Recent disappointing economic growth figures have brought a halt to what some had perceived as a budding economic recovery.  The narrative had been that a rapid expansion of government spending in 2009 had “stimulate” the economy into recovery.  Not surprisingly, the same people who supported government stimulus before are now clamoring for even more spending.  However, the burgeoning national debt, and lack of significant improvement in employment and economic growth has caused some to call the effectiveness of government stimulus into question.

According to the economic philosophy of John Maynard Keynes, economic recessions represent a failure of private markets to spend sufficiently for the economy to produce full employment.  In this view of the world, the “slack” spending should be picked up with government stimulus.  Thus, the view was born that the antidote to economic woes is to increase government spending.  The theory is that the increased government spending will flow through to both individuals and businesses who will spend it in turn, with the end result expected to be an increase in total spending that stimulates the economy out of recession, and into recovery.

However, there are a few key points that Keynesian theory fails to fully address, which cause problems when the extended impacts of government stimulus projects play out.  Primary among these is the fact that spending isn’t free.  In addition to this, is the principals that spending is different from productivity, employment is the means instead of the end, and that debt must be repaid.  The combined impact of these factors bring the fallacy of government stimulus into full view.

Spending Isn’t Free

The single fundamental premise of Keynesian stimulus is that government (deficit) spending stimulates economic activity.  However, what these tidy and neat models ignore is where the money they are spending will come from.  Put another way, the government cannot “create” anything.  It can only extract resources from one area and then spend them in another.

For many functions such as ensuring national security and enforcing laws, this resource extraction is absolutely necessary.  However, as the level of government spending increases, it requires that more and more capital be extracted from the private sector.  This capital can be extracted directly through taxes, indirectly through borrowing, or stealthily through inflation.  (Since the government has the ability to print money, it can finance its operations by simply de-valuing all of the currency already in circulation)

Thus, the only way that government spending can represent a net value gain is if the projects being pursued by the government are more valuable than the ones that would have been done in the private sector if that capital had not been extracted.  When we are talking about things like protecting the nation against foreign invaders or guaranteeing contract law for the purpose of smooth business transactions, this value chain is quite clear.  When tax credits are awarded to politically favored companies for politically favored projects, or people are subsidized to engage in activities that result in no net economic productivity, it quickly becomes apparent that the government is taking capital from a more productive purpose and moving it toward a less productive one.  It should not be particularly surprising that this process generates the prolific waste that many perceive as synonymous with government operations.

Spending is Different from Productivity

Another key pillar in the temple of Keynesian stimulus is the notion of spending being paramount.  The theory states that when people spend more, it will create more economic activity and more employment.  The problem with this view is that it takes the notion of production and output for granted.  More specifically, if many people are engaged in “make work” jobs that do not produce anything of significant market value, then their spending will simply result in more competition for the products and services that people actually do value.

The fundamental question in regards to economic activity is whether it is increasing the products and services that people value.  When activity is directed by market forces, it naturally gravitates toward value-positive activities since products or services that people do not value are not purchased and the firms producing them go out of business.  However, when there is no market mechanism present … as is the case with most government initiatives, then it means that the planners must ‘guess’ about what is most valuable.  To wit, these decisions are made based on political instead of rational motivations, and the net result is lots of spending, and very little net value.

When spending increases, but the total amount of products and services stays the same, the result is inflation.  It’s not hard to see how this comes about, since more spending will create more competition for the things that people actually value.  As more resources are dedicated to low-value spending, it will simultaneously result in less production of those valuable things and more competition for those things of value.

Employment is the Means, Not the End

Many times, the stated goal of government stimulus is to grow employment.  Because of this, many of the projects underwritten become “make work” jobs where there is no compelling desire by the market to pay for a project because of its superior value.  Instead, projects are driven based on what a political official thinks should be done.  Furthermore, focus on employment frequently involves working in a highly inefficient manner.

In market-based competitive situations, there is a strong incentive to utilize technology to decrease the amount of people that are necessary to perform a particular job.  Politicians see this as greedy businessmen placing profits ahead of people, but the public at large sees it as progress, when prices drop and quality increases.  The thing that most people miss is how labor markets are dynamic, and the constant advance of technology creates a constant churn of new employment opportunity.

Thus, the path to prosperity is not by employing s many people as possible.  Instead, it comes from optimizing people’s productivity.  Employment is an ingredient of production, but is not the goal in and of itself.  Failure to recognize this fundamental truth is the golden road to eternal waste.

Debt Must be Repaid

Keynesian economic models are built around the notion of deficit spending during recessionary times that is repaid when the economy expands.  Unfortunately, the “real” trend is that increases in government spending raise the baseline for future government spending.  This is how the massive government “stimulus” from 2009 created a permanent budget deficit in excess of $1 Trillion dollars per year.  Up until this point, the worst yearly budget deficit was in the neighborhood of $500 billion.  However, the baseline has now expanded to double that level of deficit for each and every year.  The “stimulus” has created a permanent structural budget deficit that the current leadership has absolutely no desire to address in any meaningful manner.

