Ron Paul - Fox News, 12/APRIL/2010

The Current Financial Crisis — and After

The Current Financial Crisis — and After

Mises Daily: Friday, April 09, 2010 by Kevin Dowd

[This talk was first presented at the Paris Freedom Fest, September 13, 2009.]

My main topic this morning is the resolution of the current financial crisis, and what might be done to fix the financial system and help avert another crisis in the future.

If this sounds like good news, it is indeed. But you should beware of economists bearing good news on a beautiful Sunday morning: economics isn't known as the dismal science for nothing.

There is also the bad news — and then there is the very bad news.

The bad news is that the authorities badly botched it, at massive cost to us all — except to the bankers, of course, who are laughing all the way to what is left of our banks. And we are not out of the woods yet, by any means, and the authorities' responses to the crisis are already sowing the seeds of a new, probably worse crisis down the road.

That is pretty bad, to be sure, but that's only a preamble to the very bad news. The really bad news is that, even if we get through our current problems in half-decent shape, there are some disturbing storm clouds on the horizon, and these are much more ominous than the current crisis itself.

Keynesian Economics

The first thing to appreciate is the power of ideas. And one point that this crisis has conclusively demonstrated is the enduring hold of Keynesian economics. People now forget that Keynesianism didn't work well, even in the 1930s; its short-term focus and its failure to deal with the monetary side of the economy led to inflation and, ultimately, to the miseries of stagflation in the '70s. Keynesianism's failure was then manifest, and it was rightly repudiated. Fiscal and monetary extravagance were then reined in, inflation was painfully brought down, and the economy boomed.

And then comes the next big crisis, and Keynesianism is suddenly respectable again —and back with a vengeance. We are now told that Keynesian solutions are the only solutions. And it's not just Keynesianism, but Keynesianism on a mass (or should I say, crass?) scale: massive fiscal stimulus, regardless of the cost; and loose monetary policy, regardless of the inflationary dangers.

This reminds me of an old joke: Keynes was once giving a lecture and noticed that one of his students had fallen asleep. So Keynes asked him a direct question, which woke him up. The startled student responded: "I'm sorry, Mr. Keynes, I didn't hear the question. But the answer is that we need more stimulus."

One size fits all, basically.

We have been here before. Writing in 1940, Friedrich Hayek gave perhaps the most perceptive critique of Keynesian economics ever mounted:

I cannot help regarding the increasing concentration on short-run effects … not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilisation.…

It is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science. Are we not told that, "since in the long run we are all dead," policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they wish.[1]

Then, as now, a spending orgy is not what we need. What is needed is a considered response that addresses the structural problems ailing the economy. The key issue, in essence, is that the economy's financial engine has broken down, and this engine needs to be repaired before the economy can properly recover.

Resolving the Financial Crisis

So how do we fix the financial engine? The answer is that we need to restructure the balance sheets of the main financial institutions. And, as we all know, these balance sheets are best understood using the medium of — poetry:

A balance sheet has two sides.

A right-hand side and a left-hand side.

On the right, nothing is left.

And on the left, nothing is right.

Believe it or not, this little poem gives us the key to resolving the financial crisis. So let's have a look at a balance sheet:

The right-hand side shows the bank's assets, which move up and down in value depending on whether the bank makes profits or losses. The left-hand side shows the claims on those assets, the liabilities. These liabilities consist of the bank's deposits and its share capital. This share capital is also a buffer that protects the value of the deposits and reassures depositors that their money is safe. So, for example, if the bank takes a loss, the loss is usually borne by the shareholders, but if the buffer is big enough, then the bank can absorb any reasonable loss and still have enough share capital left to be safe. This situation is illustrated in the next slide:

The bank makes a small loss, but can absorb it and still be safe.

However, if the bank takes a very big loss, we get the following situation:

The bank's loss is now so high that the value of the bank's assets is not enough to pay off the depositors in full. In this case, the shareholders are wiped out completely, and depositors take a loss too. The bank is now insolvent — it can't meet its debts.

The problem now is how to get the bank back on its feet and operating again on a solvent, going-concern basis.

The answer is to rebuild the banks' balance sheets. There are good and bad ways of doing this.

