Reports of the economy’s demise are premature, but not by much.

Russ Douthat’s column in the NY Ties today points out a few problems with the left’s gloating about winning the election. I apologize for my pessimism but I can’t help looking at the facts beneath the surface.

The re-election of Barack Obama has ended the possibility of a serious effort to deal with out of control spending and debt in this country. The “fiscal cliff” is coming soon and there is speculation that one side or the other will “cave” in negotiations. It doesn’t really matter as no serious proposal is under consideration. The tax rates on the top 2% of incomes don’t matter. It’s not worth the trouble for Republicans to defend these tax rates for a group that may not even vote for them.

The whole world cartel of spending is coming to an end and it may not just involve national bankruptcy. It may be the end of an era, maybe of democracy which seems to be incapable of managing debt. An article in Der Spiegel sounds to me like a prediction of the future.

In the midst of this confusing crisis, which has already lasted more than five years, former German Chancellor Helmut Schmidt addressed the question of who had “gotten almost the entire world into so much trouble.” The longer the search for answers lasted, the more disconcerting the questions arising from the answers became. Is it possible that we are not experiencing a crisis, but rather a transformation of our economic system that feels like an unending crisis, and that waiting for it to end is hopeless? Is it possible that we are waiting for the world to conform to our worldview once again, but that it would be smarter to adjust our worldview to conform to the world? Is it possible that financial markets will never become servants of the markets for goods again? Is it possible that Western countries can no longer get rid of their debt, because democracies can’t manage money? And is it possible that even Helmut Schmidt ought to be saying to himself: I too am responsible for getting the world into a fix?

The answer will not be pleasant to consider. We may have run the course on modern national financial competence. Japan, twenty years ago, was a warning we did not heed. Stimulus, as in spending billions on infrastructure, did not work. Japan had a real estate bubble and the response was to try to reflate the bubble. It failed.

Until 1971, gold was the benchmark of the US dollar, with one ounce of pure gold corresponding to $35, and the dollar was the fixed benchmark of all Western currencies. But when the United States began to need more and more dollars for the Vietnam War, and the global economy grew so quickly that using gold as a benchmark became a constraint, countries abandoned the system of fixed exchange rates. A new phase of the global economy began, and two processes were set in motion: the liberation of the financial markets from limited money supplies, which was mostly beneficial; and the liberation of countries from limited revenues, which was mostly detrimental. This money bubble continued to inflate for four decades, as central banks were able to create money out of thin air, banks were able to provide seemingly unlimited credit, and consumers and governments were able to go into debt without restraint.

This continued until the biggest credit bubble in history began to burst: first in the United States, because banks had bundled the mortgages of millions of Americans, whose only asset was a house bought on credit, into worthless securities; then around the globe, because banks had foisted these securities onto customers in many countries; and, finally, when these banks began to totter, debt-ridden countries turned private debt into public debt until they too began to totter, and could only borrow money from banks at even higher interest rates than before.

Ronald Reagan adopted the economics of the tax cut to “starve the beast.” This was supply side economics but also had the intention of cutting spending as the revenues available shrank. It didn’t work although the theory worked insofar as tax revenue increased.

The three supply-side pillars follow from this premise. On the question of tax policy, supply-siders argue for lower marginal tax rates. In regard to a lower marginal income tax, supply-siders believe that lower rates will induce workers to prefer work over leisure (at the margin). In regard to lower capital-gains tax rates, they believe that lower rates induce investors to deploy capital productively. At certain rates, a supply-sider would even argue that the government would not lose total tax revenue because lower rates would be more than offset by a higher tax revenue base – due to greater employment and productivity.

One large problem was that spending did not stay level. It increased, as well. Some of this was Reagan’s increase in the military, which eventually led to the collapse of the Soviet Union. The rest was the result of the domestic agenda of the Democratic Party, which ruled Congress during the Reagan era. Helmut Schmidt, Germany’s finance minister and later Chancellor, shared much of the political ideology of the US Democratic Party. He was a force behind the European Union and the Euro.

