November 1, 2008                                                                                                                       

 Why the bailout can’t and won’t work

 Like a drug-crazed junkie in withdrawal screaming for more heroin, the US economy is screaming for more credit, little realizing the very debt they seek is now toxic to their system and killing the economy just as the heroin will eventually kill the junkie.

 The financial bailout might postpone some of the damage to the economy, but that is about all that can be hoped for.  The reason - it only addresses a symptom of the problem, not the root cause.  Not only that, but it isn’t even the best way to address the symptom of tight credit markets.  Postponing the consequences also means they will be worse when we finally get the full brunt.  Amidst all of this, the US government is looking like a chicken with its head cut off - on the one hand they want to get credit flowing and people borrowing and spending again, and on the other they are telling folks to save more.  Not only is this conflicted, but it is silly to the point of being stupid and quite telling in terms of how organized the US government is in all this mess.  It is not very reassuring, but, as they say, wait, there is more…

 To give a hint as to what the real underlying problem is:  What has been the main engine of economic growth over the last four or five decades?  And a further hint:  What percentage of per capita growth can be attributed to growth in personal debt?  I am pretty sure you will underestimate your answer to the second question.

 The first mistake made by governments and central banks was to consider this an isolated liquidity event rather than the systemic debt bubble that it is.  The illiquidity and problems arising from it are a result of decades of running an economy on growth in personal debt.  It hasn’t dawned on anybody yet that you can’t use debt as a main driver for economic growth forever – at some point it has to stop; then the house of cards comes crashing down. 

 Just look at the goal of the current “fix.”  They want to get credit flowing to businesses and consumers again.  This is akin to giving a junkie more heroin.  It will alleviate the symptoms for a time, but not solve the problem.  The other key point in the bailout is that it focuses all the help at the top with the hope that it will trickle down to the consumer in the form of more credit – in effect feeding the addiction to debt.  Nobody seems too sure this will actually work as intended.  Isn’t it mighty nice of the government to use taxpayer money to help big business and not the taxpayers themselves?  The bailout is a bad idea made worse by being applied at the wrong end of the economy.  It would have been better to support the consumer and let the cash flow up – this would have helped everybody – even though it still would not solve the problem.

 If we follow the process to its logical conclusion we can easily see that it is not only bad for consumers, but potentially devastating for small business.  Here's how.  The long term effect will be to dry up money.  To prevent another meltdown anytime soon interest rates will have to trend to 0% as any rise will trigger the same cycle we are seeing.  At that rate, nobody would want to save money in a bank.  They would be inclined to put it under their mattress or invest in the markets, a riskier choice, but the only option that would offer a chance at better returns. 

 This will be good for the big guys, but not so hot for small business and especially bad for smaller banks that need consumer deposits to survive.  Since savings will dry up, so will money for small business loans.  And with small business being the major employer, jobs will be lost and things will turn down again with a vengeance.  Then the government will try to print money (like they are doing now) to try to inflate their way out of the mess and keep things from falling apart.  The end result will be the same regardless of whether we go through a hyper-inflationary stage or not.  All the economic roads lead to the same end.  All this because they are not addressing the real problem now.

 Below is a simple graph that will illustrate the true nature of the underlying problem.  It shows the percentage of per capita economic growth due to debt over the last 40 years in Canada.  Canadians are more conservative borrowers and tend to be less likely to take on debt than their American neighbors, so we can assume that the situation in the US (or Europe for that matter) is as bad or worse.

 Personal Debt as % of Per Capita Expenditure Growth - Constant Dollars Adj. for Inflation

 

 As you can see, using Gross National Product/Gross Domestic Product (GNP/GDP) as an economic measure about 250% of per capita growth in the economy over the last 40 years is due to increases in personal debt.  In terms of personal expenditure (PE) the ratio is even worse.  Personal debt has been rising two and a half times as fast as the economy, on a per capita basis.  This is a stark graphical representation of the underlying systematic problem that will not go away with any of the proposed solutions.  We have an inherently unsustainable economic system – one that is based on ever increasing amounts of personal debt to grow.