The authorities chose the bad way. They panicked — what else could we have expected? And in their panic they injected massive amounts of taxpayer money into the banks, and in so doing threw our money into a virtually bottomless hole.

A much better way, by contrast, is to rebuild the banks' balance sheets following the precedents of traditional bankruptcy law. The bank would go into some form of temporary receivership, and three things would happen:

1. Its assets would be marked down in value to reflect the losses.

2. The liabilities would be marked down by the same amount.

3. The liabilities would be reorganized so that the bank would have a decent capital base again. This new share capital would come from the depositors, some of whose deposits would be converted into shares.

We might also wish to ring fence the smaller depositors to protect them — this would make the package easier to sell politically, but this is a detail.

The restructuring is shown in the next slide:

The bank's balance sheet is now much smaller, but the new capital base is large enough to make the bank safe again. The bank can then return to normal business but on a smaller scale.

There would be no taxpayer bailout, no propping up weak institutions, no too-big-to-fail, no humoring of the banks and their bonus culture, no prolonged period of crippling uncertainty, no fiscal profligacy, no loose money. Instead, we should have a quick, emergency-room operation on the economy's financial engine followed by a rapid return to normal market conditions. This is rather different from what actually happened.

Of course, I am not suggesting that the operation would be easy. In particular, it is very difficult to work out what the "true" value of the banks' assets should be — no one really knows what a toxic asset is worth. But fortunately, it is not necessary for the write-downs to be "realistic" or accurate. In fact, it is best if the write-downs are harsh and the valuations biased on the conservative side, and these could be based on formulas reflecting worst-case estimates of what different types of asset might be worth (i.e., zero in some cases). And if those valuations later turn out to be too low, it doesn't really matter: the banks' assets can be marked up again later.

The trick in all this is speed. We could close down the banks or limit their operations for a weekend or a few days, but not for months. A prolonged disruption of bank activities would cripple the payments system and the supply of credit to the broader economy, and this would be catastrophic. It is therefore essential that the operation be carried out quickly to minimize the disruption to bank activities — and not for the sake of the banks, but for the sake of everyone else.

Looking forward, we should be looking at a reform package with a number of key elements:

"We should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly."

First, we should consider reforms of bankruptcy and insolvency laws to get the ER treatment "right" in the future: should any bank ever need emergency surgery again, this should be a straightforward, by-the-book process anticipated and thought through in advance, not some battlefield-surgery hatchet job.

Second, the financial-services industry needs serious reform. Hard to believe as it might be, there was once a time when the industry was conservative and respected, when it focused on providing straightforward financial "products" to its customers and did so well. We have got to get back to that. No more financial hydrogen bombs blowing up the financial system.

The key to this is corporate-governance reform. I am talking, not about tinkering with the number of nonexecutive directors or a new Sarbanes-Oxley, but radical reform to make the banks accountable and to rein in the moral hazards that have run rampant. And the key to good corporate governance is to remove limited liability: we should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly.

And, of course, there is our old enemy, the state. If I had my way, the state would be rolled back right: no deposit insurance, no capital adequacy rules, no financial regulation, no central bank, no monetary policy — in short, the restoration of a sound monetary standard.

Short- and Medium-Term Economic Prospects

I could easily spend the rest of my talk drooling over these wish-lists. But rather than do that, I would like to spend the rest of my time looking at our economic prospects. And our prospects are not too good. To save time, I will focus on the US, but much of what I say applies to some extent to other countries too.

Let's start with inflation.

If we look over the period 2006–2008, we see inflation of between 2% and 4% on a year-on-year basis, and the broader monetary aggregates expanding quite rapidly and growing at double-digit rates by the end of 2008. We also see an extraordinary growth in the narrowest aggregate, the monetary base, which grew 100% over 2008, a consequence of the highly dangerous and irresponsible policy of "quantitative easing."

From early this year, admittedly, we see monetary growth halting and prices falling a little. However, I wouldn't put too much emphasis in such a short downturn in the monetary growth rates, especially in a period where the demand for money is clearly falling due to the impact of the recession. Instead, we need to look over the broad period and consider the likely impact of the large amount of excess money that is already in the system. So, overall, combined with still-low interest rates, these figures indicate a loose monetary policy and the prospect of resurgent inflation once economic activity returns to normal.

