Friday, December 11, 2009

Crisis Misconceptions

A number of misconceptions seem to be swirling about the financial crisis. In particular, commentators from many corners are making comparisons between the US and Japan, and this crisis to the Great Depression. There are some parallels in both cases, but there are some differences that are important enough that I do not think we should expect anything even close to an exact replay in either case. I'll do a sort of compare-contrast of each to show why I think this is the case. Japan vs. The US There are three significant differences between the Japanese economy of the late eighties and the US today that pretty well spoil the comparison. Straightening these out will show that the crisis we face today is very different from the crisis Japan faced in the 90's. First, the yen does not serve as the global reserve currency as does the US dollar, and Japan intervenes heavily to operate as a mercantilist exporter similar to the Chinese strategy. Japan runs a tremendous trade surplus, unlike the US. As a result, the economy of Japan developed along very different lines than the US economy has. Japan has little domestic dependence on foreign manufactured goods and a vastly larger manufacturing base. Exchange rate fluctuations would have little effect on consumer prices in such an economy, but a large effect on employment levels and GDP. The opposite is true in the US. A second side effect of this policy is that most of Japan's government debt is held domestically. Though Japan has a very large debt to service, it faces virtually no risk of a mass sell-off as a result of exchange rate fluctuations as the US does. There is much less risk of a mass sell-off of yen or the Japanese government finding itself unable to borrow, again despite very high debt levels. Lastly, Japan has an extremely high savings rate in comparison to the US. This means that monetary inflation by the Bank of Japan actually has a savings base representing saved capital to redeploy, instead of being stretched thin as is the case in the United States. Monetary inflation will result in malinvestment and eventually consumer price inflation in both cases, but the responses will be very different. I would expect the US to see price inflation much more quickly than the Japanese economy, which would tend to see many more "bridges to nowhere" built before price inflation kicked in. In other words, rank economic stupidity would tend to show up more in investment patterns in Japan and more in consumption patterns in the US, since the savings rate differential would result in an inflation induced subsidy differential that played itself out over time. So, overall I think this comparison is quite bad, especially as the dollar is at the center of this crisis. Both countries have fiat currencies that will eventually go the way of all fiat currencies, yes, but other than that our currency situations could not be more different. Very different forces are at work on them. And while we're on the subject of Japan, I'd like to explode one little myth about Japan that has been tossing about for some time. Japan has not experienced significant price deflation over the past 20 years. CPI and PPI have bumped around inconsequentially between positive and negative territory. This is a pretty good performance if you ask me, actually. I wish the US had this to look forward to over the next two decades. Price deflation is not that big of a deal. I know that if I buy a computer today, I can get the same computer much cheaper in a year or two. I still buy computers. Price deflation ought to be a normal part of any economy as money supply remains unchanged but the economy becomes more productive and supplies overall increase. We can see it in the computer industry only because it is developing rapidly in comparison to FED printing. It really should be going on across all industries. But back to the controversy at hand... The Great Depression Actually, the Great Depression comparison fails for many of the same reasons. The America of the twenties was running a trade surplus and behaving much as the mercantilist/creditor nations of Asia are behaving today. Today, we are debtors with a trade deficit. The economy was likewise much more manufacturing based, as one might expect. However, there are other important differences that have no parallels with Asia. The US was on a "gold standard" at the time, which meant that money could theoretically be exchanged for gold at a fixed rate, provided not too many people did it at once. Let's not kid ourselves here -- the banking system was never all that honest. Fractional reserve banking and the FED were still inflating, but at least there was something to hold over their heads. By the end of WWII, this check had largely been removed, and is completely absent today. Now the accounting is allowed to get much more out of hand before objections get raised. But probably the biggest difference is the development of a deposit insurance system. Nowadays there is little to fear from bank runs or monetary destruction resulting from bank failure. When banks fail, there is virtually no impact on the money supply. Provided that Congress continues to fund the FDIC, which is pretty much guaranteed, this will continue to be the case no matter how bad things get. But you can expect to see huge fiscal deficits ahead as a result, since the Treasury will be paying for claims