Tuesday, October 11, 2011

US Economy, Debt, Gold Standard, Inflation, Recession 2008 (how it happened)


Excerpt from Ken's upcoming book:

Chapter 11
US Economy, Debt, Gold Standard
Inflation, Recession 2008

The high productivity and creativity of the American economy has created levels of wealth and resources that as a whole have come to sustain a lot of indebtedness.
Debt—two types:  One is by investing in something that will render a profit.  The second is for buying something we use or consume.  A car to get to workand a home to live in are the two most noteworthy and common causes 
of going into consumer debt.
A loan for a basic car to get to work in can be considered a necessary consumer type debt, and therefore a job-type investment.  An expensive sports type car goes into the unnecessary consumer debt column much as debt for clothes, vacations and concerts.
Home mortgages likewise are the usual necessary path to home ownership which, generally have proven to be an investment because they have held and usually increased in value.
So they have been a combination of consumer and investment debt.  Because of government interference in the home mortgage business the demand went up and up beyond anything in our past history.
Prices doubled and even tripled in a ten year period (mostly between 2000 and 2005) creating a bubble that eventually popped.  Foreclosures on houses worth less on the market than the amount of the mortgage debt skyrocketed.  Result:  anticipated profitable investments became painful losses.
The housing bubble collapse was so widespread and had a domino effect on so many areas of the American economy that it caused the worst recession (2008) since the 1930’s.
Of course, those in charge of taking care of other people’s money (the banker, credit unions, etc.) loan that money to you and me; obviously, we have to show them we can pay it back—and will pay it back. (How’s your credit rating?)
National Debt:  The dynamics of debt control lies in the ratio of debt to ability to pay.  While the Federal Government’s debt has gone up over the last sixty-plus years, tax revenue has also increased.  So while some have been concerned about the rising national debt, many have not been.  For many people and politicians, the pressure for more entitlement-type spending has put questions of deficit spending on the low end of the totem pole.
Without going into actual figures at this point, suffice it to say that for a number of years Federal expenditures have been going up faster than GDP or tax revenue.  Now with the Obama administration, the number of government programs, plus the increased coverage/expenditures for existing programs, has increased greatly.  At the same time, the tax revenues have decreased due to the 2008 recession.
This increasing gap has now become a source of widespread alarm­­—domestically and internationally.  National debt/deficits are financed in three ways.  First, is by using the surplus in the Social Security trust fund.  Second, is by selling bonds/treasuries to people and institutions.  And third, when there is a short fall, then the money owed is printed literally, or by electronic transfers, by the Federal Reserveeither way the money is created out of thin air.
The creation of this money is achieved by the process of printing.  The technical way this is done is not pertinent here except to say the money is “printed.”  Prior to our modern era when governments had to
make up deficits but couldn’t borrow enough, the money printing presses went into overtime.
Gold Standard:  In the past, many nations have been on the gold standard, meaning their paper money could be exchanged for gold being held in government vaults.  Being on the gold standard meant the government could not print too much paper money because there would not be enough gold to back it up.  The paper money would then decrease in value because of inflation—that is, rising prices.  When something costs $100.00 today, and in six months it costs $120.00, you have to have more paper money to buy it.  In other words,
your money buys less; it is devalued.
When too much paper money was printed, and prices began to increase, then more holders of paper money would go to the bank and exchange paper for gold.
Increasing demand for gold put the brakes on government deficit spending.  This, in turn, was a brake on rampant inflation.
Because of this brake on government deficit spending, most nations have gone off the gold standard.
The United States went off the gold standard in late 1973 as more and more holders of dollars demanded gold (Fort Knox) for their paper money.  Today most modern nations use fiat money (not backed by gold).
Governments usually print a little more money than is needed to replace that which is lost or worn out.  This surplus generally results in a small rate of inflation (1–2 percent per year).  Many economists say this inflation is not only acceptable but desirable in terms of safe economic growth.
Printing larger amounts of fiat money, however, became popular in Germany in the 1920s, in Argentina and Brazil in the 1970s and 1980s, and in some African countries.  The end result was hyperinflation which, in domino fashion, created economic havoc.  Then the economies stagnated.  In Germany, this economic state led the people step by step toward acceptance of the authoritarian voice of Hitler and his rhetoric of “solutions” to the German people’s pain.
The hyperinflations in Argentina and Brazil caused economic problems, but disasters were averted.  Loans and gift-like forgiveness of some of their debts came through the instrumentality of the International Monetary Fund (IMF)—which gets its money from members such as the United States, Japan, and European Nations.
Traditionally, the US Federal Reserve Bank (which is a quasi-private bank owned by private owners, and has a unique relationship to the Federal Government in that it has some regulatory power over the interest rates charged by the banking system.  It keeps a close eye on the money supply and the rate of inflation.  The bank claims there is a balancing act.  Too much money in the system leads to easier credit and higher inflation; conversely, credit restrictions slow down the economy.
Today as we look at the United States, we see a diminishing number of buyers of US bonds and an increasing need to create fiat-type money. 