Interest rates are low, due in part to "soft" monetary policy, but also due to a flood of hot money pouring into the allegedly safe US Treasury bond market. Low interest rates mean high bond prices, and there are signs that the T-bill market is undergoing a fair-sized speculative bubble. This bubble would seem to be very vulnerable — even a small rise in inflation could easily trigger a loss of confidence and a massive exit from the market. If that happens, market interest rates could rise sharply. And of course, we shouldn't forget that the prospect of massive federal deficits for years to come will also put upward pressure on interest rates. So interest rates are set to rise.

"For those of you who want any investment advice, my advice boils down to a choice between two positions: a cash position and a fetal one."

At the same time, the Fed faces a difficult dilemma: If it continues with its current monetary policy, then inflation will return, and probably with a vengeance. The worst thing that the Fed can then do is to put its foot down even harder on the monetary accelerator. This would push interest rates back down temporarily but lead to higher inflation and higher interest rates down the road — and, in all likelihood, to the return of stagflation and yet another massive boom–bust cycle.

But on the other hand, the best thing that the Fed can do is also the hardest thing for it to do: bite the bullet and put its foot on the monetary brakes. Such a policy would encounter massive political resistance — and risk pricking the bond-market bubble and stalling the nascent economic recovery.

In effect, the Fed now risks being hoist by its own petard, a consequence of its own past profligacy.

So the near-term outlook is not too good: the prospect of renewed inflation, even hyperinflation; higher interests rates; a bond-market crash; an uncertain and possibly stalled economic recovery; and the danger of a dollar crisis.

And for those of you who want any investment advice, my advice boils down to a choice between two positions: a cash position and a fetal one.

Long-Term Prospects: Deficits + Entitlements

But all these shorter-term worries pale compared to the long-term outlook.

Federal deficits will be more than 10% of GDP for years to come — these are extremely high.

But this is only the tip of the iceberg. We also have to take account of the unfunded entitlements to which the federal government has committed itself: Medicare and Medicaid entitlements; and pay-as-you-go funding of Social Security, that is, state pensions paid for through current tax revenue, not funded in advance.

These are set to grow massively due to there being more retirees relative to workers, retirees being set to live longer, and old-age entitlements growing higher.

Let's look at some figures:

The cost of unfunded Social Security and Medicaid is over $100 trillion — and rising. This is about ten times bigger than the total existing debt of the United States, and it is about $330,000 per man, woman and child in the United States — or about $1.3m for a family of four. And rising.

So your average US family of four is facing a government-imposed bill of $1.3m on top of existing taxes! Change the sign around and they'd all be millionaires! Welcome to the age of the negative millionaire.

It is not surprising, then, that leading experts are now openly asking if the United States is bankrupt, and they are anticipating possible futures in which young, educated Americans flee the country in large numbers to escape crippling taxes — and, of course, in so doing, leave their fellow citizens with even greater per capita burdens to bear. A real case of "last one to leave please switch off the lights."

To quote one leading authority, the president of the Federal Reserve Bank of Dallas:

I see a frightful storm brewing in the form of untethered government debt.… Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets. (Richard W. Fisher, 2008)[2]

For those of you who are young, the implications are personal. You have your college debts to pay off. It's hard to get a job, let alone a well-paying one. You can't get on the housing ladder because property is too expensive. Taxes are likely to be high and rising throughout your working life.

You won't have much left to pay for your own personal pension. And yet current projections suggest that you are likely to live well into your 90s or later, and there will be little left in the kitty for your state pension when you retire — assuming that you can retire at all. Pension experts are now talking about the end of retirement, and retirement ages are already starting to rise.

Historically speaking, a good retirement will be seen in the future as a 20th-century luxury, something that people before or since usually didn't get. And you came too late: whereas earlier generations had it easy, you can look forward to busting your gut all your life and working till you drop.

If you are not thoroughly depressed by now, then I am obviously not getting my message across.

