Brazil Is the New America: How Brazil Offers Upward Mobility in a Collapsing World (24 page)

If you care to read through old
Wall Street Journal
editions or trader's journals from the Hoover era, you see that most people were slow to get it. They did not see that trying to cushion, postpone, or turn back a credit cycle contraction, as Hoover did then and Obama has tried to do more recently, only protracts the inevitable period of adjustment.

A
depression
, unlike a
recession
of the kind seen 11 times previously since World War II, is not an inventory correction, but a wealth obliterating credit contraction that reduces leverage in the economy and compresses demand. Credit corrections don't yield to sustainable recovery until excess credit is unwound, bad debts are liquidated, and economic demand can be recalibrated on the basis of solvency.

You don't need to wonder whether genuine prosperity will be met around any corner toward which Obama is stepping, or on any nearby patch of pavement he is pouring. It is not likely for many years, perhaps decades to come. This is not a crowd-pleasing realization. Far from it. Denial is a common theme of life at all times in all places. Sometimes, as is the case now, a paradigm shift in conditions leads to a cluster of miscalculations that tend to compound errors of judgment informed by the natural human tendency toward optimism. I am all for optimism as a life strategy, but my prejudice is to believe that optimism is more constructive within a context of a realistic grasp of the facts.

Eighty years ago, when Herbert Hoover was a young president trying to turn back the tide of depression, investors repeatedly misread bounces off the bottom and random fluctuations as evidence that a return to prosperity was indeed imminent. Then as now, too many people thought that every green shoot was evidence that the economy was about to turn around. Not so.

The most extreme misreading was evidenced in the famous Sucker's Rally of 1930 when the market gained 50 percent on the widespread hallucination that the downturn was poised to end. It wasn't.

More lately, under Obama, infatuated investors bought the market on any flimsy hint of underlying economic strength, or just to ride along with the Federal Reserve's POMO operations wherein money is created out of thin air to monetize stock indices. Instead of reflecting genuine improvements in economic conditions and higher profit potentials because of repaired balance sheets, investors are gambling on the pump. They are expecting to profit from the overt effects of inflation on stock prices and from a continuing depreciation of the dollar.

Far from signifying improvement in the U.S. economic prospects, much market-moving news merely reflects deeper weaknesses abroad, and transparent statistical confections misrepresenting bottom-bouncing in the U.S. economy.

Given the fact that we are deflating the biggest credit bubble in the history of the world, genuine, sustained recovery won't be arriving soon. While the markets wax and wane over ticks up and down in an unemployment rate, the bigger picture is totally missed.

Consumption and debt growth have been strongly correlated since 1960. Rapid debt growth over the past half-century allowed consumption to grow faster than income. Conversely, if households were to go through a sustained period of deleveraging (retiring debt), then consumption growth would almost necessarily slow. That is what has happened since 2008.

The current deleveraging (credit contraction) is potentially more devastating than the Great Depression of the 1930s. This has been somewhat disguised by the introduction of food stamps and other welfare programs. These innovations in redistribution hold down the lines of hungry unemployed people that made such a vivid impression during the Great Depression. The National Bureau of Economic Research (NBER) may have determined that a recovery began in June 2009, but it has amounted to little more than Herbert Hoover's vaunted promise that prosperity was just around the corner.

It will be an effort of many years to mend balance sheets that have been severely stretched to accommodate outsized burdens of debt. The 55-year mean of Household Debt in the United States is 55.4 percent of GDP. To bring the debt back down to its mean levels implies shedding $6.33 trillion in debt. Hence, the U.S. economy is destined to remain depressed for the next 15 to 20 years. Perhaps longer.

Remember, the depression could linger for decades, as it has in Japan, where epic real estate and stock market bubbles collapsed in 1990. Japan still hasn't recovered, in spite of unremitting stimulus packages that involved trillions of deficit spending to build roads to nowhere.

Short of widespread liquidation and bankruptcy to wipe out excess debt in a hurry, there is really no option or magic potion for recovery. During the credit boom, the combination of higher debt and lower saving enabled personal consumption spending to grow faster than disposable income, providing a significant boost to U.S. economic growth. Reversing that means slower-than-expected growth, as spending lags behind income.

Shedding debt equal to 46 percent of GDP implies a much deeper and/or longer contraction than the Great Depression, when the nominal debt of U.S. households declined by one-third. The Japanese deleveraging involved shedding debt equivalent to 30 percent of GDP, so the current deleveraging process in the United States looks likely to be one of the most difficult and protracted in history. In other words, status quo expectations for resumption of debt-driven prosperity in the United States are delusional. The economy has reached debt saturation, and a large percentage of the newly created debt is devoted to refunding debts that have gone south.

The protracted political impasse in the U.S. Congress over raising the debt ceiling underscores the central role that ever-greater doses of debt play in promoting the illusion of economic prosperity. This highlights the vulnerability of the debtist economy.

As Ludwig von Mises so lucidly observed, artificial booms brought on by credit expansion cannot go on forever. He said,

True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression.
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In other words, taking debt expansion to the limit always ends badly.

The vulnerability of the system arises from the ephemeral nature of fiat money. It can be destroyed almost as readily as it can be created out of thin air. Think of a house of cards. The sustainability of the artificial credit boom is jeopardized when the economy's weakest links encounter unfavorable winds. This was illustrated in the United States by the crisis in 2008 arising from the collapse of Lehman Brothers, and the gaudy end of the subprime mortgage boom. It remained on display with the continuing collapse in residential property values, as evidenced by record foreclosures. A June 14, 2011, report on CNBC stated that:

The housing crisis that began in 2006 and has recently entered a double dip is now worse than the Great Depression. . . .

