On Wednesday I came across this fascinating analysis about the debt spiral the US now finds itself in, written by Professor Antal E. Fekete at the San Francisco School of Economics. I asked Prof. Fekete permission to republish his article here, and he was kind enough to grant my request.
Hope you enjoy this piece. Prof. Fekete has a very unique perspective, and presents an extremely well thought out argument. I always try to read thorough analysis that counters my current way of thinking, to challenge my assumptions - this piece sure did that, and I hope it does for you as well.
A. E. Fekete
All rights reserved
THE MARGINAL PRODUCTIVITY OF DEBT
Why Obama's Stimulus Package Is Doomed to Failure
Antal E. Fekete
Professor of Money and Banking
San Francisco School of Economics
E-mail: aefekete@hotmail.com
Paper mill on the Potomac
The paper mill on the Potomac is furiously spewing up new money. According to the manager of the mill, as indeed according to the Quantity Theory of Money, this should stop prices from falling and the economy from contracting.
In this article I present an argument why this conclusion is not valid. On the contrary, I shall show that new money created on the strength of a flood of new debt, is tantamount to pouring gasoline on the fire, making prices fall and the economy contract even more. The Obama administration has missed its historic opportunity to stop the deflation and depression inherited from the Bush administration because it entrusted the same people with the task of damage-control who had caused the disaster in the first place: the Keynesian and Friedmanite money doctors in the Fed and the Treasury.
Watching the wrong ratio
Conversely, a serious fall in that ratio is a danger sign that the quality of debt is deteriorating, and contracting additional debt has no economic justification. The volume of debt is rising faster than national income, and capital supporting production is eroding fast. If, as in the worst-case scenario, the ratio falls into negative territory, the message is that the economy is on a collision course and crash in imminent. Not only does more debt add nothing to the GDP, in fact, it causes economic contraction, including greater unemployment. The country is eating the seed corn with the result that accumulated capital may be gone before you know it. Immediate action is absolutely necessary to stop the hemorrhage, or the patient will bleed to death.
Keynesians are watching the wrong ratio, that of debt-to-GDP. No wonder they constantly go astray as they miss one danger signal after another. They are sailing in the dark with the aid of the wrong navigational equipment. They are administering the wrong medicine. Their ambulance is unable to diagnose internal hemorrhage that must be stopped lest the patient be dead upon arrival.
Melchior Palyi's early warning
The decline in the marginal productivity of debt has continued without interruption thereafter. Nobody took action, in fact, the Keynesian managers of the monetary system and the economy stone-walled this information, keeping the public in the dark. Nor did Keynesian and Friedmanite economists at the universities pay attention to the danger sign. Cheerleaders kept chanting: "Gimme more credit!"
I learned about the importance of the marginal productivity of debt from the privately circulated Bulletin of Hungarian-born Chicago economist Melchior Palyi in 1969. (There were altogether 640 issues of the Bulletin; they are available in the University of Chicago Library). Palyi warned that the tendency of this most important indicator was down and something should be done about it before the debt-behemoth devoured the economy. Palyi died a few years later and did not live to see the devastation that he so astutely predicted.
Others have come to the same conclusion in other ways. Peter Warburton in his book Debt and Delusion: Central Bank Follies That Threaten Economic Disaster (see references below) envisages the same outcome, although without the benefit of the concept of the marginal productivity of debt.
The watershed year of 2006
The year 2006 was the watershed. Late in that year the marginal productivity of debt dropped to zero and went negative for the first time ever, switching on the red alert sign to warn of an imminent economic catastrophe. Indeed, in February, 2007, the risk of debt default as measured by the skyrocketing cost of CDS (credit default swaps) exploded and, as the saying goes, the rest is history.
Negative marginal productivity
In view of the fact that the marginal productivity of debt is now negative we can see that the damage-control measures of the Obama administration, which are financed through creating unprecedented amounts of new debt, are counter-productive. Nay, they are the direct cause of further economic contraction of an already prostrate economy, including unemployment.