  The personal debt increase also reflects the fact that the average person is falling behind.  Without debt, the economy would be at a lower level than it was 40 years ago.  We have seen many articles and books, such as Elizabeth Warren’s The Two Income Trap, that highlight how the average family is worse off now than they were 40 years ago.  Clearly the standard of living is being propped up by debt while real disposable income is falling behind.

  Then there is all the government debt.  It will all land in the consumer's lap too.  One way or the other the ordinary person will get stuck paying all this off. 

  There are some problems associated with this debt bubble.  First, the whole notion of “growth” as something that is desirable and necessary for the economy.  It is a simple mathematical fact that any rate of growth other than zero is not sustainable over the long run.  There is absolutely no discussion at all as to where the logical end may be.  As we are seeing, it might be in our faces right now, or at least very close.

  The second problem is the need to grow populations to grow the capacity for more debt.  With low inflation, the only means to continue to feed the debt bubble is more people.  And the long term consequence of this approach is, of course, inflation, which will continually creep up over time due to population pressures.  Canada and the US employ this strategy with reckless abandon in order to grow the economy and thus profits for the few.  The result is overpopulation and inflation which piles on to the debt burden as living costs accelerate.  None of this is sustainable and yet there is no suggestion anywhere to stop the insanity. 

  The most serious consequence of this strategy is the need for ever increasing debt levels just to keep the economy where it is at.  Here’s how it works:  Say one year you spend $1,000.  The next year, you borrow $20 and spend $1,020 – you have a 2% growth.  The following year you need to borrow another $20 just to keep it the same, and $20 more if you want more growth.  The upshot is if you grow the economy with debt you have to increase debt at increasing rates to keep growing.  And just about anybody can figure out that it is not sustainable.  The US economy is a prime example of what happens when it all comes to a head.  Monetary policy can’t and won’t work anymore because any increase in rates stalls the economy.  All that is left is the printing press and the specter of future inflation (possibly hyper-inflation), or to let the debt bubble burst and suffer deflation.  There are no good alternatives.  Typically in this situation the powers that be take the easy way out – try to keep it going longer and pass the problem on to the next generation.  Meanwhile it is all accelerating out of control.

  The following graphs illustrate the nature of the problem.  The first graph reveals the painful truth that debt has to continue growing just to keep the economy at the same level.  Because debt is more than all the growth, personal borrowing and the spending it generates has to increase (albeit at a slower pace) just to keep the economy standing still. 

 The reason the debt curve is so far above the economic growth curve is because it takes about 5% debt growth to generate 2% economic growth – and after a few decades the debt is running out of control.  This is the type of parabolic rise that is terminal.  It should be obvious that this cannot continue.

  Now consider what will happen if people quit borrowing.  The following graph gives a representation of that possibility.  As you can see, keeping the debt levels where they are will cause the economy to contract.  This is the situation being represented by the various news media about the current credit crisis – credit has supposedly dried up and the contraction is imminent if not underway already.  Contrary to what they say, though it may be painful in the short term, it is not a bad thing in the long run at all.  The only good news for the short run is that due to the inefficiency of debt as a growth driver, the contractive effects are muted to some degree. 

 

 What happens if people actually start to pay down the aggregate debt levels?  From the next graph you can see that the economy contracts at a faster pace.  Again the good news is that the economy does not contract as fast as the debt does, so despite the pain there is a bit of a silver lining.  And, after debt is paid down, the economy ends up in a more sustainable mode.

 

 It should be obvious that there are no easy ways out of this mess.  Just as more drugs are not an efficient health alternative to the addict, debt is not very efficient at growing the economy.  The deadweight losses due to interest charges and other costs make it inefficient – the consumer has to pay way more to get the same result.  Apart from being inefficient, it is clearly not a sustainable means of running a stable economy let alone a growing one.  We are seeing the debt burden start to become critical and become an economic driver in an unintended way – a negative way.  When you overlay the gambling mentality of the market structure you get the conditions for the kind of market meltdown we have seen.  The markets are basically gambling on the unsustainable debt bubble to drive corporate earnings.  Easing credit can not and will not solve the problem of too much debt and a cavalier attitude of the markets toward risk.