The unfortunate impact of these continual deficits is a burgeoning national debt.  And true to form, this debt must be repaid.  As the size of the debt grows beyond the ability of government to reasonably collect taxes to pay, it will become necessary to devalue the currency through inflation in order for the government to meet its financial commitments.  Thus, the fallacy of “stimulus” becomes painfully clear.  The so-called stimulus from government spending simply extracts productive resources, deploys them in a less productive manner, and then pushes the cost of that spending onto future generations.

In the end, economic growth is and always will be driven by fundamentals.  Those fundamentals are principally about figuring out how to create more with the same amount of resources.  All attempts to circumvent this simple economic law will only result in distorted economic incentives, and a destructive level of governement debt.

 

Recent news has been dominated by the debate surrounding raising the US debt limit.  The US Treasury has stated that August 2nd is the date after which the US government would not be able to meet all of its planned spending, due to a shortage of funds.  This situation is the dreaded “default” that many have referred to in the repeated interviews and press conferences that have been conducted on this topic.

The part that most in political office fail to disclose is that the interest on government debt makes up a very small portion of government spending, and would presumably be given first priority if immediate spending cuts were required.  Evidence of this can be found in the fact that financial markets have not been plunged into the free fall that would be expected in advance of a real default.  A contributory factor to this could be the fact that President Obama has privately assured banks that payments on government bonds will not be disrupted, even if the debt limit is not raised by the August 2nd Treasury dept. deadline.

Thus, since a “default” on government bonds is clearly off the table (even for the people who talk the most noise about default), it raises the natural question of what will happen if the debt limit is not raised?  The simple answer is that the US government will be forced into immediately running a balanced budget.  In the current political and economic climate, immediately reducing government spending to the tune 0f one to one and a half trillion dollars per year will be certain to make many people very unhappy.  The current situation has been brought about by an explosion in the government budget deficit that began in 2009 and has continued through 2010, and into 2011.

A simple look at government receipts and expenditures published by the Bureau of Economic Analysis tells the story quite succinctly.  In 2006, total government tax receipts from all sources amounted to approximately $4 Trillion dollars, while total government spending amounted to approximately $4.15 Trillion dollars.  The resulting budget deficit was a relatively small $152 billion dollars.  However, in 2010 total tax receipts from all sources are still approximately $4 Trillion dollars, but total government spending has grown to approximately $5.3 Trillion dollars.  In-between 2006 and 2010 was the expansion and collapse of the real estate bubble, the financial crisis of 2008, and the subsequent economic recession.  The recession spurred a massive binge of government spending that failed to discernibly improve either economic growth or employment, since the rates of recovery for both are far slower than in previous recessions & recoveries.

This gets us to the debt limit political debate.  During 2008, the Democrat party was swept to power by a wave of voter discontentment over the weakening economy.  By 2010, that discontentment had turned around and swept the Republican party to power in Congress, based on promises to limit government spending and bring the nations finances back into balance.  In the current fiscal and economic situation, three things are highly apparent.

1. The Democrat party favors continuing high levels of government spending, which favors their constituents.
2. The Republican party favors lowers taxes and constraining spending, which favors their constituents.
3. If the current trajectory of spending is not changed, it will precipitate an economic collapse when either taxes become so high that it crushes the economy or interest rates climb so high from spiraling debt that it crushes the economy.

Thus, the current gridlock of Republicans and Democrats over the debt limit can be easily understood by viewing it as a high-stakes negotiation between two parties with opposite interests.  There have been many proposals floated over the past few weeks, but the general direction of proposals from Democrats have been heavy on tax increases and very vague on spending cuts, frequently resorting to budget gimmicks or counting spending reductions that will happen anyway as cuts.  Conversely, Republicans have been pushing back against the notion of raising taxes on the basis of an argument that it is more important to cut spending first since it is not possible to raise enough taxes to close the current budget gap without crippling the economy.

In order for the United States to move toward long-term solvency, it is most certainly true that large amounts of spending will need to be cut in one manner or another.  It is also true that the tax code will most likely need to be revised so that many of the distortions from credits and deductions are removed to re-align economic incentives with long-term growth.  However, the structure and timing of these inevitable changes seem to be the critical point of the arguments.

Democrats have stalwartly resisted any substantial change to government spending, even though most know full well that the current spending trajectory is flatly unsustainable.  Republicans have pushed back against the notion of raising taxes in accordance with the views of their political supporters, even though many are quite aware that some change in the tax code is all but inevitable.

