Money, Savings and Debt
This post can in a way be seen as an addendum to what we wrote regarding the 'gold narrative' the other day. Specifically, we want to return to the argument made in closing, namely that the present situation in terms of private and public debt relative to the economy's ability to create enough wealth to service and repay said debt is a reason to remain bullish on gold and by extension, to remain skeptical regarding the economy's future.
It is important to keep in mind that the level of outstanding debt as such actually does not prove the point. For instance, if all the credit extended were backed by real savings and if the great bulk of the extended credit were employed productively, then the size of the debt would obviously not represent a problem. After all, we would then have very good reason to expect that the investments that have been undertaken are largely sound (given the fact that they are backed by real savings) and that therefore, the economy's future output of final goods will increase sufficiently to create the profits required to service and repay the debt.
However, we know for a fact that a vast portion of the debtberg does not consist of credit that has been productively employed. Moreover, we also know for a fact that much of it is not backed up by real savings. How do we know all this?
Let us first discuss savings. What are savings? In a monetary economy, people save in the form of money. Money is a claim on real goods, it is the ultimate present good. However, in order to save, one has to refrain from consumption. Let us say that someone saves $200 per month. He certainly could spend these $200 instead of saving them, in which case he would exert a claim on the pool of final goods and consume the goods purchased. Note that by refraining from this act of consumption, not only are there now $200 in his savings account, but the goods the saver has not consumed remain with the economy's pool of real funding (the pool of real funding is the stock of produced, but unconsumed final goods).
This addition to the pool of real funding is what actually makes an increase in production possible. If ten savers put aside $200 per month, the $2,000 worth of goods thus saved could e.g. be used to maintain the life and well-being of one worker employed in production activities. When an entrepreneur applies to a bank for credit in order to expand production, he is ultimately not trying to obtain money as such, but capital. What is required to effectively fund new production activities is not money, but real resources.
To illustrate this, imagine that a few people find themselves stranded on a deserted island, and by coincidence one of the things that has been successfully recovered from the shipwreck is a printing press for banknotes and all the paraphernalia required for the printing process. Obviously they could not create any wealth for themselves by printing banknotes. It would be a pointless exercise: the banknotes could not be used to buy the necessary capital goods required to e.g. build a new boat, since these goods are simply not available on the island. This would be so glaringly obvious that they would certainly not even try – they could print billions and would not be an iota richer. If they decide to mix their labor with the natural resources available on the island so as to create primitive capital goods that bring them a few steps closer to their goal of building a boat, they would still be confronted with the problem that at the outset, their pool of real funding would be zero. They would at first have to produce whatever is necessary to keep them alive (i.e., food). If they want to spend time on producing capital goods, enough food would have to be produced that some of it could be saved to maintain their lives while they are busy with building an ax, a net, rudders, sails and so forth.
This example serves to highlight a universal truth: no wealth can be created by printing money. Money is indispensable for an economy based on the division of labor, as a medium of exchange (and all the subsidiary functions that flow from this, such as the store of wealth function) and a unit of account that enables economic calculation. It should be obvious though that adding to the supply of money does not add to the economy's wealth (in case a commodity money is used, it could be argued that the non-monetary uses of the commodity make additional supplies valuable beyond their exchange value, but as a rule the general medium of exchange derives the great bulk of its value from monetary demand).
Since 1971, the world has been on a fiat money standard. Moreover, the banking system is fractionally reserved, which means that it can literally create additional money from thin air. There is no effort involved except a few keystrokes. This system is backstopped by central banks that 'accommodate' this creation of money from thin air by supplying bank reserves, which are likewise created at the push of a button. In this system, a lot of credit is created that is not backed by real savings. We can get an inkling regarding the size of this credit creation from thin air by looking at the amount of uncovered money substitutes in the economy, i.e., deposit money that is not backed by standard money in the form of currency or bank reserves which can be converted to currency on demand.
