In the midst of the constant headlines concerning government ‘bailout’ initiatives that have resulted from a credit crisis in the financial sector, one must stop to wonder whether the government is acting responsibly and what the likely results of these actions will be. (In truth, one doesn’t have to wonder that much … the government is acting with an almost complete lack of anything resembling financial responsibility.)

The core driver of this problem is that public agencies making market decisions will tend to make them based on political expediency instead of market effectiveness.  From the perspective of a politician, “long-term” thinking only lasts until the next election.  The reason is because most politicians are unconcerned what will happen after they are out of office and can no longer take credit for successes, and will not be subject to blame for problems.

Unfortunately, this decision making framework has spilled into the realm of government subsidies and bailouts.  This has amplified the scope of collective irresponsibility since public resources are not only used to sustain an out of control government, but have now been expanded to supporting businesses that are uncompetitive in the free market and depend on political support with taxpayer money for their success.  This has allowed many companies and executives that made destructive decision to stay in business because of public funds that were granted by government officials.

In a free market, companies that make critical errors would be re-structured in bankruptcy, or liquidated and sold off to new investors.  Unfortunately, the US government is choosing to drastically increase the amount of currency in circulation as a means to finance its spending, including bailouts to keep the failing companies afloat and stem the impact of a sharp reduction in credit availability.  (This process is also known as ‘printing money’)  This drastic increase in circulating dollars will eventually produce significant inflation.  This is caused by increasing the amount of currency in circulation, but keeping the amount of national output the same . . . more money chasing fewer goods MUST result in increased prices.

When inflation occurs, it de-values savings, home equity, and fixed-rate investments like CD’s and Bonds because those instruments tend to increase in value very slowly, and the purchasing power of the dollars they are denominated in consistently erodes.  Conversely, inflation rewards people who have taken out a large amount of fixed-rate debt by de-valuing the principal & interest payments.  Effectively, inflation punishes responsible behaviors like saving and paying down your mortgage while rewarding irresponsible behaviors like taking on large amounts of debt.

Ultimately, living with an irresponsible government means that you will be indirectly punished for acting responsibly.  By working hard to earn a high income, keeping lots of money in savings, and paying off your mortgage, you will be set-up for a tremendous double-whammy from taxes and inflation.  The massive government deficits make some form of future tax increases all but inevitable … much of this will be driven by inflation pushing up the nominal wages of individuals and corporations, driving “bracket creep” where people’s higher nominal income is taxed at higher marginal rates.  The second half of this pitfall comes from de-valued savings and home equity.  The people who have worked the hardest, sacrificed the most, and saved the most diligently will be punished by the inevitable inflation that is bound to stem from many decades of irresponsibility.

Fortunately, there is a way that regular people can profit from future inflation.  The prime strategy for beating inflation involves using long-term debt leverage to purchase investment assets that produce income and appreciation.  The most common way to do this is through rental real estate investments.  The way this works is that you purchase a rental property with a fixed-rate loan and lease it out to tenants.  When the inflation starts to hit, it will push up the home value & rents because the increased amount of dollars in circulation will be chasing after the same number of houses & rental units.  Since your investment is financed at a fixed interest rate, your expenses will stay relatively flat while your income inflates.

In the end, there is nothing that any one person can do to stem the tide of collective government irresponsibility that is overshadowing the entire global economy.  However, there are things that each individual person can do to protect themselves and their families from the effects of inflation.  Ultimately, our future is driven by the decisions that we make each and every day.  As you go throughout life, make sure that each decision you make is one that will help to create a brighter future.

 

An Article recently published by the International Business Times explored the potential for problems associated with aggregate student loan debt.  Since the total student loan debt outstanding exceeds $1 Trillion dollars, the scope of the problem seems immense.  When complicated by the 30% of student loans that are 30 or more days overdue, there appears to be a crisis brewing.

The concern expressed by many is that the burden of student loan debt will suppress people’s future disposable income.  To many, this presents a dire scenario where future consumption spending cannot keep growing due to the crushing burden of student loans.  It is complicated by the high rate of unemployment among recent college graduates, and has led many to believe that government action is required to “fix” the problem.