In the end, it is likely that some form of deal will be struck in the near future.  It may or may not be by the August 2nd “deadline” set by the Treasury, but there will be no disruption to the financial markets regardless of whether the “deadline” is met due to the priority that is placed on paying government debt obligations before any other spending.  In the end, this whole issue comes back to the fundamental situation that precipitated this debate and will fuel future debates.  This issue is the trajectory of government spending.  Until something is done to address this fundamental problem, it is most likely that we will see many more of these debates emerge over the coming years.

 

Jean-Baptiste Say

One of the ideas that have been advanced repeatedly during the recent economic crisis, recession, and prolonged stagnated recovery is the notion of “stimulus” as a way to revive the economy.  This strategy is based on Keynesian economic theory, and is predicated on the notion that when an economy drops into recession, the fundamental problem is a shortage of people consuming.  The solution offered by Keynesian economist is intervention by government entities through monetary expansion, and spending to fill the perceived gap in spending.  The fundamental underpinning of Keynesian theory is the notion that consumption creates production.

A alternative view to the Keynesian theory is the one advanced by Jean-Babtiste Say, contributing to the larger Classical economic theory.  A principal idea advanced by Say was known as Say’s Law or the idea that “Products are purchased with Products.”  This theory underscores the fact that wealth is defined by what is produced, and shuffling products from one person to another in an accelerated manner does not increase the total amount of wealth.  According to Say’s law, a general economic recession is not the result of insufficient consumption, but incorrect production … namely that production has been over-pursued in some areas (such as home building) and under-pursued in others.

Furthermore, attempting to “solve” problems by printing more money does absolutely nothing to increase or change the total amount of production or the total amount of wealth.  When more money chases the same amount of products and services, the result is high prices or inflation.  Recent increases in food and energy costs, in the wake of massive monetary expansion by the US Federal Reserve have caused many to re-visit Classical and Austrian economic theory.

The importance of Say’s law is frequently difficult for people to directly see, since most employees don’t work for products … they work for money.  Thus, people equate the money that they earn with wealth.  However, it is nothing of the sort … money is simply paper.  Wealth is what you can buy with the money.  Since most people work in the preparation, sale, or delivery of some product or service, it is ultimately true that the products and services we buy are purchased with the products and services we create.  Money is simply the medium through which this transaction takes place.

Another important aspect of Say’s law is the notion that products and services are not homogeneous.  What this means is that producing more of something people aren’t willing to pay for is not the path to wealth.  This situation is actually the cause of market sector crashes when excess production cannot be sold profitably.  Furthermore, if government bailouts are created to “save” the companies that gambled incorrectly, it results in a perpetuation of low-value production that impedes economic growth.

In a dynamic, market economy, downturns in a sector such as home building will result in price declines that eventually attract investment capital without the necessity of government incentives.  The people who built speculative houses in the expectation of big profits would go bankrupt.  The assets of those companies would be sold off at a discount.  The companies that acted prudently would be able to purchase those assets very inexpensively and launch new growth initiatives.  The problem confronted with bailouts is that they reward irresponsible behavior while punishing those who are responsible by denying them investment opportunities that would emerge if prices adjusted to their true value.

This is where the fundamental flaw of Keynesian theory comes to bear.  In the view of Kenesians, supply and demand are aggregated.  This view combines the production, consumption, and unemployment from healthy sectors with unhealthy ones.  Whenever a large correction occurs, this leads to the conclusion that the whole economy is unhealthy.  However, that is not necessarily true … even in the worst of recessions, there are frequently sectors of the economy that are perfectly healthy.  Attempting to address a so-called aggregate problem with aggregate solutions results in subsidies for foolish investments and penalties for responsible investors.

Furthermore, stimulus programs are necessarily administered by government agencies and financial institutions that extract a significant amount of overhead from the total amount that is spent.  This is where the problem of intermediaries emerges.  In a market system, intermediaries only exist in situations where they add value to the system … otherwise the buyers and sellers would ‘cut out the middleman’ to get greater volumes and lower prices.  However, in the world of legislative fiat, middlemen stand between the money and the products, taking a percentage of the transaction and doing absolutely nothing to enhance or optimize the quantity or quality of total output.

This ultimately devolves into what many have called “Crony Capitalism” where large corporations dominate the marketplace, not because of any particular skill in creating or selling products and services, but because their connections to lawmakers allow for advantages that other firms do not enjoy.  The financial institutions and automotive companies that avoided bankruptcy and maintained all of their leadership / business practices serve as primary examples of this principal.  If AIG had been allowed to go bankrupt, its assets would have been sold off at a discount and a new competitor would have emerged to fill the vacancy created by AIG’s departure.  This company would have every incentive to hire the AIG employees who were responsible, and would have no incentive to hire the people who cause the company to collapse.