You might object that this nightmare scenario is an unfair rip-off, and you would be quite right. Indeed, it might remind some of you of a Ponzi (or pyramid) scheme. A Ponzi scheme is essentially a scam. Someone sets up an investment scheme and gets other people to put their money into it. These people draw in others, and they in turn draw in more people, and so on. Each new intake imagines that their money is being invested on their behalf, but in reality the money is being creamed off by those already in the system.

"The pensions/social security system is an intergenerational Ponzi scheme, the biggest scam ever invented."

The process continues for as long as enough new suckers come in, but at some point it becomes clear that the scheme cannot pay out. The supply of suckers then dries up and the scheme collapses. And collapse is inevitable. Those who come in early do well, those who come later do badly — and those who come in last lose everything.

I would suggest that the pensions/social security system — the system of intergenerational transfers in which the young get signed up by their elders, often before they are born — not only resembles but actually is an intergenerational Ponzi scheme, the biggest scam ever invented. And to you young people here, I am sorry to say, if you want to see who the suckers of this Ponzi scheme are, just look in the mirror.

So the system must inevitably collapse. The younger you are, the more you stand to lose. And the longer the scam goes on, the more it will cost you.

To you youngsters, I say: it's your choice how long you choose to put up with this. I say it's yourchoice because — with a bit of luck — those of us who are older will have departed the scene when these particular chickens come home to roost.

It's your choice.

You can play by the rules your elders would impose on you. You can expect to pay higher and higher taxes, work harder and harder to stand still, and get less and less back in return for yourselves — a life little different from slavery — and then the system will collapse anyway.

Or, alternatively, you can fight back. There is no law of nature that says you have to honor checks that other people write at your expense. You are not slaves — you are slaves only if you choose to submit to slavery. You can repudiate those checks.

I am very aware that we are in unchartered territory here, and the implications of what I am saying are revolutionary and certainly dangerous.

Let's be blunt about what I am suggesting. I am suggesting that if default is inevitable, and if default is more damaging the longer it is delayed, then it would be a good idea to consider embracing it. We should lance the boil, as it were, and kill off the scam — sooner rather than later.

Do you want a life of toil and slavery, followed by ultimate destitution, or do you want to stand up for yourselves and fight for the chance of a decent life? It's your choice.

Who was it that once told the workers of the world that they had nothing to lose but their chains?

I would like to end as I started, with the man of the moment, the prophet of the short-term, John Maynard Keynes. In 1930, Keynes wrote a delightful essay, "Economic Possibilities for Our Grandchildren," in which he peered into his crystal ball and mused about how economic life would be a hundred years hence, in 2030, now only a couple of decades away.[3]

Keynes anticipated the benefits of technological progress taking us gradually toward a state of economic bliss in which the problem of economic necessity would in essence be solved. He anticipated three-hour shifts and fifteen-hour working weeks, worked not so much out of need, but more for the sake of having something to do, and he worried about how people would mentally adjust to having so much spare time on their hands. We would be like the Biblical lilies of the field, who neither toil nor spin.

And, at long last, after millennia of struggle, real life would finally catch up with the traditional charwoman's epitaph. After a lifetime of unrelenting hard work, she went to her grave looking forward above all else to a very, very long rest:

Don't mourn for me, friends, don't weep for me never,

For I'm going to do nothing for ever and ever.

At least Keynes was right about one thing: all that spare leisure time is overrated. Thank you all.

Trust Us: Social Security Works

Trust Us: Social Security Works

Mises Daily: Wednesday, April 07, 2010 by Mark R. Crovelli

I read Counterpunch.com on a regular basis for two reasons. First, I visit the site for its extremely good articles discussing the foreign-policy follies of Western governments. Few sites feature harder-hitting and more consistently anti-interventionist critiques of the policies pursued by Western governments. The second reason I like to visit Counterpunch is to give myself a good laugh. Nothing in the world amuses me more than when self-styled "progressives" attempt to discuss economics.

During my most recent perusal of the Counterpunch archives, I stumbled upon an article by Dave Lindorff entitled "Social Security Scare Tactics." The article made me laugh so hard that whiskey came out of my nose (which is, by the way, excruciatingly painful).