The Solution that Isn’t a Solution

When college students gather in protest rallies, they frequently hold up signs demanding that their student loan debt be forgiven.  Since the overwhelming majority of student loans are underwritten by the US government, all that this would accomplish (besides delivering a free ride to people who acted irresponsibly) is to turn $1 Trillion of private debt into $1 Trillion of public debt.  This sounds great for people that are either looking for a handout or looking to buy votes by giving away a handout with government money, but it does nothing to solve the underlying problem.

By accelerating the government debt problem, it accelerates the extent to which drastic action must be taken.  Many (mistakenly) think that the pile of student loan debt can be dissipated with additional taxes on the wealthy.  Unfortunately, this strategy has two main deficiencies.  The first is that there aren’t enough wealthy people to pay the taxes.  The second is that most wealthy people hire lawyers and accountants to reduce their tax burden with (legal) income sheltering strategies.  The ultimate result is that the government is unable to tax away its debt and will need to inflate the currency.  Since inflation disproportionately impacts the poor and middle class, it will ultimately end up coming back to bite the people who were holding the signs demanding that the government wipe away their student loans.

The Real Problem

A paper recently published by Georgetown University breaks down the average earnings and unemployment rates for college graduates based on the level of education and course of study.  It comes as no surprise that subjects such as education, business, and engineering all have relatively low rates of unemployment associated with them and respectable earnings.  However, studies in subjects such as social sciences and the liberal arts have very high rates of unemployment and relatively low earnings.

Thus, the real problem is not that people carry so much student loan debt, but that people have chosen to take out large amounts of debt to finance an education that does not have a significant market value.  Another way of stating the situation is that people who study subjects like engineering and business do not have a student loan problem.  The reason is because their education prepares them for a career that allows them to generate an income so that their debts can be paid off.

The Real Solution

Understanding the real problem is the first step toward a real solution.  The only way for this lingering problem to be solved is for the people who are under all of this debt to become gainfully employed so that they can pay their debt back.  However, attaining gainful employment requires that better decisions be made in regard to the course of study that one pursues in their path of higher education.  This is the only method of dealing with this problem that will not result in a simple transfer of the burden to somebody else.

The truth is that all choices involve cost.  The decision to attend college is frequently very wise.  However, it is highly important to choose a course of study that is consistent with your long-term career interests.  Studying the arts is fine if you are content with living the life of an artist.  However, if you desire to climb the income ladder, then you must acquire skills that will allow you to generate value for an employer that are sufficient to justify a favorable level of compensation.

Student loan debt is not fundamentally different from any other kind of debt.  It is not good or bad in and of itself … student loans taken out to acquire skills that allow you to earn a good income to support your family are a very wise decisions.  Loans taken out to finance four years of partying a degree that offers no employment prospects are much more suspicious.  All debt is fundamentally neutral in nature.  It only becomes good or bad when paired with an investment that is good or bad.

Thus, the answer is for more people to make better decisions regarding what they study.  In the larger context, the investments of time, money, and education we make are what will define whether any resources we borrow to make those investments were wisely deployed.  Instead of demanding that other people bail us out after making bad decisions, we should take the opportunity to make better decisions in the future.  Each day is a new chance for us to learn.  We should seize those learning opportunities to make each successive day more prosperous than the last.

 

In the world of economics, there is a term called “Free Riding” that describes people who benefit for services and innovation that they did not pay to produce or develop.  There are many ways in which ‘free riding’ benefits people, since technology tends to be prohibitively expensive when it is first developed.  However, as it is adopted by more people the prices come down and quality increases with the increased competition.

Thus, the people who benefit the most from technology are the ones that wait until prices decrease and quality increases before making a decision to buy.  However, none of this would be possible unless there were people that were willing to pay high prices for the new technologies.  In this way, the ‘early adopters’ of technology indirectly subsidize the lower prices for people who wait to buy since the research costs of new products are frequently dissipated by charging higher prices when the products are released.  The beauty of this system is that it is provides very real benefits to both the early adopters who pay prices and the late adopters who buy at lower prices.  Since the system is completely voluntary, all of the people involved must necessarily be made better off by the transaction, or they would not buy.

There is another version of ‘free riding’ that is much less beneficial, and considerably dangerous.  This variety of free riding involves the phenomenon of using government legislation to re-distribute resources from one group of people to another so that they can get a ‘free ride’ in the form of direct payments, government services, or tax subsidies.  The implicit danger comes from the fact that the people who are riding for free have a tremendous incentive to organize for the purpose of extracting more resources to create an even larger free ride.