US money TMS-2 by economic categorization. Covered money substitutes (dark blue) consist of deposit money that is backed by either vault cash or bank reserves held at the Fed. Uncovered money substitutes (also known as 'fiduciary media') represent deposit money that has literally been created from thin air and for which no standard money backing exists – click to enlarge.
As can be seen above, although the Fed's 'quantitative easing' policy has vastly increased the portion of money substitutes that are covered by bank reserves (the often cited excess reserves), the amount of uncovered money substitutes outstanding nevertheless stands at a new record high. In theory, all of this money should be available on demand. In practice, the banks could only pay out the covered portion and would have to contract credit if they were required to pay out more than that.
The main problem with the creation of money from thin air is that by throwing additional fiduciary media on the loan market, the market interest rate is pushed below the natural interest rate dictated by society-wide time preferences. This sets the boom-bust cycle into motion. The lower interest rate makes long-term investment projects that appeared to be unprofitable at a higher rate look profitable, so investment will be drawn toward such projects. The lower market interest rate suggests that the pool of real savings has increased so as to make the funding of these long-range investment projects possible. However, this is a mirage: the additional real savings do in fact not exist. To paraphrase Mises, the entire class of entrepreneurs finds itself in a situation akin to that of a master builder who attempts to build a palace with three stories, while unbeknown to him, the building material available is only sufficient for two stories. Obviously, the later he discovers this error, the more significant the loss will be, as a lot of resources will have been wasted.
Moreover, the creation of fiduciary media makes exchanges of nothing for something possible. The early receivers of newly created money can exercise claims on the pool of real savings, although no commensurate contribution to the pool has actually been made. The earlier receivers of newly created money will benefit to the detriment of later receivers, as by the time the new money has percolated through the economy, prices will have risen to reflect the increase of the money supply. Obviously, the earlier in the process one gets to spend newly created money, the bigger one's advantage will be. Thus wealth is redistributed from late to early receivers. Moreover, by exercising their claim without an offsetting contribution to the pool of real savings having been made, these early receivers make life more difficult for genuine wealth creators, who now must contend with a diminished pool of savings. In short, printing additional money enables consumption without preceding production. Obviously this cannot possibly be sustainable – ultimately consumption is constrained by production (one cannot consume what hasn't first been produced).
In a nutshell the problem posed by the mountain of debt that has been built up over time is the following: it has misdirected investment and falsified economic calculation, which in turn has distorted the structure of production and led to the consumption of scarce capital (which is usually disguised as illusionary accounting profits) during the boom periods. Subsequently this became painfully obvious as the inevitable economic busts set in.
What's more, the duration and amplitude of the boom-bust sequences has continually grown, as after every failed boom, the amount of new credit and money thrown at the economy to 'rescue' it from the bust has been vastly increased. Ever larger additions to the amount of money and debt outstanding have resulted in ever smaller additions to economic output.
If we consider the total amount of credit market debt outstanding depicted above, it is clear that large portions of this debt are indeed unproductive and represent a millstone hanging around the economy's neck. There are for instance (in the case of the US) more than $16 trillion in cumulative public debt. This represents the government's debt-financed consumption of the past. Even those who erroneously believe deficit spending to be economically beneficial must realize that this debt that is the residual of past deficit spending can only harm future economic development.
As Ludwig von Mises wrote regarding this point in Human Action:
“But if the government invests funds unsuccessfully and no surplus results, or if it spends the money for current expenditure, the capital borrowed shrinks or disappears entirely, and no source is opened from which interest and principal could be paid. Then taxing the people is the only method available for complying with the articles of the credit contract. In asking taxes for such payments the government makes the citizens answerable for money squandered in the past. The taxes paid are not compensated by any present service rendered by the government's apparatus. The government pays interest on capital which has been consumed and no longer exists. The treasury is burdened with the unfortunate results of past policies.”
We would note to this: one of the many Achilles heels of deficit spending that aims to provide 'economic stimulus' is precisely that the wealth creators in the economy know very well that they will eventually be taxed to pay for it. It is a good bet their reaction will reflect this knowledge. They will become cautious, take fewer risks and curtail their investment activities. This is one of the reasons why massive deficit spending schemes such as that enacted in Japan over the past two decades consistently fail to work.
