Friday, January 02, 2009

The Coming Economic Mess

Last weekend's Wall Street Journal carried a brief but potent piece by Peter Schiff, President of Euro Pacific Capital, entitled "There's No Pain-Free Cure for Recession."

Schiff, a self-identified member of the Austrian school of economics, casts new doubt on the vaunted coming $1T stimulus package later this month. Reminding us of the common sense of cutting spending and cleaning out weak businesses in the periodic recession that grips all economies, he begins his editorial,

"As recession fears cause the nation to embrace greater state control of the economy and unimaginable federal deficits, one searches in vain for debate worthy of the moment. Where there should be an historic clash of ideas, there is only blind resignation and an amorphous queasiness that we are simply sweeping the slouching beast under the rug.

With faith in the free markets now taking a back seat to fear and expediency, nearly the entire political spectrum agrees that the federal government must spend whatever amount is necessary to stabilize the housing market, bail out financial firms, liquefy the credit markets, create jobs and make the recession as shallow and brief as possible. The few who maintain free-market views have been largely marginalized.

Taking the theories of economist John Maynard Keynes as gospel, our most highly respected contemporary economists imagine a complex world in which economics at the personal, corporate and municipal levels are governed by laws far different from those in effect at the national level.

Individuals, companies or cities with heavy debt and shrinking revenues instinctively know that they must reduce spending, tighten their belts, pay down debt and live within their means. But it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system. In their view, absent the stimuli of the New Deal and World War II, the Depression would never have ended.

On a gut level, we have a hard time with this concept. There is a vague sense of smoke and mirrors, of something being magically created out of nothing. But economics, we are told, is complicated."

Allowing for Schiff's sarcasm, he has a valid point. It's interesting to see Keynesian economics brought back to reality by exposing its central flaws so directly.

Schiff continues,

"It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid. However, this is precisely what we are planning on a national level.

I believe these ideas hold sway largely because they promise happy, pain-free solutions. They are the economic equivalent of miracle weight-loss programs that require no dieting or exercise. The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice.

Governments cannot create but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn't have a surplus, then it must come from taxes. If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing."

This is really the crux of the matter in the modern global economy. Individuals must borrow capital they do not have, in order to use it. Nations either borrow, tax, or devalue their currency and create inflation. There is no other 'out.' Congress can't simply create a new way of financing the coming huge spending programs. It must choose one of these three, two of which require national belt-tightening elsewhere, in time or sector, if the spending is to go forward.

Schiff concludes by observing,

"By borrowing more than it can ever pay back, the government will guarantee higher inflation for years to come, thereby diminishing the value of all that Americans have saved and acquired. For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation.

The good news is that economics is not all that complicated. The bad news is that our economy is broken and there is nothing the government can do to fix it. However, the free market does have a cure: it's called a recession, and it's not fun, easy or quick. But if we put our faith in the power of government to make the pain go away, we will live with the consequences for generations."

I agree wholeheartedly with Schiff. As I noted in the linked post above to my last piece on Samuelson's accelerator-multiplier theory, all economies must cycle through recessions. It's a mathematical certainty stemming from the natural consequences of varying economic growth rates.

Instead of letting a normal recession clean out bad business models, reallocate resources to their most efficient usage, and let risk be taken sensibly, we are, instead, embarking on the lunacy of Federal investment by fiat of printed money.

Reading Schiff's piece, I think my experiences with the Nixon-Carter era stagflation is, sadly, going to be useful soon.

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