This results in a ‘moral hazard’ as the number of people receiving government benefits increases relative to the number of people who are producing and paying taxes.  The source of this problem stems from the fact that a vast disconnect can grow between the number of people who produce and the number of people who ride for free on the backs of the producers.  If this imbalance grows too large, the free riders can add to the burden of the producers by continually adding new taxes and regulations.

The unfortunate part of this event chain is that if the people who produce the resources are taxed too heavily, they will either find ways to legally avoid the taxes & regulation, or choose to produce less.  For some reason, politicians seem to be terminally infected with the notion that taxes and regulations can be increased indefinitely without impacting incentives to produce.  The fundamental problem is that most people (especially politicians) are only able to see the world as it currently exists.  However, it is always true that the world of the future will look different than the world of the present.  It is also true that the activities which produce the highest returns will garner the most effort and attention.

If the best returns come from creating new products and services, vast amounts of resources will go into finding ways to develop these emerging businesses to capitalize on the opportunity.  Alternatively, if the only path to exceptional returns is through lobbying and litigation, it is all but inevitable that a bureaucratic state will emerge where a perpetually smaller portion of the populace produces anything of value while everybody else attempts to fight for a bigger share of the pie.

The problem is very similar to the farmer who killed the goose that laid the golden eggs because he wanted all of the eggs at once.  Of course, when he opened up the goose there were no eggs to be found.  Each of us should be very careful with our desires for a free ride that is financed with golden eggs.  It may be a lot of fun for a while, but big problems can emerge when the golden eggs run out.

Greece is currently experiencing this exact scenario, and the prospects are grim.  With a tremendously inefficient economy, and an extremely high percentage of total spending driven by the government, they are stuck in an economic trap.  In order to shift toward a market oriented economy with the ability to produce sustainable growth, Greece needs to go through a period of very painful economic adjustment.  However, if they attempt to forestall this “tough medicine” through continued government spending, it will only serve to expand the scope of the problem.

Ultimately, riding for free in the political arena continues to carry dangerous consequences.  Politicians love to create free rides, because it allows them to purchase votes with public resources.  However, there is a limit to how much of this structural inefficiency that a country’s economy can absorb.  Greece has already pushed past their limit, and the Unite States is approaching its breaking point at a rapid rate of speed.

As this point of no return approaches, each individual person must become aware of the fact that they will ultimately be responsible for their own financial future, since the government is all but certain to be unable to deliver on its past promises.  In the end, it is the actions that we take, which will determine the future of our lives.  With each passing day, we should seek to take actions that propel us closer to our goals.  This is the best defense against the danger that is posed by a societal free rider problem and its inevitable consequences.

 

Recent news about the advent of rapidly rising gas prices has brought the subject of energy into the forefront of public opinion.  Unfortunately, the majority of the discourse occurs over typical “political football” issues such as profits from oil companies and proposals for higher taxes.  Recently, the topic has shifted toward the topic of exporting domestically produced oil to other countries.  Naturally, this is being portrayed as unpatriotic greed on the part of the oil companies who are subverting the national interest of the United States for their own selfish interests. What this phenomenon really represents is a signal.  It is a signal to the United States that the “loose money” policies of permanently low interest rates and perpetual monetary expansion has consequences.  The government is clearly attempting to inflate values in the stock market and real estate sector by pumping money into the economy.  The problem is that this has the net effect of reducing the real value of dollars that are already in circulation.  It also has the effect of making products & services we sell to other companies less expensive, while making products & services they sell in the United States more expensive. One of the products made less expensive by a loose money / weak currency policy is oil.  When the US intentionally devalues its currency to support government spending programs and financial markets, it increases the relative purchasing power of other global currencies.  As the purchasing power of these other currencies increases, it allows them to purchase more energy than they otherwise would have bought.  This translates to increased incentives for oil companies to export their product instead of sell it domestically, unless the domestic price increases. Thus, the phenomenon we are seeing is not any kind of conspiracy or the result of evil intentions by corporate plutocrats.  It is nothing more or less than the predictable result of loose money policies.  It is certainly convenient for politicians to blame the usual suspects of “corporate greed” or “big oil” … however, the current situation is one that has been intentionally created.  It was not created to reward oil companies, it was created in an attempt to avoid a double-dip recession and conceal the sluggish growth of the US economy.