 The bailout is a variation of an old-fashioned “quick fix” approach to such crises – inflate your way out and hope you can shove it far enough into the future to be someone else’s problem.  The idea is to avoid any short term pain.  History shows that this always fails.  The approach is to throw money at the problem which will lead to inflation – this effectively shrinks debt at the expense of the lender, but keeps the debt system running.  The trouble is that the best strategy for the individual is to borrow as much as they can as fast as they can to buy hard assets to hedge against the inflation – this in turn causes even more inflation and it eventually runs out of control.  Zimbabwe is a good example of that – you get hyperinflation just before it all falls apart.  We saw that play out in several South American countries a few decades ago.

 There are only three ways to get rid of a debt problem once you’ve allowed it to take over your economic system, and none are without serious side effects.  You can pay it off, you can write it off, or you can use inflation to effectively reduce the burden.  You can see from the current response that the inflation option is being adopted.  This is possibly the worst option in that its goal is to keep the system running on debt.  And when inflation begins to take off, the government won’t be able to raise interest rates because that would cause the same problem they have now – it would put them back at square one.

 You see, once inflation rears its ugly head, then the prudent thing to do is to borrow as much as you can, as fast as you can to buy hard assets as a hedge against inflation.  But this just fuels the debt bubble more, and soon the vicious cycle is out of control – first hyper-inflation, then collapse.  This approach is akin to cutting the junkie’s heroin – thus stretching it out (just as inflation reduces the effects of debt).  But the junkie ends up using more and more as you dilute it further – the end result is the same one you tried to avoid at the start, you just postponed it for a while.

 As with many systemic problems, the long term fix requires some serious short term pain to remedy.  That is the typical hurdle in any addictive cycle – it must get worse before it gets better.  The easy way out, and the one currently being adopted, is to improve the symptoms over the short term.  The whole focus is on getting more credit to those who are already overburdened with debt at a time when the whole system is strained to the limits because of all the debt.

 The simple analogy is to create a population of junkies so large that it taxes the ability to provide heroin.  Then, to solve the problem of not enough heroin, you expend all your efforts and resources to increase the supply of the stuff, and at the same time diluting the supply to stretch it out.  That is exactly what we are doing, and it will ultimately be as destructive.  Debt is just as addictive to those who run our economy as heroin is to junkies and those who supply them.  The Federal Reserve (Fed) and the US Treasury are out there trying to resupply all the existing addicts and create new ones if they can.  But this is the cause of the problem in the first place.  What we need is an approach to break the addiction.

 We need a fix to the stupidity in the markets and clean up the banking and insurance system.  These have become little more than a big casino.  Before any fix can be implemented to the debt-driven economy, the markets have to be restructured so that they are no longer just big gambling casinos.  There are some simple fixes that could probably be implemented using existing regulations.  There would be a lot of whining from the Wall Street types who would lose their jobs, but they arguably don’t perform any productive, useful function for the most part anyway.  I say “for the most part” because there are some useful functions of the market, but the bulk of the derivative trading is little more than wasted time and money that generates commissions for the traders but serves little or no useful purpose for the economy.  Recent events have shown that it is more apt to be harmful.

 Fixing the markets is pretty straightforward.  Get rid of all derivatives with respect to anything other than commodities.  No options, no futures, no index trading, no currency futures or options.  Nothing.  Outlaw all hedge funds – they serve no useful purpose and have clearly shown to be destructive to the economy in the long run.  If you want to buy or sell the actual currency, stock, bond, or treasury paper, fine.  But none of the other nonsense that has been going on.  It should be obvious by now that the derivatives just lead to abuse.  Why is that?  Well, when you can hedge and pretend that you are diluting your risk, you engage in riskier behavior.  And that is exactly what has happened.  While it might be okay for one or two to do this, it doesn’t work when everybody does it.

 It would not take a genius to show that derivatives lead to inefficient markets – if you eliminate, mitigate or reduce risk and its consequences in the short run, you encourage riskier, inefficient behavior.  In effect, risk mitigation distorts the markets - just look at what is happening now.  Plus, if people are making proper actuarial decisions in the purchase of the primary instrument, then it is axiomatic that derivatives are inefficient (for derivatives to be efficient, then the primary security markets have to be inefficient otherwise there would be no need for the secondary markets).  Derivatives actually lead to inefficient markets because they effectively separate decision makers from the consequences of their decisions.  So much for the economists’ “efficient markets” assumptions.  If we get rid of the derivative markets then we will force a better discipline on the remaining markets.  I doubt anyone would shed too many tears for those who lose their jobs in the process given all the turmoil they have caused.