In the end, products and services are truly paid for with other products and services.  Attempting to circumvent this simple economic reality has resulted in tremendous mis-allocations of capital, and enriched politically connected organizations, while preventing real economic growth from emerging.  Unfortunately, we do not have the capacity to stop this trend as individuals.  However, we do have the ability to adjust our own decisions so that the impact of these trends on our lives is minimized.

The most important thing that any person can do is to work and live in the “real” economy that produces real products and services for real people that they purchase by producing real products and services for other real people.  The runway for extracting resources through smoke-and-mirrors financial manipulation is drawing short.  The time is quickly approaching when governments can no longer afford to rely on smoke-and-mirrors to disguise fiscal problems and unfunded promises that cannot be kept.  When this reality finally emerges, it be very painful for many people who have become dependent on the fictional reality.  Make sure that your well being is built on a solid foundation.

 

Recent news that the rising cost of food and energy has brought the topic of inflation back into the forefront of public awareness.  Specifically, food prices jumped 3.9% in February, which was the highest since November of 1974.  In addition to this, housing starts are at the lowest level since April of 2009, and are the second lowest in the last 50 years.

All of this adds up to some very interesting economic dynamics.  The “core” component consumer price index has food and energy removed, meaning that government statistics are currently showing very low rates of inflation.  However, these reports are coming in the midst of rapid price increases for many items that are considered ‘necessities’ of living a normal life.

In the economic environment that is emerging, we are seeing two simultaneous opposite movements in prices.  One set of movements is coming in commodity products such as food and energy that are purchased with cash, and the other movements are coming in the realm of technology, luxury goods, and assets that are purchased with credit.  Put another way, the price of things that people “need” are going up, while the price of things people “want” are coming down.

Things We Need Getting More Expensive

The important thing to understand about price movements for things like food and energy is that they are commodity products people purchase with cash, and that are bought on a very frequent basis.  This means that when new money is created by the Federal Reserve, its impacts are felt first and most intensely by the items that are traded frequently and bought with cash.  This is the reason why inflation hits food and energy first and hardest.  As the government continues to use monetary expansion as a way of financing its operations, it will continue to place upward pressures on necessities such as food, energy, and other consumable commodities.

Things We Want Getting Less Expensive

In contrast to food and energy, we have technology products, luxury goods, and credit-based assets.  Technology products are driven by Moore’s Law, which describes how the transistor density of integrated circuits doubles every 18 months.  By extension, this means that the cost of compute power drops in half every 18 months.  This has enabled fantastic advances in technology at continually declining prices.  However, in a recent media event by the Federal Reserve, it was pointed out that the iPad 2 is twice as powerful as the original iPad, but at the same price.  In response to this, one of the people in attendance stated:  “I can’t eat an iPad”.

In addition to technology, we have luxury goods and credit-based assets.  The reason why these two items are becoming less expensive are very similar.  In the case of luxury goods, there has been a dramatic decrease in the number of highly affluent people.  This has resulted in an imbalance of luxury goods available relative to the number of people who are willing to pay for them, which is placing downward pressure on price.  In the case of credit-based assets such as houses, the stringent tightening of lending standards by government lending agencies has constrained the availability of credit.  This constrained ability of credit means that many potential buyers have dropped out of the marketplace, and prices have adjusted downward.  This trend has been accelerated by a proliferation of foreclosures that are suppressing prices even further, and triggering more defaults.

What Can I Do?

The current economic environment is one of correction.  For many years, lending standards were too loose and people simply borrowed to spend and assumed that they could continue re-financing their home indefinitely to absorb this additional spending.  Borrowing to consume is an unsustainable economic trajectory, and always results in a period of adjustment.  In this case, the problem was allowed to grow very large, so the adjustment is proving to be very painful.  (There are many who believe that the current trend of government borrowing to finance entitlement spending will precipitate an even larger adjustment in the future)

While we are going through this period of correction, it is important to understand the fundamental economic drivers so that we can make more informed decisions.  When it comes to food and energy, little can be done to address the base cost inflation, but individuals can realize considerable savings by ‘cutting out the middleman’ and buying un-processed or lightly processed food.  The reduced processing means less cost (in addition to less convenience).  Many people can trim their food budget considerably by substituting meals at a restaurant for cooking at home.  In the short-term, there is also little that we can do to directly address the cost of energy.  As costs continue to escalate, it is likely that car-pooling will increase and people will choose to run their appliances less.  None of these actions can directly stop rising energy costs, but when combined they can help to avoid excessive budgetary strain from rapid price shocks.

In the midst of cost increases, there are also many cost decreases that people can take advantage of.  With technology products becoming perpetually less expensive, it has never been easier to create a web-based small business.  In addition to this, the price reductions in many real estate markets have resulted in superior investment opportunities.  It is important to understand that every period of adjustment or correction creates opportunities.  The people who capitalize on those opportunities are the ones who will emerge from our current economic slump with brighter prospects for their personal, professional, and economic lives.