Canary in the Coal Mine

In years past, coal miners would take a canary down a mine shaft as a signaling mechanism.  If the canary died, it meant the air was becoming toxic and that they need to vacate the mine … quickly.  Similarly, these rapidly rising gas prices should be viewed as an indicator of what is going to happen as a result of continued easy money policies by the government.  It is an indicator of what the future holds for our economy.  Unfortunately, addressing the underlying problem that causes these higher prices carries with it separate problems.

A Rock and a Hard Place

The most certain remedy to the recent rash of price inflation is to begin tightening the money supply.  By raising interest rates and pulling-back money from circulation, it will increase the relative purchasing power of dollars.  This will make it (relatively) more profitable to sell oil in the United States than in other countries, so more supply will be attracted to the US.  This increase in supply will drive prices down to a new equilibrium.  The same effect will happen for food, which has also experienced a dramatic run-up in its price over the past few years.

The problem is that if interest rates are not constrained, and if money is removed from circulation, it will place significant downward pressure on both real estate prices and stock market values.  Increasing the cost of borrowing will also suppress business investment in new plants & equipment.  The unfortunate truth is that inflation has become the price we are paying for cheap money.  The irony of this observation is that the result of this policy, which is being pushed by the self-proclaimed champions of social justice is to disproportionately impoverish those at the bottom of the wealth and income ladder.

Since people who earn less income or are dependent on government subsidies tend to spend a higher percentage of their income on things such as food and energy, inflating the prices of these commodities to artificially reduce the costs for stock market investors and home buyers results in a net transfer of real wealth from those at the bottom to those at the middle and the top.

An even more concerning fact is that the current government entitlement liability has grown so large that long-term inflation is all but inevitable unless significant changes are made within the next few years.  Since entitlement programs are very popular with the people who receive the payments, it has become a matter of political suicide to propose any changes to these programs.  Unfortunately, the people who rely on these ‘safety net’ programs are the same ones who will be the most intensely impacted in the future when prices continually increase as the government prints money in an attempt to meet their financial obligations.

In the end, we must all decide what we will personally do to ensure that we are able to personally resist the coming inflationary wave.

 

The terms ‘profit’ and ‘loss’ are common parts of the business vernacular, but not many people fully understand their role in a market economy.  This has become even more pronounced after the recent financial crisis, as the government has attempted to perpetuate a system of profits without losses.  The problem implicit within trying to build a market economy without both profits and losses is that it will inevitably lead to one of two extremely undesirable results.

One sentiment that was popular in the middle of the 20th century was the notion that private profits are fundamentally immoral and that all production should be socialized.  This is the fundamental tenant of socialism and communism, and ultimately results in a stifling of risk taking since the rewards for entrepreneurship become non-existent.  In this environment, the resources available for redistribution don’t grow, and the costs of government control place a tremendous burden on national output as access to wealth becomes a function of political connections instead of skill or productivity.

Another sentiment that has been unfolding over the second half of the 20th and early 21st century is the notion of socializing losses from private activities through creditor bailouts.  The textbook term for business sector that enjoys government sponsored monopoly power and implicit (or explicit) guarantees of solvency is the “corporate state.”  In this model, profits are privatized to politically connected businesses and losses are socialized on the backs of taxpayers.  Some people refer to this as “crony capitalism” … however, the term is an oxymoron since capitalism is a system where market conditions are allowed to prevail and political officials are unable to provide special benefits to their “cronies” through the power of government.

The fundamental characteristic that both of these flawed models share is that they distribute wealth based on political influence instead of ideas and productivity.  In both cases, the government wields tremendous power and entrepreneurship is suppressed by either an absence of profits from success or from entrenched competitors with government backing that crush competition.  The danger that is posed by this model is that the “profits” it generates look the same as earnings from legitimate business activities.  However, the former provides nothing of net value to the marketplace, and the latter is the fundamental foundation of every market-based economy.

In a ‘real’ capitalist economy, profits are generated by success in the marketplace and failure results in losses for both equity and debt investors.  The current brand of “crony capitalism” has architected bailout after bailout of creditors who financed excessively risky business operations.  The importance of this comes from the fact that creditors have historically been the primary guardian of prudence in business activities.

Consider that a creditor receives no premium if a business is successful like a stockholder . . . all that they get is their regular interest payment.  Because of this, creditors in a ‘normal’ environment will demand a higher interest rate from risky businesses.  These higher interest rates will temper risk taking by entrepreneurs since the increased financial obligations will reduce their probability of success.

