Credit Where Credit is Due By Peter Schiff

[zigzagman]

Credit Where Credit is Due By Peter Schiff

Euro Pacific Capital, Inc.
Friday, 16 January 2009

This week, in a speech before the London School of Economics, Fed Chairman Ben Bernanke offered a perverse economic theory in his quest to gather support for never-ending Wall Street bailouts; "This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt." In other words, credit is the lifeblood of our economy, and the continued operation of credit providers is an issue of national security.

In truth, not all economies run on credit. But over the last decade, the United States became a bubble economy that needed unlimited credit to keep from collapsing. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings. It's too bad our Fed chairman does not understand the difference.

That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken and not encouraged. What we need in America is more restraint and less indulgence. For example, Americans in the current economy should not go into debt to buy new cars. Given the level of debt that weighs down the typical family, Americans should defer such purchases until they have paid down existing debt, or replenished their savings to the point where they can afford to pay cash. Until that time, Americans should continue driving their old cars. In the meantime, the untapped savings could be made available to local businesses that would use it to finance badly needed capital investments.

But such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming Administrations appears willing to consider. By providing perpetual support to lenders who have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.

Credit is indeed vital to an economy, but it does not constitute an economy within itself. The important thing to remember is that credit is scarce, and is limited by the stock of savings. Savings loaned to one individual is not available to be loaned to another until it is repaid. If it is never repaid, the savings are lost. Loans to consumers not only crowd out more productive loans that might have been made to business, but they have a far greater likelihood of ending in default. In addition, while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent, and do not create conditions that will make repayment easier. When businesses borrow to fund capital investments, the extra cash flows that result are used to repay the loans. When individuals borrow to spend, loans can only be repaid out of reduced future consumption.

One of the reasons we are in such dire straits is that consumers have already borrowed and spent too much. Many did so based on the false belief that ever-appreciating real estate would ultimately provide the means to repay their debts and finance their lifestyles. Now that reality has finally set in, why should the spending spree continue? The fact that a GDP comprised of 70 percent of consumption is currently contracting should not surprise anyone. In fact, such a contraction is long overdue and the government should not do anything to interfere.

In trying to perpetuate the illusion, the government wants to revive the spending spree that has led us to this disaster. But how can such actions possibly help? How will more debt improve the economy? Wouldn't our circumstances be vastly improved if we paid off some of our debts and replenished our savings? Wouldn't we be in better shape if instead of buying more stuff we concentrated on producing it?

The unpleasant reality is that years of bad monetary and fiscal policy have over encumbered our economy with debt and undermined our industrial capacity. The sooner we can begin to repair the damages, the sooner we can right the ship. If instead we merely administer more of the same, the ship will sink in a sea of inflation

http://news.goldseek.com/EuroCapital/1232157600.php

[rffrydr]

This deal rang like a bell in my head--not that it was big enough on its own, but the scale of the LTV. I just spent a couple of nights here...a nice collection of run-down cabins with some historic celebrity flare. That's gotta be close to the ultimate of "high-yield." Symbolic.

I am buying into broad commodity indexes here, based on fundamentals and the backtest of the 1970-present trend line.
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

My general feeling is the less time spent on japan the better: the comparisons break down on almost every level. One that does not is that japan has a savings culture. If that culture is now ours (76milllion spendthriftless boomers add a demographic dimension) that money needs to be allocated.

This alone is a huge brake on the inflationary implications coming out of this stimulus. Add in the dollar-denominated wealth destruction, nationalizations of production, breakthroughs on fuel and energy consumption and structural clampdown on banks, developing-world population controls... I continue to bet against gold and diamonds.

http://globaleconomicanalysis.blogspot.com/2009/01/brink-of-debt-disaster.html
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Today is the Tomorrow you worried about Yesterday!

[HenryTo]

Diesel,

Totally agree on Japan, but I would say that is negated by the fact that:

1) Japan's demographics are horrible; total population peaked in 2006 and is now shrinking every year;

2) Japanese productivity is overrated. Aside from some global companies like Toyota and Honda, their companies for the most part hold no competitive advantages. Their ROEs of just over 10% (relative to American companies of over 20%) are a testament to that.

3) As we move forward in the 21st century, the most educated and the most innovative country wins. The US still attracts the best talent and has the top universities in the world, and in every field imaginable.

What is the use of working in a 9-5 job, living at home, and accumulating reserves? And especially if you don't know how to invest your money? The PhDs, MDs, and MBAs who took on debt to finance their educations will mow you down in no time as the world moves to a more knowledge-based economy going forward. Americans also own a substantial amount of foreign assets, and actually had positive net investment earnings in 2007. This makes up for the "fault" of the Americans who took on subprime mortgages and who overconsumed on an annual basis.