 

There is a persistent trend among people in the news media and political establishment to misunderstand wages, labor, and productivity when it comes to employment, trade, and economic output.  Unfortunately, this misunderstanding has driven many decades of public policy that impedes economic development.

On balance, there are three fundamental mistakes that are driven by this misunderstanding.  The first is assuming that ability and productivity are the same.  The second is assuming that hourly wages and labor per unit of output are the same.  The third is assuming that economic output is driven by employment and not productivity.  Understanding these three distinctions will provide critical insights into both the national and international economy.  It will also provide the key to making ourselves more valuable to our customers and employers.

Mistake #1: Assuming that ability and productivity are the same

At first glance, these two words appear to be describing the same thing.  However, there is a very important difference in the extended meaning that each conveys.  Ability describes the skills that we bring to the table when undertaking a given occupation or profession.  It is the piece of achievement that is unique to ourselves.  On the other end of the continuum, we have productivity.  The relationship between these two concepts is that ability plays a part in productivity, but it is not the only factor.  Our total productivity is a combination of our ability, the environment or system that we operate in, and the resources at our disposal to generate output.  Thus, it is possible that two people of equal ability who live and work in different areas can have vastly different levels of productivity.

Mistake #2: Assuming that hourly wages and labor per unit of output are the same

A common misconception about ‘labor’ is that it is equal to the hourly compensation paid to workers.  While this is certainly one way to measure the cost of labor, it is much more relevant to measure the cost of labor per unit of output.  The difference between these two measurements is that one simply looks at what workers are being paid while the other takes into account what and how much is being produced.  Because of this, a worker who is paid a high hourly rate and produces a high level of output may generate a lower labor cost per unit than a much lower paid worker who is not as productive.  Thus, the competitive danger to business is not from “low wage labor”, but from “high productivity labor” . . . some high productivity labor may come from countries with relatively low wage rates and relatively high levels of productivity, but most of the time high productivity comes from working smarter with better ideas and a better business model.

Mistake #3: Assuming that economic output is driven by employment and not productivity

One of the statements that is most commonly heard in political circles is that “America is losing its manufacturing base”.  The truth of this statement depends on whether you are measuring employment or output.  It is most certainly true that manufacturing employment is declining over time, but it is also true that output is rising over time.  The reason for this is that manufacturing employers are far more productive (on average) than they were 10, 20, 30, 40, and 50 years ago.  This means that much more output can be produced  per person employed.  The public at large benefits from higher quality and lower prices than otherwise would have been possible, and the overall economy benefits from the opportunities that emerge from an economy that is on a consistent path of improving productivity.  The implicit cost of these gains in productivity is that they will systematically render some jobs and business sectors uncompetitive or unnecessary.

This concept is extremely important as it relates to public policy, since many subsidies, bailouts, and other forms of government intervention are specifically aimed at preserving employment in a particular economic sector.  However, the funds that are given to those companies must be extracted from somebody else who is being economically productive without any government assistance at all.  The net result of repeated interventions and subsidies is that the government extracts resources from economic activities and individuals who are the most productive and gives it to those who are the least productive.  The recipients of these resources are always happy to have assistance in staying competitive, but the economy at large is made steadily less productive with each transfer that is made.  It is certainly true that in the political realm, there is a consistent trade-off that exists between the policies that are the most growth optimal and those that are optimal for generating favor with constituents.

In the end, there is very little that we can do as individuals to change public policy.  However, there is quite a bit we can do to change the trajectory of our own personal, professional, and financial life.  One thing that we can do is focus on how we can be more productive for the benefit of our employer and customers.  Instead of demanding more compensation for our “qualifications” we should seek to optimize what we produce with our skills and abilities.  By shifting the focus away from what we “do” to earn a living and more toward what “value” we produce, it opens the door for a marvelous journey of personal, professional, and financial growth.

 

The recent financial turmoil in the global economy has caused many people to adopt a dour perspective on the state of financial responsibility in the nation, and across the world.  Much of this cynicism is certainly well deserved, as there were many governments enforcing irresponsible regulations, banks making irresponsible loans, and people taking on an irresponsible amount of debt.

However, it is important to avoid overlooking the fact that there are many people who have remained very fiscally responsible throughout all of this financial silliness that has erupted recently.  The dynamics of the current credit markets are such that risk tolerance has almost completely disappeared, creating a ‘flight to quality’ that has drastically increased the demand for guaranteed treasury notes.  This increase in demand has significantly reduced the interest rate for mortgages that are tied to these treasury notes . . . but only for the people that qualify for loans under the current (more stringent) standards.

Thus, in a strange turn of events there is a ‘responsibility dividend’ that is available to people who have managed their finances prudently.  Since the market appetite for risk has evaporated, there are tremendous opportunities available for low-risk borrowers to make intelligent investments.  This is because the financial crisis has pushed most of the high-risk investors out of the market since they can no longer get capital from lenders that are very timid about taking risk in the current economic environment.