However, if the government guarantees the debtors of a particular company, then they have no reason at all to encourage prudence . . . they are going to get their money back from the government if things go upside down.  This creates perverse incentives where risk taking becomes more and more intense while the cost of borrowing stays low because of a government guarantee.  When big profits roll in, management gets big bonuses.  If a collapse occurs, the government bails out the creditors and the taxpayers get stuck with the bill.

Even in cases where government guarantees have been “successful” for companies that did not require an explicit bailout, they have contributed to insane risk taking that eventually culminated in the financial crisis of 2008.  Furthermore, these ‘successful’ bailouts are fomenting an even larger collapse, since the fundamental incentives have not changed.  Thus, the system of government guarantees results in an ever increasing avalanche of risks that are concealed from the public through clever accounting tricks until they eventually explode into a massive market collapse.

In the end, both profits and losses are necessary for true capitalism.  Unfortunately, true capitalism has not been present in the developed world for nearly 100 years.  In an environment of increasing manipulation and government control, the strategy for success is to gain control of income producing assets that can be financed with fixed-rate debt.  This will allow you to realize financial gains when the day of financial reckoning arrives and the US government falls back on creating inflation by printing money to finance its bailouts and entitlement promises.

 

The “Occupy Wall Street” protests of recent months has placed a lot of attention on income inequality and the reviled top 1% of earners.  The protestors loudly proclaim themselves to be a part of the 99%, and profess all sorts of beliefs about what should be done to remedy this perceived injustice.  Predictably, the desired remedies take the form of government financed subsidies.  As the protests have persisted, they have become notable for the disgusting state of protest areas, the deplorable behavior of some protestors, and the lack of a coherent message.  This has attracted all of the usual pro-socialist protesters to the movement, and steadily pushed it further away from the mainstream on its way to the fringe.

How About the “United States” 1%?

To the extent that there is a message from “Occupy Wall Street” that message seems to be that the top 1% are too affluent relative to the rest of the population.  The idea of income and wealth disparities have garnered quite a bit of media attention over the past few months, so it is reasonable to make a deeper examination of what the top 1% really means.  Fortunately, one of the economists from the World Bank named Branko Milanovic has done a considerable amount of research on the subject of inequality.

So how much do you have to earn to be in the top 1% of US earners?

Answer: $380,ooo per year

Many people are likely to reply that $380,000 is a lot of money and that a lot of the people earning those high incomes got them because of inside connections with the government to rig the game so that they have an unfair advantage.  However, there is an important distinctions that need to be made.  Not everybody in the top 1% got there through graft and corruption.  Many are owners of productive businesses, innovators, creators, entertainers, and people who generate otherwise valuable products and services.  If graft and corruption are the problem, it would make much more sense to protest against graft and corruption instead of protesting against the fact that some people have succeeded in generating high levels of income.

As far as having an unfair advantage is concerned, there is certainly credit to the argument that certain people have advantages that other people do not enjoy.  In Milanovic’s work, he calculated that 60% of global income disparity is explained by where a person is born.  To many people it is painfully obvious that some folks have more advantages than others, and that this is fundamentally unfair.  Because of this, some believe that the government should take resources away from those that produce the most so that they can be re-distributed to those who have not had as many advantages and produce very little.

How about the “Global” 1%?

This is where the conversation gets really interesting.  With global affluence being even more heavily skewed than the United States, it is reasonable to extend the analysis out to the whole world.  Assuming that one fundamentally believes in equality, then it should stand to reason that the top 1% of the world’s largest economy is too narrow of a sample.  What happens when we look at the whole world as our sample?  How does that change the dynamics of the discussion?

So how much do you have to earn to be in the top 1% of global earners?

Answer: $34,000 per year

Thus, it turns out that most of the people who profess to be in the (United States) bottom 99% are actually in the (Global) top 1%.  Ironically, the very people who are protesting against domestic inequality have themselves benefit greatly from global inequality.  If the philosophy of re-distribution is suitable for inequality within a country, it should stand to reason that it is suitable for a global scale?

Of course, this is where the self-centered hypocrisy of many protestors comes to bear.  The overwhelming majority of people protesting against domestic inequality have absolutely no interest in making intense personal sacrifices to remedy global inequality.  By expanding the scope of the debate, it becomes much more clear what is truly motivating the discussion.  The protestors have no interest in equality … otherwise they would be advocating for ‘global’ equality, which would require that they make sacrifices.  They are using equality as a shill to advocate for extracting resources from high producers.