There is less enthusiasm for the US debt instruments due to the increasing fear of US debt soaring out of control—or that it will—because of greatly increased spending both now and in the future, given the policies of the Obama Administration (and the new higher debt ceiling).  As this is being written, (May 2011) money is being created out of thin air to pay for bonds issued in the past and bonds to pay for the new debts needed to pay for current deficits.                                                                                                                                  
Perhaps more accurately, S&P recognized that the United States will pay its debts, but the money used to pay them will be worth less (meaning it will buy less on the market).  Therefore, those buying the bonds will need a higher rate of interest to compensate for receiving back, at the end of the loan agreement, dollars of lesser value (in other words, dollars that buy less).  This warning was recognition of a higher rate of inflation in the future.  Now when the government (any government, company, etc.) has to pay a higher rate of interest, the indebtedness has increased
costs. 
At some interest rate point, companies, municipalities, people, etc. decide against debt (or more debt) because it is not financially feasible.  Obviously they can’t print/create money; but the Federal Reserve Bank can, and is doing so at a greatly increased rate.
In an accompanying article are reports that the US treasury has been “fully funding treasury needs since December 2010. . .”
Donald McAlvany, founder of a prominent newsletter, The McAlvany Intelligence Advisor, writes that US debt obligations are so high that they can never be paid by raising taxes—and severely cutting government spending has become politically untouchable.
McAlvany believes the entitlement spending is now so mentally ingrained, has so much traction, that our elected public servants will not cut expenditures enough to set right our financial ship of state.
Economic Causes and Effects:  What caused the 2008 Recession? It is a mystery to many people! 
Step one:  The recession started with the Housing Bubble when government policies caused two conditions.  First, demand was stimulated by government pressure on loaning institutions to make sub-prime loans.  People not able to come up with a traditional down payment and people who weren’t credit-worthy were enticed into house purchases.  Second, this increased the demand for houses to the point housing prices skyrocketed—eventually outstripping wages and ability to pay even under the sub-prime terms.
Step Two:  Financial mortgage-buying investment firms bought mortgages bundled together without adequate examination to determine their credit-worthiness, and/or with too much optimism that housing values would hold or increase.  The careless lessening of credit-worthy standards was also the result of government pressure to make loans to those ordinarily not qualified.  Also, some loans contained government loan guarantees.
When the Housing Bubble popped (falling prices and foreclosures), the mortgage investment firms—and the companies that invested in them—were headed for bankruptcy.  While over simplified, we can say, for example, that the insurance giant AIG was so big in the United States and Europe that, had it gone under, the domino effect would have wreaked havoc in both the United States, Europe, and even around the world.
The Federal government, via TARP (The Troubled Asset Relief Program), spent $700 billion in the rescue—up to this time the biggest financial rescue package ever.  This action kept the world’s fiat money-based economy from collapsing.
AIG owed so much money to so many, many large banks, that if it had defaulted, a ripple (tsunami) effect would have devastated those banks.
The banks themselves were also holding housing assets whose value had gone down; a deflationary crunch.  While many believe the economic dislocations will end up causing serious inflation, there are those who feel the depression in the housing market will continue and
even affect other segments of the economy.
Also, a part of this picture or puzzle is the international status of the dollar (for more on this go to the end of this chapter.)
Central to this issue is creating or printing money—out of nothing but faith in the United States and its treasury.  The Fed’s intervention (Quantitative Easing, or QE) was successful to some people, at least in the near term.  But students of this are debating whether the QE should have been implemented, or should have allowed the banking structure to take its losses, restructure itself, and start back up.
Both sides make compelling arguments.
A second stimulus, QE-2, was needed in 2010–11 ($600 billion).  Fed Chairman Ben Bernanke allegedly sees subsequent iterations of QE as maybe necessary in order to keep the economy functioning.
Suppose you have an aging horse.  When it starts to teeter, it gets drugs which prolong its life, but ultimately it dies anyway. 
This metaphor may be useful in looking at government money creation (QE’s) which ultimately cause the dollar (value) to die via hyperinflation.
 In 1980, we saw inflation at around 15 percent.  Since that correction, US inflation has been at 5 percent and less—usually 1 to 3 percent.
Fifteen percent inflation doesn’t deserve the label of hyperinflation—not as the world has seen cases called hyperinflation.  The inflation nevertheless causes adjustments that traditionally the Federal Reserve strives to avoid.
Since December 2010, the US Treasury has not been able to sell enough bonds to do cover its debts.
To repeat, the US debt has gotten so high that it can’t be totally financed by selling bonds, so the “printing presses” are filling the gap.
We also see a red flag indicating caution in terms of credit worthiness.  In the financial world, the higher the risk, the higher the interest rate charged.  A credit rating institution called Standard and Poors estimates the ability and will of companies, municipalities, states, and the Federal Government to pay debts. 
In the early part of 2011, S&P issued a red flag warning on the ability of the Federal Government to pay its debt. If you own a bond with a fixed rate of interest, say 7 percent, then in a year you have lost 8 percent of its face value if the inflation rate is 15 percent. 