For those of you who don't want the punch line of the article spoiled, stop reading right now. For everyone else, put down whatever it is that you're drinking, because here it is: there's nothing seriously wrong with Social Security! That's right, Lindorff apparently really believes that all of the dire talk about the inevitable and impending bankruptcy of Social Security this year is nothing more than scaremongering designed to manufacture a "fake crisis." Don't get up off the floor just yet, because there's more: Lindorff apparently really believes that the Social Security "trust fund" actually has real money in it, instead of a bunch of worthless IOUs from the Treasury Department!

Now that I've spoiled the punch line, let's have a look at the evidence Lindorff gives for his knee-slapping claim that Social Security is not in dire straits. I use the word "evidence" rather loosely here, however, because Lindorff apparently doesn't think that any actual evidence is necessary to substantiate his claim.

One would think, for example, that any claims that an institution could easily be made fiscally sound would require substantiation by looking at the institution's actual books. Specifically, one expects that such a claim would be substantiated by looking at the actual assets and actual outstanding liabilities of this socialist totem in order to determine whether it is even possible for Social Security to live up to all of the promises it has made to future beneficiaries. For Lindorff, however, looking at the books is not necessary, because he somehow already knows that there's nothing fundamentally and irreparably wrong with Social Security.

For those people not gifted with accounting ESP like Lindorff, Social Security's unfunded liabilities are conservatively estimated to be around $17.5 trillion. Oh yeah, and that "trust fund" that Lindorff mentions as if it were really overflowing with saved money — all the money has already been spent by Congress. As you can see, the numbers are not exactly as rosy as Lindorff's ESP has led him to believe.

What is really interesting is that even while Lindorff is trying to make the case that Social Security's fiscal condition is not all that serious, he concedes that Social Security will indeed go bankrupt this year. He writes:

So with beneficiaries rising faster than anticipated, and the total national payroll in sharp decline, of course things have gone negative for Social Security earlier than originally anticipated.

One would think that an institution going "negative" (i.e., bankrupt) is a sign that there is something fundamentally flawed with it. For Lindorff, however, bankruptcy is nothing to get ourselves worked up about, especially since the bankruptcy is only caused by the demographic problem posed by the baby boomers.

Lindorff thinks the boomers are only a "demographic wave that will eventually pass." He's right — we only have around 30 more years until the "wave" passes. Thirty years of bankruptcy is nothing that need trouble us!

To mention that Social Security is completely bankrupt right now and cannot possibly pay out everything it has promised is nothing but a "scare tactic." One wonders if it occurred to Lindorff to make the same claim when Bear Stearns and Lehman Brothers went bankrupt two years ago. Don't worry everyone, bankruptcy — I mean, "turning negative" — is nothing too serious! Anyone who talks about Lehman's complete "insolvency," or, better still, Bernie Madoff's "insolvency," is just a scaremonger! That's right, Lindorff uses scare quotes around the word "insolvency," as though the word itself is inflammatory.

We know, of course, that socialists like Lindorff were making no such claims back in 2008, because progressives of his stripe view the world through Manichean glasses. In their view, there's the corporate world of greed and theft, and there's the world of ordinary, helpless workers who are protected by selfless government programs that can't possibly do wrong.

People like me who defend the free market but who also have blue-collared shirts must perplex white-collared progressives like Lindorff because we don't fit into this Manichean model. I suppose I've just developed an insidious "false consciousness" by examining the actual books of Social Security, Medicare, the FDIC, etc.

According to Lindorff's banal, progressive worldview, the problem with Social Security is not that it is a bankrupt Ponzi scheme, but that greedy employers are not forced to pay enough into the system. You see, employers only pay half of a worker's contribution to the program. God forbid! The solution to the "fake" Social Security crisis, according to Lindorff, is thus to dramatically jack up the percentage paid by the employer to, for example, a "40/60 split, with the employer paying 50 per cent more than the worker, or even a 30/70 split."

Like any good progressive, Lindorff salivates when he thinks about extorting money out of businesses for his pet projects — businesses that he childishly imagines are bloated to the gills with superfluous cash that could be used to finance grandpa's Social Security checks. However, he never explains the effect that this scheme would have on employment in this country. He doesn't mention this because the scheme would produce one of two outcomes, both of which would be devastating to working people in the United States: it would produce either massive and permanent unemployment, or else lower salaries and wages across the board.