The Fixed Pie Fallacy

The principal issue underlying the context of these conversations is a fundamental fallacy that believes the world’s resources are a fixed pie, and that this pie is divided up into “haves” and “have not’s” by some autocratic power structure.  When viewed through this fallacious lens, the answer seems to be one of simply re-distributing the pie.  However, all of the things that are consumed must first be produced.  Typically, the people who enjoy the most wealth and income are the ones who produce the most.  So it stands to reason that when the rewards of being productive are reduced or eliminated, there will be less production.

Unfortunately, government policies and financial markets have created a situation where many of the most highly compensated people engage in activities that produce very little in terms of real output.  Exploiting subsidies, regulatory protection, and market arbitrage can produce high incomes, but does relatively little to increase overall output.  It makes complete sense that these avenues of resource extraction without commensurate real production should be sought out and eliminated.  The free market is about rewarding real production and innovation.  The phrase “crony capitalism” is an oxymoron … capitalism is about competition.  the only way cronies can be rewarded is when a political authority is impeding the competitive market.

This is where the ‘real’ solution to the global inequality can be found.  Namely that emphasis should not be placed on how to extract more resources from those who are productive, but that emphasis should shift toward finding ways to help those at the bottom become more productive themselves.  Put another way, it is much better to focus on growing the whole pie instead of focusing on who has the biggest piece of the existing pie.

Envy Economics

Unfortunately, encouraging real productivity isn’t high on the priority list for most politicians.  The reason is because promoting free markets doesn’t deliver many votes.  There’s much more political mileage to be gained from higher taxes, more government subsidies, and higher regulations than the opposite.  The economic pie grows the most when tax rates are low, exemptions are low, regulations are light, and government intervention is modest.  However, high tax rates mean that you can lobby for campaign contributions from businesses and individuals who want deductions and exemptions.

Empirical studies have shown that the net tax rate paid barely changes over time, regardless of what marginal rate is published.  When rates are high, politicians can sell exemptions for campaign contributions.  This results in very little net tax revenue but a vast increase in net political contributions.  Light regulation promotes growth, but lobbying groups always prefer more regulation that benefits their contributors.  Most workers would be better off with a robust job market than government subsidies, but it’s much easier to take credit for subsidies than for a job market.

In the end, economic well-being on both the national and global scale must come from productivity.  The only sustainable way to increase the affluence of the people at the bottom is to help them become more productive.  Put another way, it is much more beneficial to help the people at the bottom climb up than it is to target the people at the top and bring them down.

 

Harbor at Midnight

During the late 18th century, an economist named Adam Smith wrote an essay challenging the fundamental assumptions of the prevailing economic system.  This system emerged during the middle ages, and has come to be known as Mercantilism.  Many of the key tenants in a Mercantile system bear a striking similarity to prevailing political sentiment that persists to this day.

The primary thought behind a Mercantile system is a focus on domestic industry.  In this system, there is very tight government control of foreign trade.  High tariffs on imports are very typical.  The desired outcome of these actions is to maximize exports, and minimize imports to support domestic industry.  The “protectionist” sentiment is still alive and well in the current era.

Another key aspect of Mercantilism is heavy government involvement in the economy.  During Medieval times, monopoly rights were granted to favored families.  This led to high profits for the favored families, high prices for consumers, and limited availability of products and services.  In the modern era, this takes the form of government subsidies for businesses that engage in politically favored activities such as “green” industries.

In addition to this, many Mercantile economies engaged in colonial expansion.  The colonies of Mercantile countries were typically forced to export raw materials to the “mother country” and purchase finished goods from the state sponsored monopoly companies at the elevated monopoly prices.  One of the typical results of this situation is anger on the part of the colonies over high prices, high taxes, and a lack of political representation.  The most famous case of colonial strife is the American Revolution that started in 1776, which just happens to be the same year Adam Smith published the Wealth of Nations.

Modern Mercantilism

To many people, the principal desire of Mercantilism seems very appealing.  After all, if imports are reduced with taxes and tariffs while exports are subsidized by the government, it seems that the result would be more domestic industry and more jobs.  This sentiment has picked up many followers in recent years as the mix of employment has shifted with many jobs being done overseas that were previously done domestically.  In response to the problem of American jobs going overseas, many people favor a Mercantile system.