Best regards,

Henry

[diesel]

[HenryTo]

Diesel,

Think of it this way - the excess cash held by the private sector is still being hoarded. The cash-rich citizens in the private sector are only willing to lend to the government. Money velocity has totally collapsed. Given this scenario, the government borrowing $1 trillion in return for lending it to cash-starved businesses and entrepreneurs will definitely restimulate the economy. This classic formula of GDP holds:

GDP = P x Q = M (Money Supply) x Velocity

In the above formula, GDP will inevitably collapse if M is being hoarded, as velocity will collapse to zero. Having over $3 trillion in money market accounts does not mean there is liquidity unless the money gets turned over - into investments or consumption.

We may yet see a spike in Treasury yields but only because if there are better alternative investments. Actually, we should pray for a spike - that will be an indication that the economy is growing again.

With the Obama stimulus, US public debt as a percentage of GDP will be at over 80%. This is relatively high across time, but still very tame compared to Japan, and of course Italy. The UK public debt situation would be very similar to that of the US 12 months from now. More importantly, the deleveraging that is currently going on within the US private sector (households) will more than offset the re-leveraging by the US government. I don't mean to brush this off, but everything is relative. Look at Japan: Public debt as a percentage of GDP is a whopping 160%, and yet the 10-year JGB yield is at a miniscule 1.24%. And the Japanese pension system has as much of a problem as we do.

The trillions in unfunded pension and healthcare liabilities is only a notional number. The reason why the US is always being bashed over this is because the US is the best at disclosures. Retirement and healthcare obligations are much greater (as a percentage of GDP) in many Western European countries than it is here in the US. Also, the US is much better at innovating to deflate upcoming healthcare costs (e.g. if US scientists can find a "cure" for Alzheimers in 20 years, this will reduce a noticable burden on the US economy, not just in the form of greater productivity from former Alzheimers sufferers, but in the form of less personalized/home care costs as well).

We're certainly living in interesting times.

Henry

[diesel]

Yes quite true however if the government borrows $1 trillion, where does it come from? If it soaks up excess cash from the private sector, it is only redistributing the capital - not stimulating the economy as a whole. Whatever the Government soaks up in capital, creates an equal and opposite effect of suppressing economic growth.

Think of it this way, the first law of thermodynamics applies. There is a fixed amount of energy within the economy. We can neither create nor destroy it. All we can do is redistribute the energy causing it to change form. The reason capital concentrates is because that is a natural product of any system. There are people who enjoy working and there are those who prefer to do as little as possible and be provided for. There are those who resent the wealth acquired by the workaholic and demand that the wealth be redistributed to make it fair because one person should not have more than another irrespective of how much work he does. Communism failed because they suppressed innovation which is the key to creating new ages of prosperity, i.e. Schumpeter. Distribution of wealth on an equal basis undermines the individual incentives leading to periods like the dark ages where there is no cooperation.

At the moment we are dealing with a debt crisis where the confidence in the public sector may yet collapse. We are dealing with a contagion that is spreading. It is the massive cronic deficits and the mismanagement of the public sector including the failure to fund the future entitlements combined with the massive new debt being created to solve current problems, that best demonstrates the nature of the current crisis. The crisis we face is where will the funding come from for the new debt i.e. more than $1 trillion. There are only 3 possible outcomes:

(1) We sell the new debt, it is absorbed domestically and globally, causing the yield curve to steepen as the long term rates rise faster in response to the amount of new debt coming to the market, with any possible stimulation limited to the debt sold offshore.

(2) The contagion spreads globally forcing interest rates to rise and therefore limiting sales domestically, causing only a redistribution of cash extracting it from those who could invest and stimulate the economy while the money supply contracts sharply.

(3) Confidence swings back to the private sector (not banks) causing the new debt to take the form of monetization due to the inability to sell the new debt either domestically or globally.

When you step back the US is stuck in a corner as it is also facing almost $40 trillion in unfunded programs for the baby boomers. The US must monetize in combination with borrowing in a delicate balance. If the US were to borrow everything, it will extract cash needed to stimulate the economy to cover losses by the bankers. This will place the US at risk of economic deflationary implosion.
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All cats are gray in the dark.

[HenryTo]

Guys,

Well, the US government can now borrow at for five years at 1.45%, ten years at 2.30%, and 30 years at 2.89%. Moody's AAA are at 4.82%, while Moody's Baa are at 7.91%. In other words, the private sector is only lending to the US government, while shunning corporates and households alike. In such a scenario, it makes sense for the government to borrow at these low rates and channel the proceeds to corporates and households. Instead of "crowding out" the private sector, the government is actually reliquifying it.

The fact that the private sector is not lending to corporates or individuals is not because of huge government borrowing, but the fact that certain parts of the corporate sector and individuals have overleveraged and overborrowed, which have destroyed their credit.

Best regards,

Henry

[zigzagman]

[diesel]

The funny thing is that everyone presumes that if we borrow our money rather than print it it is more responsible. This is a fallacy as the national debt is exploding mainly due to the interest alone. Another thing to consider is that when the government borrows, it competes with the private sector suppressing economic growth.
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All cats are gray in the dark.