over and above the FDIC's ability to pay, which is going to be pretty much all of it. America also had far less debt back then and no Social Security or Medicare to pay for. There was far less pressure on the government to prod the FED into inflating just to finance the government deficit. But then again, there was WWII... At any rate, overall, the major forces acting on the economy were quite different in 1929 than in 2009, especially with respect to currency. Better Parallels There really are no good historical parallel to America's present predicament. There has never been a global fiat currency system, much less one that operates off a single reserve fiat currency. Most of the banking and financial "innovations" like deposit insurance schemes are fairly new developments. But there are a few parallels that I think are slightly more fitting. Britain of the twenties effectively made sterling something like the reserve currency of several European nations. Their central banks refused to exchange currency for gold, but would exchange it for pounds sterling, which were then exchangeable for specie (precious metal), again, theoretically, at the Bank of England. This is not exactly the same as today's floating exchange rates since the rates at that time were fixed, but it is reminiscent of the Bretton Woods "gold exchange" arrangement that was the predecessor of today's system. As the Brits exploited the system by inflating their currency, they set up many of the events that contributed to the Great Depression. They even managed to drag the US into their scheme, as chronicled by Murray Rothbard in America's Great Depression. This is one of the less discussed contributors to that event, but is possibly one of the most important. Notice that in this scenario, the US is playing more or less the role of today's China, with Britain taking the role of today's US. The parallel has led some commentators to describe this crisis as China's Great Depression. The fits are inexact, especially with respect to deposit insurance and fixed exchange rates amongst currencies and gold, but better than direct US-US comparison. Two other parallels are better fitting, in my opinion, even if they are still not very good. Those would be the examples of Argentina and Russia in the nineties. Both nations had enormous foreign debts, implying large trade deficits and weak currencies, and an expansive and expensive welfare state. Both found their central banks forced to debase the currency to cope with the debt burden, and both eventually defaulted and saw systemic political and economic chaos as a result. On the other hand, because their currencies were not serving as reserve currencies for other nations, their individual collapses were mostly contained within their own respective borders and economies. Neither had the extended and complex division of labor that the US has, either, so in many respects, the economic adjustments they had to make were less severe that what the US would be facing. The True US Debt Burden A lot of commentators will argue that countries like Japan have a larger debt burden than the US, so they are actually in worse shape. At $12 trillion, the US debt burden has yet to reach 100% of GDP, while Japan is already approaching 200% and rising quickly. Therefore Japan's currency should be under greater threat than the US currency. This is only true in the narrowest sense. As I talked about last time, a great deal of America's debt burden and future liabilities are off-book, and as Leo pointed out, Medicare and Social Security are both already in the red if you check the numbers closely enough. This means that these hidden liabilities are incrementally being rolled into the official debt numbers, which is a big reason that the deficits have been rising so dramatically. Using more realistic accounting, the Social Security - Medicare debt burden is in the range of $80 trillion. To this we can add the on budget deficit of $12 trillion, plus the FDIC claims likely to result from bank failures to arrive in the ballpark of $100 trillion dollars. Now, to be sure, not all of this is going to wind up on the official, on-budget deficit all at once. The transfer will be incremental, if at all. But it should be clear: there is no way that the US can possibly pay the interest on this level of debt. At only 3%, interest payments are $3 trillion, more than 20% of GDP. Such payments would absorb pretty much the entire Federal budget. As it stands, only the interest on the on-budget $12 trillion is actually being paid, with the SS-Medicare interest simply accruing as more meaningless book-keeping IOU entries. Social Security and Medicare effectively operate on a pay-as-you-go basis with some clerk keeping track of the imaginary accumulating deficit that will never be paid. The government cannot endure 10% unemployment for long. It is driving down tax revenues and increasing welfare claims. We won't persist in this condition as the "Japan Argument" claims. The US is already bankrupt. It is simply a matter of time before the bluff is called. The faster Social Security and Medicare deficits are transferred to on-budget deficits, and the faster the on-budget deficit increases, the sooner the day of reckoning comes. Then, the history writers will say that an old era ended and a new began. But we will know the transition actually occurred long ago.

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