Businesses that are forced to pay more per worker in the form of Social Security "contributions" (without a concomitant increase in labor productivity) will hire fewer workers, and the cost of their goods will rise. The price for labor affects both the quantity of labor demanded and the price of the finished goods the labor is a factor in creating. Employers could offset this increased price for labor by offering their workers lower take-home salaries and wages, (i.e., shift the cost onto workers), but this is precisely the outcome that the Lindorff scheme claims to avoid.

In either scenario, it is the workers who suffer through either widespread unemployment and higher-priced goods, or lower take-home wages and salaries. So much for Lindorff's silly attempt to saddle supposedly greedy employers with the Social Security bill.

These inexorable economic consequences do not trouble Lindorff in the slightest, because he's still got the example of Germany up his sleeve. According to Lindorff, the fact that Germany has a gigantic social-welfare system coupled with the fact that Germany exports more than it imports is proof that social security is not a real problem for the United States.

The economic reasoning is hard to follow here, even by Lindorff standards, but the logic seems to run something like this: Germany has a massive social-welfare system and exports a lot of stuff. Exporting lots of stuff is virtually identical with economic prosperity. Therefore, the United States shouldn't worry about Social Security, because social-welfare programs are not incompatible with shipping lots of your stuff to other countries. If this is indeed an accurate representation of the logic of Lindorff's argument, then we have no choice but to say that he is just as historically ignorant as he is economically illiterate.

"Progressives' faith in government programs and bureaucrats cannot be changed by looking at how real government programs and real bureaucrats operate in the world."

In the first place, this argument is a complete distortion of German economic history since World War II.[1] Indeed, the historical record shows quite clearly that the years immediately following WWII were marked by the return of almost 19th-century-style laissez-faire in West Germany, which led to miraculous economic growth, while East Germany languished in poverty and stagnation under the ultra-"progressive" Soviets.

Beginning in the 1950s, however, the West Germans turned away from laissez-faire and toward a state-controlled welfare system of the sort defended by Lindorff. Far from bringing prosperity to the West German people, the new social-welfare state brought what socialism always brings in its wake: recession, unemployment, and reduced productivity.

Lindorff's reference to German history also neglects to mention the case of East Germany, where there was a "safety net" in the form of Soviet-created jobs and welfare for the sick and indigent. East German economic history is not particularly helpful for making Lindorff's argument, however, since socialism, Soviet-style, brought nothing but poverty and economic backwardness.

Lindorff's argument is even worse than this, however, because his argument is completely irrelevant to the issue at hand. The question at hand is whether or not the American Social Security system, which Lindorff himself recognizes will go "negative" this year, can afford to pay out what ithas promised. It is thus completely irrelevant to point to Germany and say, "See, their system isn't hopelessly broke yet."

The argument is like Lindorff pointing to his friend's car and exclaiming "See, his car is paid off. Mine must be, too!" And this is setting aside the fact that the European social-welfare states aremuch poorer than economically ignorant American progressives like to think, and setting aside the fact that exporting lots of stuff to foreigners is not the same thing as prosperity, as any serf in the Chinese hinterlands can tell you.

The problem with people like Dave Lindorff, and with progressives generally, is that they don't ever care to investigate whether the articles of their progressive faith are indeed justifiable in the light of economic theory or economic history. Economic theory is nothing more to them than a constant and tired rephrasing of the old Marxist canards condemning business, coupled with the most childlike faith in the power of government bureaucrats.

What's far worse, however, is that their faith in government programs and bureaucrats cannot be changed by looking at how real government programs and real bureaucrats operate in the world. Hank Paulson was a bureaucrat. Sheila Bair is a bureaucrat. Tim Geithner is a bureaucrat. Ben Bernanke is a bureaucrat, and Alan Greenspan was, too. Those incompetent jerks down at Lindorff's local DMV are bureaucrats.

All of these people are incompetent, and most are liars and thieves of the most despicable sort, but these facts can never persuade the progressive mind to abandon its unshakable belief in the power of government bureaucrats and government programs to remake the world. In the end, this is the reason why progressivism as a system of economic thought is every bit as bankrupt as Social Security.