Another factor that draws many people toward Mercantile ideas is a fundamental mistrust of market forces.  Many people believe that if the market is left alone, it will result in under-investment in socially valuable projects such as “green” energy, technology, or industrial development.  The belief is that if government subsidizes these industries, it will give the country a head start relative to other players in the global economy and will ultimately benefit the people at large.

One can easily see where these sentiments come from, but it is another matter entirely to determine their level of validity.  The important factor to consider in regard to evaluating an economic system is that the best of intentions frequently produce results that are not necessarily consistent with those intentions.  Thus, it is important to understand the results and how those results can be different from the intentions.

What’s the Problem with Mercantilism?

Analysis of the Mercantile system begins and ends with an examination of what happens when imports are restricted through tariffs, exports are expanded through government rules, and favored businesses are subsidized.  The first level of this analysis is to ask where the resources come from to fund the subsidies?  The second level is to examine who benefits the most from these policies and who is the most disadvantaged.

Consider first that no government can create resources out of thin air.  Everything that any government spends must be extracted from somebody.  In order to subsidize favored businesses, higher taxes must be collected from the rest of the population who is not being subsidized.  These higher taxes result in higher prices for consumers.  In addition to this, the high tariffs on imports result in yet another increase in consumer prices because of decreased competition.  Ultimately, all of the costs are paid by the consumer.

In addition to this, we must consider who really benefits and who really pays.  This analysis starts and ends with the businesses who are favored by the government and receive preferential treatment through tariffs restricting competition or direct subsidies.  In medieval times, the families who ran the government sponsored monopolies were directly responsible for the King maintaining his throne.  In contemporary times, the companies who receive the most government support are the most active in lobbying politicians for favorable legislation.  The key to this whole cycle is that the people in charge must have a large degree of discretion over taxes, spending, and regulation to reward their allies in an amount that is sufficient to garner their continued support.

It is not difficult to see how this cycle will produce many undesirable results.  High amounts of government spending will attract high amounts of lobbying (both ‘above’ and ‘below’ the table).  These subsidies will direct resources away from what produces the highest rates of return.  The high consumer prices will dramatically reduce the real standard of living for the general population. Ultimately, Mercantilism is a systematic impoverishment of the masses for the exclusive benefit of politicians and favored companies.

This is the driving force behind colonial expansion.  An inefficient economy requires that resources be continually extracted from somebody else to subsidize an unsustainable economy.  Much of the strife that occurs throughout the world is driven by the fact that inefficient dictatorial economies can only sustain themselves by extracting resources from somebody else.  This leads to persistent fighting over natural resources by governments who want to extract that wealth for the benefit of the people they favor.

What Capitalism Really Means

Adam Smith wrote about a system that has come to be known as Capitalism.  The central tenant of Capitalism is that when commerce is more free to operate in a market environment, it produces (unintended) beneficial results.  According to Adam Smith, people are more likely to serve others out of self-interest than genuine altruism.  However, through the process of serving others to advance their own self interest, other people are made better off.

Capitalism is most beneficial to new businesses, and is most threatening to established businesses.  The reason is because open competition means that new innovations can very rapidly displace old ways of doing business.  This means that nobody can afford to sit on their past successes.  However, this competitive environment can only exist if the government allows market forces to prevail.  This means that a system of discretion and intervention must give way to a system of stable rules and market based results.

Thus, it becomes very easy to see why ‘true’ Capitalism is so hard to instill, and even harder to maintain.  The lynchpin of the whole system is regulatory rules vs. political discretion.  However, politicians always prefer discretion because it gives them more power and allows them to extract more support from business entities who benefit from the status quo.

In a bitter twist of irony, the infamous “Occupy Wall Street” movement that purports to be protesting against Capitalism is citing the tenants of Mercantilism as their complaints.  To wit, the hackneyed phrase “Crony Capitalism” is an oxymoron … Capitalism by its vary nature lacks the political discretion that is necessary for elected officials to reward their friends and contributors.  In another ironic situation, the purported solution to the perceived evils of Capitalism is dramatic expansion of government power and political discretion. And the inevitable result will be greater concentration of power in government and more favors being steered toward politically connected, powerful businesses while the population at large pays through higher taxes, higher prices, and less innovation.