Another point worth considering is that there is also still a vast amount of mortgage debt outstanding that is effectively 'underwater'. The collateral is worth less than the remaining debt, as a consequence of the housing bubble. No-one dares to write this unsound debt off, as doing so would denude the banks of capital. And so various extend and pretend schemes have been enacted (ranging from the adoption of dubious accounting methods to delaying foreclosure proceedings to various tax-payer funded interventionist schemes that aim to prevent a write-off of this debt). This is in many ways a drag on the economy, as both lenders and potential borrowers are paralyzed by this overhang of unsound debt.
Wealth Creation in the Market Economy and the State
In spite of the foregoing, it is important to stress that the market economy, even though it is extremely hampered, continues to create wealth. We once attended a presentation by Professor Hans-Hermann Hoppe, in which he discussed the 2008 crisis and its aftermath. There was one remark he made during the Q&A that struck us as especially pertinent to this discussion. He essentially said (we are paraphrasing from memory): “We can gauge how powerful the market economy's ability to create wealth is by considering that in most modern-day regulatory democracies, perhaps 30% of the population can be said to be involved in genuine wealth creation activities. In spite of the fact that the entire amount of wealth is created by this small minority, and that this minority is subjected to the most onerous regulations and taxes, it still manages to improve the well-being and standard of living of all of society over time.”
Along similar lines, Mises stressed that although an artificial credit-induced boom leads to impoverishment, this does not mean that we should expect that we will necessarily be poorer overall at the end of a boom than at its beginning. This is so because even under the unhealthy conditions of a boom, genuine wealth creation continues. If that were not the case, the capitalist system wouldn't have been able to increase the world's stock of wealth continually ever since capitalist production processes have been adopted. However, it is also important to realize that all of this has happened in spite of the hampering of the market economy by taxation and regulations and the failed central economic planning by central banks.
Obviously though, there must be a limit to the depredations the economy can handle. Today, the State has created an environment in which most of the intellectuals who propagate political and economic ideas are essentially bought off, as the government can offer them levels of remuneration that are way beyond the value their services would command in a free market. Naturally they will tend to sotto voce engage in the vilest statist propaganda. Very few dare to bite the hand that feeds them, even if they are aware that they are promoting a harmful ideology. Presumably, quite a few of them even believe in what they are promoting.
We can see this in many obvious contradictions, such as the fact that e.g. most economists today agree that the market economy represents the by far best system for creating wealth, but at the same time support fiat money and central economic planning by the central bank, deficit spending by the state, and all sorts of state interventions in the economy. This is an inconsistent position. Either the free market is the best system, or its opposite, full-blown socialism, is. It is simply absurd to claim that what we really need is just enough socialism so as not to kill off the market economy altogether.
We are happy to report though that the intellectual handmaidens of statism are finding it ever more difficult to propagate their memes due to the internet having opened up alternative channels of communication and information that are outside of establishment control. This has made it possible for many people to learn of ideas that have previously been suppressed. On the other hand it is clear that we are still very far from the tide having decisively turned.
In fact, because the State now finds itself under increasing financial and economic pressure, it reacts in a manner that it regards as the politically palatable 'solution' to the debt problem. This solution consists primarily of inflationary policy (see the chart of TMS-2 above for evidence), and various forms of 'financial repression'. Inflation mainly robs the poorest members of society, while financial repression, depending on what forms it takes, robs everyone. The alternatives, such as writing off the unsound debt that has accumulated or cutting unsustainable government spending, are policies that are regarded as highly detrimental to winning elections. The welfare state has created so many dependents and hangers-on, not least including a vast and powerful class of bureaucrats who represent a large block of votes, that no politician dares to veer off established lines too much. Hence financial repression is chosen as the 'lesser evil' from the point of view of the ruling classes (whose main aim it is to preserve their rule and privileges).