The result of the current situation is that investors who have remained responsible over the past few years will have a brief window of opportunity to make lucrative investments with very minimal competition.  This will result in many fortunes being made over the coming years, just as new fortunes are always created from economic recovery.  Each of us must ask ourselves whether we will be one of the people who create a new fortune.

 

The persistent economic recession that was triggered by the financial crisis of 2008 and has lingered through 2010 is showing every sign that it will drag into 2011.  This is not intended to be a foreboding of doom and gloom, but an honest assessment of the fundamental mis-alignment that the economy is still attempting to reconcile.  The reason for this slow, anemic recovery is a fundamental misunderstanding of the fundamentals that drive economic growth, bubbles, crashes and recovery.

The advent of business cycles is certainly not a new phenomenon.  Economic expansions and contractions have been commonplace throughout human history.  The thing that has made this economic downturn so painful is the fact that it followed successive decades of “fine tuning” the economy by government and quasi-government institutions that skewed incentives and systematically diverted economic resources away from their optimal use.  When this artificial stability (necessarily) collapsed, the result was a much more intense adjustment than most people had anticipated.

In order to understand this phenomenon more completely, we should begin by examining the six stages of boom, bust, and recovery.  These stages are built on top of a natural growth trajectory for free markets that systematically allocate resources to their optimal economic use.  The reason why booms and busts materialize in the first place is when public policy shifts the incentives for market players so that they reap greater rewards from pursuing actions that are not economically optimal.  (Even if they are politically favorable)  These six stages are the bubble (aka ‘boom’), the peak, the bust (frequently involving a ‘crisis’), the decline, the trough, and finally the recovery.  Each of these stages plays an important role and merits further examination.

The Bubble

Bubbles are a market phenomenon where the price of something (such as stocks or homes) rises much higher than is justified by its underlying fundamentals.  Stock Market bubbles are frequently driven by speculative buying of companies that have not yet produced a profit but are expected to grow rapidly in the near future.  Real Estate bubbles are typically driven by a change in financial policy that makes it easier for people to obtain financing, resulting in more buyers and higher prices.  In all cases, market bubbles rely on continued escalation in price for a particular type of labor or asset that eventually surpasses its fundamental value.

The Peak

When bubbles reach their zenith, they result in a market peak.  These peaks are impossible to predict in advance and only become apparent when viewed in hindsight.  The way that they typically emerge is when ‘casual’ investors hear about the spectacular profits being made by other people and finally decide to buy into the market.  Unfortunately, many of these casual investors buy-in just as the irrational value escalation reaches its apex.  All bubbles share a common characteristic in that the price increases will eventually reach a point where no new buyers can be found.  Thus, what the peak really represents is the stopping point where nobody else is willing to pay more than the last person did.

The Bust

When bubble markets eventually rise to a peak, there is typically some type of ‘trigger’ event that initiates a sell-off.  Sometimes it is a disappointing earnings report, sometimes it is news about political unrest that may disrupt food or energy prices, and sometimes it appears to be nothing at all.  However, in all bubbles, there eventually comes a time when new buyers willing to pay higher prices cannot be found and prices fall.  If a rapid succession of bad news accompanies this reduction in prices (as was the case in the fall of 2008) then the adjustment can turn into a crash.

The Decline

At this point in the market cycle, most of the players finally come to realize that the assets they were buying aren’t fundamentally worth the previous market prices.  When it becomes apparent that the hot new stock is not going to reach profitability as expected, or that the large speculative property will not have any buyers, it frequently results in a sell-off among investors who cannot afford to carry the asset indefinitely without selling.  During the bubble, there was a surplus of buyers relative to sellers and now there is a surplus of sellers relative to buyers.  The decline can be further intensified by the fact that many investors feel uncertain about buying-in since they do not yet know where values will eventually hit bottom.

The Trough

When values finally reach a low enough point that investors are willing to accept the risk of further losses in exchange for the opportunity to capture upside gains, a value bottom is frequent reached.  In some cases, the trough can last a very long time if investors are systemically unwilling to begin buying aggressively because of fears that future growth expectations will materialize.  Alternatively, if banks are holding a lot of foreclosed properties, they will naturally want to sell those properties as quickly as possible, provided that they do not drive down the market prices even further.  Ultimately, the length of the trough depends on how many mistaken investments need to be disposed of.  This process is extremely important, because it systematically shifts the ownership of capital toward people with the prudence to deploy it responsibly.

The Recovery

Once the over-priced capital has been sold at reduced prices and the new owners begin deploying that capital in a way that produces value, a recovery can ensue.  Fundamentally, economic growth emerges when the same amount of input can produce a greater output.  (This is also called productivity growth)  Put another way, the recovery unfolds when labor and capital eventually find their optimal use.  This is the only way that our economy will return to a path of real growth.