Schmidt, as Germany’s finance minister in the 1970s, set the debt spiral in motion and fueled the illusion in Germany that countries could go into debt, and that this was good for everyone.

When Schmidt’s predecessor, Karl Schiller, resigned from the government in protest over 4 billion deutsche marks in new debt, he said: “I am not willing to support a policy that creates the impression, to outsiders, that the government pursues the motto: After us comes the deluge.”

Schmidt incurred 10 billion deutsche marks in new debt. Inspired by crisis economist John Maynard Keynes, the German government believed that economic stimulus programs would stimulate growth, but only under the condition that the debt was to be brought down again in better times.

This economic policy was known in Germany as “global regulation.” As finance minister, and later as chancellor, Schmidt took advantage of the oil crisis to drive up the government deficit with economic stimulus programs. When Schmidt stepped down in 1982, annual government spending tripled in comparison to spending in 1970, reaching the equivalent of €126 billion ($161 billion), and the public debt increased fivefold, to €313 billion. By today, the combined debt of federal, state and local governments has climbed to more than €2 trillion.

Germany, which has a strong economy compared to the rest of Europe, still faces serious debt problems but they are much less critical than those faced by the US which is ignoring them.

From today’s perspective — leaving aside all the effusive rhetoric about Europe — the introduction of the euro is nothing but the continuation of debt mania with more audacious methods. The euro countries took advantage of the favorable interest rates offered by the common currency to get into even more debt.

Can all of this be blamed on some sort of human debt gene? Is it wastefulness, stupidity or an error in the system? There are two views on how the government should use its budgets to influence the economy: the theory of demand, established by Keynes, advocates creating debt-financed government demand, which in turn generates private demand and produces government revenues. In other words, building a road provides construction workers with wages. They pay taxes, and they also use their wages to buy furniture, which in turn provides furniture makers with income, and so on.

The other view, supply-side economics, is based on the assumption that economic growth is determined by the underlying conditions for companies, whose investment activity depends on high earnings, low wages and low taxes. According to this theory, the government encourages growth through lower tax rates. In the last few decades, the frequent transitions of power in Western countries between politicians who support supply-side economics (conservatives, libertarians and now some center-left social democrats) and those who advocate Keynesian economics (social democrats) has driven up government debt. When some politicians came into power, they reduced government revenues, and when they were replaced by those of the opposite persuasion, spending went up. Some did both.

There is the US dilemma. George Bush invaded Iraq and Afghanistan, which earned him the hatred of the left in this country. Did Clinton’s ignoring the risk of radical Islamist enemies increase the chance that Bush would have to act ? During the Clinton administration, two African embassies were blown up, a US military barracks in Saudi Arabia was blown up and the USS Cole was attacked. These attacks were largely ignored. As Clinton’s Secretary of State once said, “We did not ignore terrorism. We had meetings every week about it.” Nothing was done and the terrorists grew more bold.

What do we face now ? Unsustainable debt. Some of which can be blamed on Reagan who began the “starve the beast” philosophy. Some can be blamed on Bush, who spent too much on military actions in contrast with his intentions when elected. Clinton has largely been spared blame under the illusion that he balanced the budget. This is a myth since the alleged balance was achieved by raiding the then-surplus in Social Security for spending. Now, Social Security needs that money that was spent and it is gone.

A country isn’t a business, even though there are politicians who like to treat their voters as if they were employees. Politics is the art of mediating between the political and economic markets, convincing parliaments and citizens that economic policy promotes their prosperity and the common good, and convincing markets and investors that nations cannot be managed in as profit-oriented a way as companies.

After four years of financial crisis, this balance between democracy and the market has been destroyed. On the one hand, governments’ massive intervention to rescue the banks and markets has only exacerbated the fundamental problem of legitimization that haunts governments in a democracy. The usual accusation is that the rich are protected while the poor are bled dry. Rarely has it been as roundly confirmed as during the first phase of the financial crisis, when homeowners deeply in debt lost the roof over their heads, while banks, which had gambled with their mortgages, remained in business thanks to taxpayer money.