 Commodities are the exception as they represent something real.  Here there needs to be restrictions on futures trading.  Futures should be restricted to one side only.  That is, if you produce a commodity you can sell a contract for future delivery.  At the termination of the contract you can deliver the commodity.  If you consume the commodity you can buy a contract to take delivery.  At termination of the contract you have to take delivery.  Get the speculators out of it and get it back to the original purpose.  If you want to buy commodities, buy them.  If not, stay away.  If you want to sell them, then sell them.  Don’t gamble them.  Same with stocks and everything else on the market.

 If I had my way, we would even go so far as to restore stock markets to their original purpose – the raising of risk capital for business ventures.  This trading of existing stock back and forth is little more than gambling, with little or no connection between any intrinsic value and what shares trade for.  I would have stock transactions limited as well – you can buy stock off the company or sell it back to them, but not to anyone else.  Then, to get investment funds, companies would have to provide a means to distribute earnings to investors rather than dole out huge benefits to management.  A side benefit would be more, smaller companies being more responsive to ownership.  For too long the stewards have been assuming ownership privileges.

 A system that favors smaller firms would be advantageous in reducing the influence of the powerful few in the political process as well.  Looking at the mess they have created I don’t think many would be upset if their influence was diminished.

 There are few things necessary to clean up the debt market concurrent to unwinding it as a vehicle for economic growth – a necessity due to the unsustainable and increasingly untenable nature of it.

 Banks need to get back to banking, and insurance companies need to get back to insurance.  We need to get rid of all risk sharing and have stand-alone businesses in these sectors.  These companies should stand or fail on their own operations rather than pooling with others.  We have seen the results of risk sharing – it provides encouragement for these players to take on inordinate amounts of risk.  It is better to have a few fail than the whole system.  The financial system needs to be uncoupled – when everybody gets tied together you have a prescription for disaster.  What could have been isolated local events ended up being a global catastrophe.  That is the dark side of globalization that never gets discussed.

 The other perverse effect of risk mitigation is that it actually makes the foreclosure problem worse.  If the banks were forced to hold the paper on their loans they would be more careful in lending.  When loans get in trouble it would be more profitable for the bank to try to renegotiate the loan so they could get the most back.  Foreclosure auctions would result in steep losses, and the bank could reduce the losses by changing the arrangements with the borrower.  This would also help to keep home prices stable.

 Contrast that with the current nightmare.  The banks sell the paper to a third party who ends up with all the risk.  They have no capability to renegotiate loans so they just repossess and sell the property at a huge loss.  Everybody loses.  Again this is an example of the derivative market creating inefficiency.  It reduces the value of property below what could be recovered from the homeowner so results in unnecessary losses to the system.  It also creates an arbitrage opportunity for those with cash – they get to purchase assets at an artificially deflated price and realize a windfall in the long run.  This should not be allowed.

 For markets to work properly you need individual players rather than having everybody connected at the hip trying to manipulate and control markets.  Bring back some good old-fashioned competition – does anybody remember what that is?

 There are some simple fixes to unwind the debt bubble that nobody at the top of the food chain will like.  First, outlaw interest charges to individuals.  A consumer credit-driven economy is not sustainable and at some point it has to stop – so stop it right now.  If you can’t charge interest to consumers, then there won’t be a lot of lending.  With no interest, folks can pay off the debt they have and won’t be able to take on new debt because there will be no lenders.  At the same time ratchet up the reserve requirements for banks.  This will increase demand for deposits and thus generate better savings interest for consumers.  Since the only borrowers will be business, there will be lots of room for this and it will make the system more secure.  Banks won't make as much, but that's just too bad for them.

  The government and economists have been saying people need to save more.  If the government is serious about that they would make all net increases in savings tax deductable.  If, at the end of the year you have increased your savings, you can write the increase off, if you net withdraw, you pay income tax on the net withdrawal.  A simple approach that would also lead to cost savings from reducing all the administrative costs associated with current government sponsored tax-exempt retirement savings plans.  this would be simpler, and easier and cheaper to administer, and with the same net result but give the individual the opportunity to manage their own money.