In the end, market cycles are critically important to long-term growth and prosperity.  They are a way of systematically steering resources to their optimal use.  This happens as the people who made foolish decisions go out of business and are replaced by people who purchase their assets at low prices and have a built-in incentive to operate more prudently. The important thing for each person to understand is that this process cannot be avoided.  Attempts to ‘fine tune’ a ‘soft landing’ for the economy will only drag out the inevitable adjustment.

Economic progress means that capital and labor must find its optimal use.  When the economy gets to a point where the present use of capital and labor is far away from it’s optimal use, that means a period of extreme adjustment is inevitable.  However, for the people who see this trend and capitalize on the opportunities inherent in times of change, there are historic opportunities for gain.  The only question remaining is whether you will take advantage of the opportunity or be thrown about by the change.  The forces are the same . . . the circumstances are the same . . . it is your decisions and actions that will make all the difference.

 

Joseph Schumpeter is widely regarded as one of the greatest economic minds in the history of mankind.  One of his principal contributions to posterity is the notion of Creative Destruction.  The premise of this idea is that economic progress often requires current economic entities to be displaced by new competitors that can provide a better product at a lower cost.

It is not hard to see this concept in practice if one looks at a long time interval.  In the 19th century, the railroad companies held a daunting monopoly over transportation.  However, the emergence of automobiles and the trucking industry displaced the railroad monopoly by making it obsolete.  In a similar fashion, the emergence of hand held calculators quickly made the use of ‘slide rule’ instruments obsolete.  The reason why this phenomenon carries such power is that established market players tend to have high profit expectations from financial stakeholders.  This leads to relatively high prices, which gives new entrants a lot of room to undercut and still create a profit.  When new entrants come into the market, they are not beholden to an entrenched business model and can capture efficiencies that are not being practiced by the current market leader.

The importance of this concept lies in the fact it is extremely easy to become resistant to the dynamic change that is needed to keep a market economy moving.  This resistance typically comes from jobs and pensions that are locked-in to a specific way of doing business that may become obsolete over time.  (Please allow me to drop a ‘sledge hammer’ hint and point out that the current market turmoil is being caused by a breakdown of the ‘hybrid’ business-government relationship in free markets that can only be worsened by a perpetuation of this relationship through repeated ‘bailout’ initiatives.)

It is important to keep this in mind that in the current global economy, attempting to protect obsolete business models through political influence will only forestall the inevitable transition to new ways of doing business.  If this protection is carried too far, the new ways of doing business may be suppressed entirely.  This can result in one of two undesirable scenarios.  The first is that the economy becomes stagnant, as entities fight for control of a shrinking pie.  The second is that the creative inertia shifts overseas, and the global influence of our economy becomes obsolete itself.  The key for each of us is to ensure that we are constantly moving toward emerging waves of the economy, instead of clinging to obsolete ways of doing business.

 

The German story of Faust is well known throughout literary and scholastic circles.  In the story, Faust is a successful scholar who is unsatisfied with his life and bargains with the Devil.  He offers his soul in exchange for unlimited knowledge and worldly pleasures.  The popular term: “deal with the devil” originates from the story of Faust.  This story has also been interpreted by some as a metaphorical representation of an ambitions person who compromises their moral integrity to achieve power and success.

A more appropriate interpretation for the current political climate is the process by which government entities borrow from future generations to finance social benefits that secure power for the political class.  However, this model has begun to unravel in Europe as many countries are in the midst of a sovereign debt crisis that is on track to land in the United States.

The basis of this debt crisis comes from promises made by politicians for the bestowment of material prosperity in excess of what people produce.  The narrative used to sell this package of fictional prosperity is a promise to “make the rick pay their fair share.”  The universal assumption of this redistributive economic model is that the ‘rich’ are taxed in excess of the services they receive so that the ‘poor’ can receive more than they produce.  To many, this model carries a populist attraction because of its perceived benefit for those at the lower end of the social and economic spectrum.  Unfortunately, it ultimately regresses toward Faust’s “deal with the devil” that requires the submission of a nation’s soul when the price comes due.

So how does a nation lose its soul in this way?  It all starts and ends with incentives.  All people naturally have incentives to behave in ways that result in a better life for themselves and their family.  For people in the productive class, a better life is achieved through taking risks and realizing gains.  Furthermore, these people have incentives to structure their financial affairs such that their tax burden is reduced to the legal minimum.  Conversely, there are many people in the lower classes who view their path to a better life as the election of political leaders that promise to tax the producers and redistribute the resources to them.  Both groups of people are acting in a way that seems completely logical.