However, there is a big problem with this. As the above-mentioned Professor Hoppe e.g. remarks in “The Economics and Ethics of Private Property” with regard to taxation:
“Thus, by coercively transferring valuable, not yet consumed assets from their producers (in the wider sense of the term including appropriators and contractors) to people who have not produced them, taxation reduces producers’ present income and their presently possible level of consumption. Moreover, it reduces the present incentive for future production of valuable assets and thereby also lowers future income and the future level of available consumption. Taxation is not just a punishment of consumption without any effect on productive efforts; it is also an assault on production as the only means of providing for and possibly increasing future income and consumption expenditure. By lowering the present value associated
with future-directed, value-productive efforts, taxation raises the effective rate of time preference, i.e., the rate of originary interest and, accordingly, leads to a shortening of the period of production and provision and so exerts an inexorable influence of pushing mankind into the direction of an existence of living from hand to mouth. Just increase taxation enough, and you will have mankind reduced to the level of barbaric animal beasts.”
Hoppe also points out that regulations (which compel or prohibit exchanges between private parties), while they are just as economically harmful as taxation, don't increase the economic resources in the hands of the government. They merely satisfy the lust for power. He concludes that this is the main reason why in wars between industrialized Western States, the less regulated ones tended to win against the more regimented ones.
However, we would point out that even the US economy, which is still widely regarded as one of the less hampered and regulated Western economies, boasts the following statistics as of 2012 (Source: the Ten Thousand Commandments):
• Total costs for Americans to comply with federal regulations reached $1.806 trillion in 2012. For the first time, this amounts to more than half of total federal spending. It is more than the GDPs of Canada or Mexico.
• This is the 20th anniversary of Ten Thousand Commandments. In the 20 years of publication, 81,883 final rules have been issued. That’s more than 3,500 per year or about nine per day.
• The Anti-Democracy Index – the ratio of regulations issued to laws passed by Congress and signed by the president – stood at 29 for 2012. That’s 127 new laws and 3,708 new rules – or a new rule every 2 ½ hours.
• Regulatory costs amount to $14,678 per family – 23 percent of the average household income of $63,685 and 30 percent of the expenditure budget of $49,705 and more than receipts from corporate and personal income taxes combined.
• Combined with $3.53 trillion in federal spending, Washington’s share of the economy now reaches 34.4 percent.
Does anyone profit from these costly regulations? Yes – for instance many of them are designed to protect established businesses from competition by upstarts. This is also why the greatest economic growth takes place in cutting edge fields like technology where often no established businesses exist yet, simply because the products created are entirely new. There can be no doubt that these regulatory costs vastly diminish society's wealth creation ability as a whole. As per Hoppe's analysis of the effects of taxation on production, here too it is not enough to simply look at the direct cost of $1.8 trillion per year. It is the follow-on costs that are probably the far bigger problem – the wealth that has not been created at all because these regulations stood in the way.
Needless to say, the situation is even worse in Europe, which has become a fiefdom of bureaucratic rule that is historically likely only second to the structures established under full-blown communism in the former Eastern Bloc.
Under these given conditions, governments have apparently decided on a 'flight forward' that consists of a mixture of massive monetary inflation, the imposition of ever more stringent regulations and taxes and various (other) forms of financial repression. Bureaucracies continue to grow like weeds, and so does their output. Is it any wonder that we are looking at these developments with growing dismay and pessimism? We are not happy to have to adopt a gloomy outlook, especially as we are well cognizant of the world's potential and the power of human ingenuity (which is evident even in the severely hampered market economy we are saddled with). However, with governments continually chipping away at the market economy's wealth creation ability, the day may well come when capital accumulation ceases or even reverses (if it hasn't begun already: just look at Europe). To come back to the beginning: this is a major reason to invest in gold as a form of insurance (this is beside the fact that gold may also be simply be regarded as an alternative currency to store one's savings in). The fundamental backdrop is what it is; perhaps sound money and sound economic policies will be adopted again once the failure of the current course becomes so glaringly obvious that what is considered politically unpalatable today comes to be seen as the only way forward. However, we are not there yet by a long shot.
Charts by: St. Louis Fed, Michael Pollaro
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