Wednesday, November 12, 2008

More credit is not the solution if it can’t be repaid.

The unavoidable rules of traditional economy were:
1. Only production creates wealth.
2. You can only spend what you earn.
3. You should always save part of what you earn.
4. Sooner or later, all debts must be paid.

If these rules still apply to America in the 21st century, then we are in deep trouble because we are ignoring each one of these rules at the national, corporate and personal levels. We are in a deep financial crisis, which was caused by excess liquidity, and no one tells us to think about the fundamentals. I am not an economist, but I want you to read this short article and think with common sense.

The crisis that the economies of the world are suffering is the result of the Federal Reserve Bank having kept their interest rates way too low for way too long. They did that to keep an economy that produced less than it consumed moving. It did not encourage more production however; it just created situations that were ripe for speculation. The result of the Fed’s policy of irresponsibly low interest rates was a giant pool of cheap money that investors used to speculate in a variety of different markets, wreaking havoc in each one and moving on to the next.

First came the dotcom boom, when everyone was getting rich investing in tech stocks that rose meteorically without ever having made a single sale. Neither the small investor nor the institutional investor nor the Wall Street pundits ever had an inkling that the tech stocks wouldn’t keep rocketing upwards indefinitely. Something new and spectacular had happened! Everyone was going to get rich and the market was going to just keep climbing forever! Tech stocks didn’t have to produce sales, they were new and different! No one looked at rule #1 above. Speculation does not create wealth, production does and the dotcoms hadn’t produced a blessed thing. Even though the individual investors may be deluded or stupid, the group consciousness of the market eventually remembers the basic rules, therefore speculative bubbles burst. The instant millionaires instantly quit being millionaires when the dotcoms dove off of a cliff at the end of the 20th century.

But as the dotcom bubble burst, the Fed was afraid that a slowdown could ensue, or even the dreaded recession. The economy had to continue strongly forward, so they lowered the interest rates and flooded the markets with cheap money hoping that capital would work wonders and gets everything moving ahead again. This time the excess liquidity ended up in real estate and commodities. Housing prices began to rise as speculation became all pervasive. The truly moronic people in the government thought that this was the moment to put everyone in their own home, and even if they wouldn’t qualify to rent a three-bedroom apartment they were authorized to purchase a $200,000 house. Housing prices rose like the dotcom prices had five years earlier. Banks offered to let people cash equity out of their homes to go on buying sprees.

At the same time the cheap money started to speculate in commodities, driving up the price of basic foodstuffs and thereby actually killing people in Africa through starvation when food became too expensive to buy. Speculation drove the price of oil through the roof, almost bankrupting the aviation industry and severely hurting poor Americans at the same time that food got more expensive.

The investors on Wall Street were making more money than ever before in history. CEOs were considered so brilliant that they paid themselves eight and nine figure salaries. They invented complicated derivatives to make certain that they made the best use of the endless pool of cheap money provided by the Fed to leverage their investments and wagers by thirty or even as much as one hundred times. It was all a great party until the slow thinking group consciousness of the market pondered the four rules above and came to the conclusion that there was no production here and began to cash out. Kaboom! The market slides dangerously towards the brink until….

Paulson and Bernanke charge to the rescue at the head of the Congressional cavalry! There they went, Barney Frank mumbling away, Nancy in her pearls, Barack the chosen one and Bomb-bomb McCain all following the lead of the criminals that created the problem in the first place. And they decided that the solution was to do the same things that had created the crisis: increase debt and flood the markets with liquidity.

It is not working and it won’t work. The bailout will cause stagnation at best and a complete collapse of the dollar and the American economy at worst. The geniuses forgot the fundamentals. Instead of imposing tariffs and producing more here in America, instead of allowing bad companies enter into receivership where their “illiquid assets” can be disposed of and where their good assets can be bought by good companies, instead of waiting until credit for good companies loosens back up, instead of following the fundamental rules, the geniuses Bernanke and Paulson have followed the European socialists. They are trying to make us borrow our way out of trouble, but they forgot rule #4 above. Sooner or later all debts have to be paid, and it appears that neither the American government nor the American people will be able to pay their debts.

Why won’t we be able to pay our debts? Because we don’t produce anymore, instead we consume. Look at these three realities below and ponder that if they are accurate and will continue to be true that there is no way for us to pay our debts. Read them and tell me how we are going to pay a 12 Trillion dollar national debt. As more and more American jobs go overseas how are people going to pay their 3.5 trillion in consumer debt?

1.- America imports much more than it exports.
2.- The government spends much more than it collects in taxes.
3.- Americans take on more debt than they save.

Since our national economy began to be incorporated completely into the global economy twenty years ago, our production has declined while our consumption has increased. A large percentage of our production jobs have gone overseas. The goods that were once made in America are now made in China and Mexico, and the American companies that made the products here are still producing many of them, but the jobs are done by Mexicans and Chinese and Indonesians.

Since our good paying production jobs have gone, ours has become a "service economy". That means that we make caramel macchiattos for each other, spend a ton on medical attention and sell each other shiploads of stuff that is made overseas. We have become professional consumers and all of our consumption was paid for with debt.

There is a thing about debt. Sooner or later it must be paid. (Rule #4, top of the page) But we cannot pay our debt because we have a giant trade deficit, which the politicians won't touch because to question "free trade" is taboo. As China and India and others become more efficient and American plants become more run-down, how do the free-trade politicians (read Obama) suggest that we begin to produce more than we consume so that we can pay our personal, corporate and national debts?

It has come to the point that a magic fairy wand cannot be waved over our economy. Either we produce or perish. And that means dumping the free-trade mantra and protecting what little industry we have left. I am a pessimist. I do not think that we will be able to pay our debts and I think that the net result of that will be much worse than most people can imagine.

Just watch what transpires at the upcoming international financial summit. The creditors are going to have their say….


Wayne said...

I've added a link to your site from BlogWatch: Economy (The Crash)

Chris Ferrell said...

Thanks wayne, your site is a great resource

Larry Bilotta said...

Chris Ferrell, you are a brilliant explainer of complex ideas so an average person can understand. Say, do you have any ideas of what the awake, average conservative with a job can do about this impending disaster?

Chris Ferrell said...

You can't do anything about the coming disaster. It is alrady locked in. All you can do is try to prepare yourself for a financial crisis that may be quite a bit worse than the Great Depression.

Take whatever investments that you have out of dollars or dollar-based instruments such as stocks or CDs. Don't trust the Euro very much either. If you are going to put money into a currency, the Yen is probably thesafest currency right now.
But the best bet is to invest physical gold. Do not invest in gold certificates because when the crap hits the fan you will find that your gold certificates are just paper. Buy gold coins at as close to market prices of gold as possible.

Think about your job. Will people who are in a subsistance mode need what you do?
If not, what do you know how to do that people will need?