine this chart showing Government Spending as a % of GDP:

The trend is clear. Government spending has steadily increased as a percentage of GDP.  The picture will worsen considerably as baby-boomers retire, putting pressure on Medicare, Social Security, pensions, etc. QE and bailouts have really only just begun.

Inflation seems inevitable with this much debt, and a full pipeline. We’re reflating the bubble temporarily, and if it works, the Fed’s job is to reign in all the money that “saved” us. They won’t, can’t. Those who think we’re going to get out of this mess by cutting expenditures and raising taxes will be proven wrong, I think. See Flaws in the Deflation Case for more on that.

Blasphemy! Jon Najarian of Fast Money would feign condescending laughter and pffffftttt at such ideas (at least that’s how he treated Bill Fleckenstein the other day). His Goldman buddies doubtless advise him to dismiss such nonsense. This recovery is real, didn’t you see Big Ben’s victory speech from Jackson Hole? The guy saved the freaking world, give him some respec’.

I’m reading Murray Rothbard’s America’s Great Depression, which is both fascinating and frightening because of its relevance.  The book argues that loose-money and government tinkering in the 1920′s led to the crash in 1929. Rothbard presents a logical and detailed case, which happens to go against everything our current leaders believe.

The passage below especially struck a chord with me. It describes various attempts to keep the bull-market going 1926-8. This 1928 quote by Treasury Secretary Andrew Mellon sticks out, “There is an abundant supply of easy money which should take care of any contingencies that might arise“. Mellon is often portrayed as a ultra-free-market liquidationist, but only the latter part of that may be accurate. He appears to have intentionally goosed the markets in the 20′s (Rothbard offers a lot of evidence of this) and advocated shoveling cash at problems in ’28.

This section of Rothbard’s book casts doubt on the widespread belief that The Great Depression could have been avoided if government acted more quickly. They were providing liquidity as a crutch long before the crash in 1929. From 1921-1929 there was 7.8% annualized inflation, almost all of it caused by various government interventions. This was exacerbated by creative abuse of reserve requirements, which increased the multiplier effect.

People have been trying to engineer an everlasting bubble for a long time, undeterred by the fact that it has never worked. It reminds me of the the perpetual motion machine. It is 100% physically impossible, yet people keep tinkering away with magnets and ball bearings. The Fed is the same.

Source: America’s Great Depression by Murray N. Rothbard. You can order it online here.
Updated 8/22/2009.

Guest Post by Stefan Karlsson, a Swedish economist who has made some prophetic calls. In 2005 he wrote, “But there is also a darker side to the current boom. It is to a high degree driven by the cheap-money policy of the Federal Reserve.” More articles can be found on his blog and Mises.org.

Economists were shocked by the relatively high U.K. inflation number for July 2009, 1.8%. By comparison inflation is -0.7% in the Euro area and -2.6% in neighboring Ireland. How could price inflation stay that high given the deep slump in the U.K. economy and the dramatic drop in commodity prices from their peak in July 2008 (the base month for this 12 month number)?

Perhaps it could have something to do with, you know, the dramatic depreciation of the U.K. pound. If you look at the individual inflation numbers for European countries, you can see that countries with the euro (or with currency pegged to the euro) have generally much lower inflation than those who have their own freely floating currencies. The exceptions being Switzerland and to a lesser extent the Czech Republic, but that reflects that the Swiss franc and the Czech Koruna has been much stronger than other small floating European currencies.

Some might object that while the pound is down dramatically since July last year, it has stabilized and even appreciated somewhat against the euro since its low late December 2008. But this shows just how these economists are deceived by their “perfect market” models.

Assuming “perfect markets”, prices adjust immediately. A 10% depreciation will immediately raise import prices by 11.1% so that prices are equal in all countries. But in reality, companies are reluctant to change local currency prices too often because they fear it could, for example lead to permanent loss of market share even though the currency fluctuation is only temporary. So as long as they think that the currency fluctuation might be temporary they will not raise prices, even though prices are unsustainably low in the long run. But eventually as the depreciation appears increasingly permanent they will raise prices. Alternatively, if the depreciation proves temporary they will not raise prices, but they will abstain from the price cuts that you would otherwise expect.

What this means is that the inflationary effect of currency depreciation has a lagged effect on price inflation. Meaning that even though the pound hasn’t depreciated any more this year, previous weakness still continues to create upward pressure on prices.

Eventually, the effect of last year’s brutal pound depreciation will pass through entirely, and assuming the pound doesn’t depreciate any more, this will cause relative inflation in the U.K. to fall. But the lagged effects of the previous pound depreciation, just like the lagged effects of the depreciation of the Swedish krona and other weak European currencies, could continue to put upward pressure on prices for many more months.

Visit Stefan Karlsson’s blog here.

[Editorial of the year candidate] Deflation theory is lemon we have been sold – (Bloomberg) Thank you, Matthew Lynn.

“Deflation may be bad for particular interest groups, which happen to be very powerful. It is bad for chief executives. It is easier to keep your profits rising in a mildly inflationary environment. You can just jack up your prices a bit, and you can often cut workers’ wages by stealth by holding wages steady.”

The banking industry, which has come to rely on inflation to make highly leveraged loans sustainable, also dislikes deflation. Likewise, it is bad for governments, which use inflation to reduce the value of their debts.

Will It All Come Tumbling Down? – (Karl Denninger) “This much we know for certain – you’re being screwed – systematically – to cover the sins of these banksters who made loans to people who they had no reason to believe could pay:”

Tim Geithner will Answer Diggers’ Questions – This should be good. One the questions that TTT will have to answer, “Are you, yourself, troubled by the massive amount of government spending? What do you think will happen to the dollar over the next 10 years?”

China reduces US debt holdings by most in 9 years – (BBC) In June, China cut its holdings of US securities by about $25bn, a fall of 3.1%.

Does deflation really cause depressions? – (Minn Fed, PDF) Or does it fix them? Deflation is a natural market reaction to disastrous policies and past binges. Drinking off a hang-over doesn’t work, either. Well, maybe for a bit…

Right before they had 120% inflation.

Prices in Argentina dipped in late 2001, just months before inflation took off. Before it was over, annualized inflation hit 120%. That’s just one of the many interesting points made by Eric Janzen of iTulip.com in this report. Good charts and discussion too.

While noting that America’s situation is somewhat unique, Janzen’s draws some thought-provoking comparisons:

Argentina’s quarterly fiscal deficit threshold before triggering a crisis: 3% of GDP.

Compared to the U.S. projected fiscal deficit of 12.3% in 2009, Argentina’s government spending in 2001 was austere. In March 2009 we projected a worse case U.S. fiscal deficit of 8% in 2009 and 12% in 2010. As usual, we were optimistic.

This is especially relevant with many pointing to recent US deflation as proof that deflation is the only real concern.