The head of the European Union and Czech prime minister Mirek Topolanek has publicly characterized president Obama's plan to spend nearly $2 trillion to push the U.S. economy out of recession as "road to hell". There is absolutely no reason to castigate Mr. Topolanek for this characterization. True, it would have been more polite and diplomatic if he had couched his comments in words to the effect that "the Obama plan was made in blissful ignorance of the marginal productivity of debt which was now negative and falling. In consequence more spending on stimulus packages would only stimulate deflation and economic contraction."
Hyper-inflation or hyper-deflation?
While prices of primary products such as crude oil and foodstuffs may initially rise, there is no purchasing power in the hands of the consumers, nor can they borrow as they used to in order to pay the higher prices much as though they would have liked to do. The newly created money has gone into bailing out banks, and much of it was diverted to continue paying bloated bonuses to bankers. Very little, if any of it has "trickled down" to the ordinary consumers who are squeezed relentlessly on their debts contracted in the past.
It follows that price rises are unsustainable, as the consumer is unable to pay them. As a consequence the retail and wholesale merchants are also squeezed. They have to retrench. Pressure from vanishing demand is passed on further to the producers who have to retrench as well. All of them are experiencing an ebb in their operating cash flow. They lay off more people, aggravating the crisis further as cash in the hand of the consumers is diminished even more through increased unemployment. The vicious spiral is on.
But what is happening to the unprecedented tide of new money flooding the economy? Well, it is used to pay off debt by the people who are desperately scrambling to get out of debt. Businessmen in general are lethargic; every cut in the rate of interest hits them by eroding the value of their previous investments. In my other writings I have explained how falling interest rates make the liquidation value of debt rise, which becomes a negative item in the profit/loss statement eating into capital that has to be replenished as a consequence. Worse still, there is no way businessmen can be induced to make new investments as long as further reductions in the rate of interest are in the cards. They are aware that their investments would go up in smoke as the rate of interest fell further in the wake of "quantitative easing".
Self-fulfilling speculation on falling interest rates
Note also the crescendo of the dumping of equities and the desperate attempt to redeem toxic assets by private parties, sending the demand for cash sky high. The dollar, at least the Federal Reserve note variety of it, will be increasingly scarce. Rather than falling through the floor as under the hyper-inflationary scenario, the purchasing power of the dollar will soar. You say that Ben Bernanke and his printing presses will take care of that? Well, just consider this. The market will separate vintage Federal Reserve notes from the new issues with Bernanke's signature on them. In a classic application of Gresham's Law people will hoard the first, bestowing a premium on it relative to the second variety, which will fall by the wayside.
Bernanke can create money but cannot make it flow uphill
Karl Denninger envisages unemployment in excess of 20%, with cities going "feral" as showcased by downtown Detroit (see References below).
What has all this got to do with the marginal productivity of debt? Well, once it is negative, any further addition of new debt will make the economy shrink more, increasing unemployment and squeezing prices. Bernanke can create all the money he wants and more, but he cannot make it flow uphill.
Bernanke is risking something worse than a depression
Denninger says that the "death spiral" will lead to fire sales of assets in a mad liquidation dash and, ultimately, to the collapse of both the monetary and political system in the United States as tax revenues evaporate. He opines that probably not one member of Congress understands the seriousness of the situation. Bernanke is risking something much worse than a Depression. He is literally risking the end of America as a political, economic, and military power.
Indeed, the financial and economic collapse of the last two years must be seen as part of the progressive disintegration of Western civilization that started with government sabotage of the gold standard early in the twentieth century. Ben Bernanke, who should have been fired by the new president on the day after Inauguration for his part in causing irreparable damage to the American republic may, in the end, have the honor to administer the coup de grace to our civilization.
March 28, 2009
References
Bernanke Inserts Gun in Mouth, by Carl Denninger, March 20, 2009, http://market-ticker.denninger.net
Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, by Peter Warburton, first published in 1999; WorldMetaView Press (2005)
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