  Of course some kind of restraint in government spending is needed too.  Start with a novel idea of prioritizing and work from there.  Fund the number one priority fully, then number two - and when you run out of money stop - the rest get none.  In this way at least things that need to be done would be done right.  This will unwind the debt bubble.  This will provide the least painful transition.  Notice I said “least painful” – there will be pain for sure but the end will be worth it.

 We will get back to an older system that worked fine – individual stores would allow reliable customers to carry a balance until the end of the month, at no charge, as long as they paid it off promptly.  If they fell behind, they had to start paying cash.  Nobody got buried in debt because debt was considered a bad thing.  They will also have more disposable cash on hand so they can buy more stuff or save more.  Banks will take a bit of a hit, but they have been the big beneficiaries of the debt bubble anyway, so that is only fair.  The real economy won’t be affected as much as people will still be buying things, and staying in their homes.

 An economy that is run on cash is necessary (thought not sufficient) for long term sustainability.  Debt robs future expenditure to support current spending and is not tenable as a long term sustainable means of running an economy.  The problem is in aggregation – the synergies of everybody doing something are not the same as if a few do it.  Pay as you go can work and only requires some sacrifice at the beginning to implement.

 As to home mortgages, simple.  Make everybody come to the table with 20% down payment.  For the mortgage, either government loans or government backed loans at no interest up to some limit – say the value of an average home.  Above that, you pay cash.  If any interest were to be charged it would a nominal amount and fixed to cover any associated risk such as foreclosure.  This risk would be small with the 20% down payment.  The period of the mortgage would be 20 years maximum.  The only pain in all this will be saving for a few years to get started.  You sacrifice at the front end to be secure in the back end. 

 As an example, I know a guy who always paid cash – even when buying a home.  He started out modestly and saved for the next purchase.  At 60, he is now worth about $1 million, and has never made more than about $15 per hour.  He paid himself the interest rather than paying somebody else.  I use this example to counter those who will say it can’t work.

 All interest charges should go to business.  If you believe in markets you would have to agree with this one – this lets the market decide.  A business borrows money, and if they have the right products or services and do a good job, people will buy them and they can repay the loans.  If not, they go broke.  That is how the market is supposed to work.  Since people will be saving, there will be investment funds for businesses.  As is now the case, government can insure deposits to protect individuals’ money.

 A side benefit is that banks will have to compete for deposits rather than engage in all this interbank lending etc. which should be outlawed.  This is just a variation on the derivative market.  Banks should only be allowed to lend based on deposits.  All of these measures uncouple the system.  Rather than everybody being on the titanic, we will all be in smaller fishing boats.  One or two might sink, but they won’t take us all with them.  We need a change of thinking away from the “bigger is better” fallacy we have bought into.

 The “bigger is better” model has tied us all together and increased overall system risk.  It has worked fine for the few – they are getting out of this relatively unscathed.  But the common person is getting stuck with the bill on top of a mountain of debt.  The result has been a steadily declining middle class and increasing numbers of poor.  The ordinary person is falling behind to support those at the top.  This is all part of the unsustainable nature of the existing system.  It cannot continue as is for much longer without falling off the track.  When it eventually falls apart, the well to do can move on to greener pastures, if there are any left, while the rest of us are left with a big mess.

 We need to get rid of the “get rich quick” culture and restore the idea of making money the old-fashioned way – by earning it.  We need to get back to a system where we live within our means.  Save first and buy later.  The question is whether we want to actively takes steps in this direction and make the necessary sacrifices, or do we want the natural course of events to force it on us with far worse consequences.

 Oh, and one last thought – it seems from the current fiasco that the elites can’t even look after their own interests let alone run everything.  They can’t get by without the little guy bailing them out for their mistakes.  So much for the notion that elites are somehow better equipped to run things or know more than the rest of us.  I mention this because at my daughter’s graduation from Harvard I was struck by the outright conceit in some of the speeches given – they were dripping with elitism about how “Harvard graduates” would make the world a better place.  Well, it is the ordinary hardworking people who make the world a better place, and they are also the ones who get stuck cleaning up the mess left by the elite.  Let’s not forget it was the elites who got us into this mess.