Thus, the movement against Capitalism is nothing more than Mercantilism redux.

 

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.

 

How can you lower your portfolio’s risk in a world of rolling government-debt crises? Start by taking a deep breath. Then, see if you need to do some tinkering—but not too much.

With Europe in turmoil, investors are so eager for a “safe haven” that this week they were willing to accept a return of only 0.01% a month to hold Treasury bills. Such yields on short-term Treasurys are barely a sliver above their all-time lows, even as Uncle Sam’s own debts may be teetering on the brink of default.

Fears are rampant that the U.S. may lose its triple-A credit rating, that the economy will stay stagnant, that inflation will eventually surge and that the dollar will wither. Lately, U.S. Treasurys and the dollar have rallied mainly because other nations are in even more of a mess.

Amid such uncertainty, you can’t reduce one set of risks without raising others. If, for instance, you buy gold, you lower the risk that a collapsing dollar will crush your wealth. But you incur other hazards by paying all-time-high prices for an asset that generates no investment income, lacks intrinsic value and has a weak record of combating inflation. Other hedges carry other risks and trade-offs.

Thus, making a sharp course correction may cut your exposure to the U.S. dollar or inflation—but if today’s fears don’t materialize, or the future turns out to be full of its customary allotment of surprises, then your sudden shifts may turn out to hurt you. So moderation is the key.

Normally, explains Laurence Siegel, research director at the Research Foundation of CFA Institute, U.S. investors should tilt toward holding assets denominated in dollars, since their future spending also will be dollar-based. “However,” Mr. Siegel says, “today’s extraordinarily low yields on dollar assets drag the solution the other way—toward international diversification.” If, for instance, you normally keep 20% in non-U.S. stocks, you might begin raising that to 25%.

Some heavy-hitting investors are beginning to move in that direction, even in their own portfolios. “Going into the crisis, all my [personal] safe money was in U.S. Treasurys,” says Howard Marks, chairman of Oaktree Capital Management in Los Angeles, which manages more than $80 billion. “Now, it’s in the debt of a variety of countries, on the assumption that some of their currencies may well gain versus the dollar.”

Likewise, Todd Petzel, chief investment officer at Offit Capital Advisors in New York, says his firm is spreading its clients’ assets into short-term securities issued by non-U.S. governments. Mr. Petzel favors countries with low levels of debt and a wealth of natural resources, such as Australia, Brazil and Canada.

Relatively new mutual funds make it easier for small investors to spread bets—again, in moderation.

WisdomTree Dreyfus Commodity Currency and WisdomTree Dreyfus Emerging Currency are exchange-traded funds offering exposure to foreign currencies that, so far at least, have been relatively unscathed by the government-debt crisis. Commodity Currency provides exposure to money issued by Australia, Canada, Russia, New Zealand and four other countries that are major exporters of raw materials; Emerging Currency offers Brazil, China, India, Israel and eight other developing nations.

SPDR DB International Government Inflation-Protected Bond and iShares International Inflation-Linked Bond are ETFs that hold the debt of more than a dozen governments world-wide, designed to keep pace with inflation in those countries. Such a fund could offer partial protection against a decline in purchasing power in the U.S.

The debt of developing countries is no longer cheap, but it still may offer some diversification. The iShares JPMorgan USD Emerging Markets Bond ETF holds debt denominated in U.S. dollars, while Market Vectors Emerging Markets Local Currency Bond is a basket of government securities issued in Brazilian reis, Chilean pesos, Russian rubles and so on.

But remember: While many emerging-market nations may have better fiscal outlooks than the U.S., they still are risky. (If lending to Russia doesn’t make you nervous, someone needs to check your pulse.) The currency funds may spread your overall portfolio risks, but they distribute income only once a year and aren’t a substitute for cash.

“If the markets get scared again and there’s another flight to quality,” says Larry Swedroe, director of research at Buckingham Asset Management in St. Louis, “then the dollar will go up and kill your unhedged foreign bonds just when you most want them to keep you afloat.”

If you do move any money in response to the debt crisis, move small amounts slowly. A future that seems this inevitable may not even happen—precisely because it seems so obvious. As Mr. Marks asks: “Is the world less safe than it used to be? Or was it never as safe as we thought it was? Maybe the risks were higher before, when nobody was conscious of them.”

—
intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj

Article source: Wall Street Journal