On the open market, that asset will fall in price.  The price will fall until the yield on the asset has risen enough to offset the inflation rate, in  
this case 15 percent.
Hyperinflation stifles the entrepreneurial spirit because of the unpredictability of the economy.
Martin D. Weiss, Ph.D., in his Safe Money Report, provides the following commentary and charts:
“Today, Fed Chairman Bernanke’s new money printing makes all those prior money printing episodes look like tiny hiccups by comparison…
“The horrific truth is that the US Federal Reserve is now engaged in the greatest money-printing scheme since the Weimar Republic in Germany!”
Ultimately it took three trillion marks to buy a single dollar.
Weiss’ warning reports “From September 10, 2008 through the end of 2010, the Federal Reserve chief increased the nation’s monetary base from $851 billion to $2.03 TRILLION!
“That’s an irresponsible, irrational, absolutely insane increase of 138.6% in America’s monetary base in just 27 months…and there’s literally NO END IN SIGHT!”
Federal Reserve Chief Bernanke is continuing to create dollars to finance our record federal deficits.  Weiss continues “So, with no real end to this madness in sight, global investors have been dumping dollars on a massive scale, sending the greenback into a nosedive.
“And believe it or not there’s an even more terrifying threat to the US dollar on the horizon…
“On February 10, 2011, the International Monetary Fund (IMF) disclosed details of its plan to replace the US dollar as the world’s reserve currency!”
David Walker, former US Controller General and head of the US Government’s Accounting Office (GAO), is warning that Washington’s debts could sink the economy.
No fewer than ten former chairs of the White House Council of Economic Advisors—including President Obama’s former top economic advisor, Christine Romer—have added their voices of warning of a potential economic catastrophe.
An editorial published by Politico, a bipartisan group, warned that unless the White House and Congress slash the Federal deficit, bond investors are likely to turn on the US and trigger an economic crisis that could “dwarf 2008.”
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