Prices have fallen some 33 percent since the market began its collapse, greater than the 31 percent fall that began in the late 1920s and culminated in the early 1930s, according to Case-Shiller data. . . .

Then there is the issue of underwater homeowners—those who owe more than their house is worth—representing another 23 percent of homeowners who cannot leave or are in danger of mortgage default.

Indeed, the foreclosure problem is unlikely to get any better with 4.5 million households either three payments late or in foreclosure proceedings. The historical average is 1 million, according to Dales' research.
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If anything, the housing crisis deepened as 2011 drew to a close. Average new home prices fell in each of the last five months of the year (through November) at an annual rate of −25 percent. Meanwhile median prices deflated at a −24 percent annual rate. With 6 million homeowners either late on the payments or already in foreclosure, deflationary pressures continue to build.

A little appreciated facet of the foreclosure debacle is the fact that each property that is sold in foreclosure extinguishes debt and thus reduces the money supply. This deflationary impact is amplified by the fact that many foreclosed properties are sold for cash. The fact that buyers tend not to rely upon credit financing means that there is no counterbalancing growth in the money supply to offset the debt that is extinguished by the defaults.

Every artificial credit expansion is limited at points where weak players threaten to implode the tottering edifice of debt, touching off an avalanche of deflation. The imperative that drove the bailouts of Wall Street banks in 2008 and drove the European bailouts of Greece, Ireland, and Portugal more recently is the same. The authorities cannot permit the weak players to default without imperiling the whole system. As a result, you have a daisy chain of insolvent banks supporting insolvent governments and insolvent governments supporting insolvent banks.

The logic of fractional reserve banking (where trillions in debt are leveraged out of a thin sliver of bank capital) means that the whole banking system itself soon becomes insolvent when even a small fraction of existing debt goes sour. Without bailouts to re-fund the debt, the collapsing value of U.S. home mortgages or Greek government debt would soon undercut the claims of “innocent” counterparties in the banking system.

This creates both a fiscal and a monetary problem. The point where the two intersect is with deficit spending where governments issue IOUs as collateral for the creation of money out of thin air. In the early stages of a credit boom, the magic of deficits consists of the fact that the credit of the central government is generally unquestioned. This enables the government to escalate debt to a higher level (kick the can down the road or climb to a higher diving board) by taking on bad credits and re-funding them as part of the national debt. Yet even the good credit of the central government is not infinite, a point illustrated in different ways by the crises in the eurozone and the protracted political struggle in the United States over raising the debt ceiling.

Both crises illustrate an inescapable facet of reality, a point that Ralph Waldo Emerson developed in his “Essay on Compensation.” Emerson wrote about the fundamental futility of trying to get something for nothing. He said,

The absolute balance of Give and Take, the doctrine that every thing has its price,—and if that price is not paid, not that thing but something else is obtained, and that it is impossible to get any thing without its price,—is not less sublime in the columns of a ledger than in the budgets of states, in the laws of light and darkness, in all the action and reaction of nature.
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In the century and three-quarters that have elapsed since Emerson penned his classic essay, common sense has been perverted by the experience of credit bubbles fueled with fiat money and the Keynesian habits of modern politicians intent on spending from an empty pocket.

Consequently, the budgets of states, are no longer a standard of rectitude in comparison to a household ledger. Government budgets are now more ridiculous than sublime. Notwithstanding the fact that Greece has been in default for the majority of the time since it became independent of Turkey in the nineteenth century, the yield on Greek government debt fell to a level equivalent to that of Germany when Greece joined the eurozone.

By joining a currency union with Germany, Greece saw its debt suddenly priced like German debt. Of course, Germany had run one of the more conservative fiscal regimes in the second half of the twentieth century in the wake of hyperinflations after World War I and during World War II. The Greeks, on the other hand, had utterly no experience of fiscal rectitude. It was a stretch for the market to conclude that the mere association of Greeks with the Germans in the European Monetary Union would induce Greek politicians to forgo the considerable electoral advantages they could enjoy by exploiting lower interest rates on their national debt.

Borrowing funds that they were ill-prepared to repay may have assured long-term ruin, but it permitted Greek politicians to promote short-term illusions of democratic consensus by spending money the country could ill afford on lavish government salaries, early retirement programs and Northern European-style entitlements. The spending rewarded and gratified Greek government employees who could not otherwise have commanded such high incomes. And because these benefits were funded in large measure through debt rather than taxes, the success of spending constituencies in wresting unaffordable entitlements from the Greek treasury did not entail an equal and immediate loss to taxpayers.

A very similar dynamic promoting the illusion of democratic consensus through deficit persists in the United States. Witness the accumulation of underfunded liabilities that amount by some tallies to as much as $202 trillion. U.S. obligations are so many and varied that their sum is beyond calculation for most citizens.

What is calculable from the U.S. government's official GAAP accounting of its financial position, published annually, is that the accrual deficit of the United States has been expanding by roughly $5 trillion annually. This equates to a rate of increase in unfunded liabilities by more than 33 percent of GDP annually. In assessing the viability of the U.S. political economy in light of the rapidly escalating unfunded liabilities, you must consider the drastic slowdown in real growth of the private economy in the United States. When the annual cash deficit of the U.S. government is subtracted from GDP data, average annual economic growth in the United States since 1980 is actually −0.3 percent. Pretty grim.

Obviously, there is no combination of potential tax increases and spending cuts that could bring the U.S. federal budget into balance on an accrual basis (that is to say, with full accounting for the changes in assets and liabilities), just as Professor Laurence Kotlikoff observed in his Bloomberg article, the “U.S. Is Bankrupt and We Don't Even Know It.”
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