The fundamental problem with nations that engage in this redistributive economic model is that there is a fundamental limit to how much tax revenue can be raised.  An empirical analysis known as Hauser’s Law has found that total US tax revenue since World War II has held steady at approximately 19.5% of Gross Domestic Product, despite a wide range of marginal tax rates and tremendous volatility in tax policy.  This suggests that tax payers will self-select into activities that lower their tax burden when rates of taxation increase.  This means that there is an implicit cap on sustainable government spending that is equal to approximately 19.5% of GDP.  Spending in excess of this amount must necessarily be financed with borrowing or monetary inflation.

As nations incur deficit after deficit for decade after decade, the size of their national debt will eventually become so large that it becomes literally impossible for it to every be paid back without massive monetary inflation.  In this situation, investors will frequently become wary of investing in the nation’s debt securities.  As the number of willing investors decrease, the yield required on the debt necessarily increases.  As the effective interest rate on debt increases, nations must devote more of their resources to debt service.  Eventually this results in a debt spiral where a country’s debt obligations occupy so much of its resources that the government cannot function.  In this situation, one of two outcomes inevitably occurs.  If the nation owns a sovereign currency, it will simply expand the supply of its money, devalue the currency already in circulation, and eliminate the debt through inflation.  If the nation’s currency is pegged to another currency or it is part of an economic union, the only remaining option is default.

Another complicating factor is the fact that taxation rates are inversely related to economic growth.  This means that raising taxes to capture revenue will stifle future GDP growth.  When entitlement promises exceed tax revenue, it results in terminal borrowing that eventually creates higher interest rates on the debt.  These higher interest rates place a further pinch on the budget since taxes can only be raised so much before they stifle economic growth and incentivize people to either leave or shift their efforts toward activities that generate less output, but are more tax efficient.  The recent protests in Europe over budget cuts by Greece in an attempt to curb its deficits demonstrate the difficulty implicit in reversing this course of systemic over-spending with borrowed money.  The eventual result of perpetually delivering something for nothing can only be a financial collapse and default.  This is the point where Faust’s bargain comes due and the devil lays claim to the nation’s soul.

For people who do not wish to be caught by the collapse of debt-based entitlement spending, it is critically important to ensure that your personal well-being is not tied to government programs.  When the collapse occurs, it will most likely create dramatic cuts, reductions, or outright default on many of the programs that the government uses to perpetuate its base of political favor.  When this river of support from the government stops, it will instantly impoverish millions of people who have been conditioned over multiple generations to depend on somebody else for their well-being.  The unfortunate impact of this fact is that there will be massive amounts of people whose financial lives are literally destroyed by the collapse of debt-based entitlement spending.  As an individual, I do not possess the power to stop or even influence this phenomenon.  However, I do have the power to impact my own decisions and personal financial situation.  By focusing on what we can influence, instead of worrying about what we cannot change, it will allow people to protect the future of themselves and the people they care about by taking prudent action.

 

In the current environment of bailouts, government entitlements and economic uncertainty there is a perpetual supply of politicians who will claim to be the ‘savior’ of the middle class.  In a strange twist of irony, the way in which most elected officials purport to ‘save’ the country is by taking money away from some people through taxes, borrowing and inflationary money printing so that they can give it to another group of people that just happen to be likely to support them in re-election.

This trend of elected officials using government resources to ‘buy votes’ for re-election has created a problem that is beyond most people’s comprehension.  Multiple decades of an unsustainable spending trajectory has placed the government and economy in position for an unprecedented collapse.  The way that this collapse will precipitate is by the actions that the government will need to take in order to satisfy their spending promises.

The current national debt stands in excess of $14 Trillion dollars, with the government budget deficit running well over $1 Trillion dollars per year into the foreseeable future.  The ultimate consequence of these terminal budget deficits and spending obligations is the fact that the government cannot possibly tax or borrow enough to satisfy its spending promises.  Ultimately, this means that the only way the US government can satisfy its promises is by creating new money and devaluing the dollar.

The expanded impact of this monetary inflation will be a destruction in the value of savings, debt and fixed-income payments such as pensions, annuities, and government assistance.  As people begin to experience a destruction in the ‘real’ value of their assistance payments, it will result in many being ‘pushed off the edge’ of economic viability.

As this phenomenon unfolds, the same government that created the problem will rush to ‘solve’ the situation.  It is most likely that the resources diverted to address the problems of people who are economically destitute will not leave any remaining resources to help those in the middle class who have seen their wealth collapse.

In the end, it will ultimately hold true that “I am my only hope” for financial success.  The government is hurtling toward the edge of an economic cliff and will pull many people along with it into the chasm.  Those who are astute will come to realize that they are the last stop for the well being of their family.  Once this realization has been made, the next step is to take action so that the financial future of you and your family are preserved.  Once the collapse begins to unfold, many will find that it is too late to take the action that is necessary to attain prosperity.