In the second phase of the crisis, after countries were forced to borrow additional trillions to stabilize the financial markets, the governments’ dependency on the financial markets grew to such an extent that the conflict between the market and democracy is now being fought in the open: on the streets of Athens and Madrid, on German TV talk shows, at summit meetings and in election campaigns. The floodlights of democracy are now directed at the financial markets, which are really nothing but a silent web of billions of transactions a day. Every twitch is analyzed, feared, cheered or condemned, and the actions of politicians are judged by whether they benefit or harm the markets.

This anxiety has a lot to do with why Romney lost. The problem is that the choice made, Obama, was even worse.

The decision by the American Federal Reserve Bank to inject hundreds of billions of dollars into the markets again to stimulate economic growth results for the inability of Democrats and Republicans to agree on a compromise between limiting debt and economic stimulus programs. Printing money — or betting hundreds of billions once again — is the last desperate response on both sides of the Atlantic.

What began four years ago with the bursting of a credit bubble in the mortgage market is being combated with more and more new debt in the trillions, thereby inflating the next, even bigger credit bubble.

The fresh trillions circle the world in the search for yield, but only a small part of the money flows into the real economy, where investments in new production plants produce lower returns. Instead, the trillions slosh back and forth, from one financial market to another, from the foreign currency market to the commodities market, and from the gold market to the stock market and back again.

Because these trillions are not reaching the real economy, the risk of inflation is currently smaller than Germany’s central bank, the Bundesbank, and its president would have us believe. But every saver and everyone with a life insurance policy pays for the central bank’s low interest-rate policy with low interest rates. When central banks keep interest rates close to zero for long periods of time, which they have done for years, they disadvantage ordinary savers and favor major investors, gamblers and banks, which can borrow at low rates and invest the money elsewhere at a profit.

As Claire McCaskill said in a moment of honesty, the recession has a silver lining. It has kept inflation low.

The European depression is only prelude, with the Japanese disaster waiting in the wings. The country’s debt-to-GDP ratio is 230 percent, and the government is dependent on the opposition approving the issue of new government bonds. Lurking behind it all is the American abyss, the debt drama of the next few months, the showdown and duel between Democrats and Republicans over which party can blame the other one for a national bankruptcy.

And then, finally, we have a clear view of the three biggest problems in finance-driven, democratically constituted capitalism: First, how can a debt-ridden economy grow if a large part of demand in the past was based on debt, which is now to be reduced?

Harding and Coolidge solved this problem in 1922 by radically cutting government but the government is too large today, with Obama having increased it even more the past four years. No good solution exists. The only possible solution was rejected by voters this month. that abyss awaits.

It is always only at first glance that the world is stuck in a debt crisis, a financial crisis and a euro crisis. In fact, it is in the midst of a massive transformation process, a deep-seated change to our critical and debt-ridden system, which is suited to making us poor and destroying our prosperity, social security and democracy, and in the midst of an upheaval taking place behind the backs of those in charge.

A great bet is underway, a poker game with stakes in the trillions, between those who are buying time with central bank money and believe that they can continue as before, and the others, who are afraid of the biggest credit bubble in history and are searching for ways out of capitalism based on borrowed money.

I see no solution and those who continue to talk about extraneous matters earn only my contempt. I have taken to reading old novels that still give an image of a world that was more hopeful. That was only 20 years ago.

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2 Responses to “Reports of the economy’s demise are premature, but not by much.”

  1. Alina says:

    I really like your blog, I think I will always come.

  2. doombuggy says:

    Surreal. I’m reminded of Stalingrad, where couriers would place reports of the growing Soviet buildup on the desks of commanders, only to watch the German commanders ignore the reports.

    Is Obama our von Paulus, an obedient bureaucrat put in place to carry out the orders of others, while the thing collapses?