How the US became a credit driven economy

Dec 15, 2014

Washington, DC

Stocks down hard on Friday, with the Dow losing 315 points.

It is bound to happen sooner or later. Stocks will enter a bear market. Nothing can stop them. Nature and the gods command it. The Dow will fall as much as 1,000 points in a day.

Then, we'll see if our analysis is correct. We believe the Fed will be unwilling to stand back and let markets be markets. We believe it will step in with more stimulus...and probably bring on the wildest, craziest stock market extravaganza we've ever seen.

Whether that happens sooner or later, we don't know...so let's continue our discussion of the Big Picture, and why we think the Fed must keep stick with its game plan.

Macro, Part II

Endless discussion, books, reports, theories and blahblah have been devoted to the subject of markets' cyclical moves...and the roll of human psychology. For our purposes in this "crash course" let's just remember that they don't make it easy for us. When markets look their best, they are often most treacherous. When they are forgotten, neglected and held in contempt, that is when they are most likely to give you 'positive beta' (the kind of investment return you get from being in the right market at the right time.)

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In that sense, whole markets are like individual stocks or bonds. You are generally better off buying them when they are cheap. Your analysis of the company may be right or wrong, but the low price gives you a 'margin of safety.' You will still get some stinkers, but they will be cheaper stinkers.

But let's now turn to good the particular macro situation in today's financial world. Since this has been the focus of our interest for so many years we are tempted to write a book about it. But we already did. Four times. The books were warmly received by readers. On the other hand, elite economists and policy makers have not so much as acknowledged them. In the interest of full disclosure, our analysis of the contemporary macro-economic situation is at odds with a very long list of Nobel Prize winning economists and powerful opinion makers - Krugman, Summers, Bernanke, Yellen, Stiglitz and et al. The list is so stellar that you will have to ask yourself at some point why you bother to listen to us. But we accept that challenge. We are in a very small minority and the burden of proof lies squarely - if a bit uncomfortably - on our shoulders.

This 'crash course' is too abbreviated for a full explanation of why the world's leading economists are wrong and we are right. You will find that, and more, developed over the course of months...and years!...in these Diary entries. For our purpose today, we content ourselves with a few questions.

Economists of mainstream academia, government and the media believe they know how to 'fix' an economy so that it does what they want. Where's the evidence? In every example known to man, the more the authorities try to control an economy, the worse it functions. More broadly, they believe they can boost the output of the economy, making people wealthier than they would be without their interventions. From the beginning of time to the present, is there a single case where this has happened? Not that we know of. In general, we are left with the suspicion that these economists believe what they believe because it serves their own interests, not the interests of the economy or other people in it. They gain fame, jobs, prestige by claiming to improve the workings of free markets. We see that they have improved their own position...and shifted trillions of dollars to their cronies in the financial industry. But is there a clear, undisputed example?

Again, none that we know of. On the other hand, there are plenty of examples of economies that have been severely damaged by ambitious central planners. The most in-your-face example is the Soviet Union, whose 7-decade experiment with central economic planning was finally abandoned in 1989.

A quick review of how the world economy has evolved since the '30s:

WWII was the biggest 'stimulus' program in US history. The economy boomed. Wages were high. But consumer items were scarce. Then, when the war was over economists worried that the economy would fall back into the depression. Instead, the soldiers came home, started families, got jobs, had children, set up businesses, and the economy boomed again - this time with output that raised standards of living.

Increased prosperity led people to believe that there really was no limit on what they could do. Previously, politicians believed that they had to make a choice -- guns or butter (war...or domestic programs). Lyndon Johnson decided to do both. The Vietnam War and the Great Society. This expense so weakened the finances of the US that the following administration felt itself forced to abandon the gold-backed dollar. Thereafter - after August 1971 - the dollar was 'elastic.' In practice, this meant that there was no effective limit on how many dollars you could create. There was not even a need to print them. The financial industry created them, simply by issuing credit cards and lines of credit.

Not surprisingly, this new purchasing power - which no one ever earned or saved -- was very popular. The supply of credit money increased 50 times over the last 40 years. In effect, Americans spent $33 trillion dollars that they never earned nor saved. That huge amount of excess credit is what built and sustains many of the shopping malls, housing developments, Chinese imports, federal spending programs, wars in the Mideast and other things that we take for granted.

The economy now depends on continued expansion of credit (and debt) just to remain at present levels. Perhaps it is unnecessary to say so; but without expanding credit, today's stock market is kaput.

Trees do not grow the sky. Nothing lasts forever - certainly not a financial trend! Credit (and the debt that results) is a claim on resources and output. When you borrow, you shift resources from someone else to yourself. But you have to pay it back. Or the lender will lose the wealth he thought he had...and not lend you more.

This is why, earlier in this series, we looked at where "capital" resources really come from. They are real - representing real savings and real resources. They are the part of wealth that you don't consume on a current basis. They can be used to increase output...or they can be consumed. But if they are used up, rather than invested for more output, how does the borrower repay his loan?

And what happens if the lender didn't really have any capital to lend?

Ah, this is beginning to get complicated. Sorry, not our fault. But let's try to understand. Economies naturally breathe in and breathe out. They expand and contract. They make mistakes - bad investments, bad loans - and they correct them. They increase credit and they reduce it.

Yes, credit is cyclical too. The more you borrow, the more you had better prepare to pay back. Sooner or later every debt is paid, if not by the borrower, then by the lender. And occasionally, when inflation reduces the value of the principle, by the whole society.

Over the last few decades, and especially since the 'crash of '87' each time the economy has tried to breathe out - expelling its bad credit, overpriced assets and oversize debt - the Federal Reserve, America's central bank, has rushed to stop it. Instead of allowing prices to decline, and accept the losses, bankruptcies and defaults that usually accompany a credit contraction, the Fed has insisted on keeping the expansion going. It lowers borrowing costs, making more credit available at lower prices.

Having avoided many smallish contractions, the world economy now faces a biggish one. Total world debt now exceeds $100 trillion. And the authorities in almost every major economy are desperately trying to keep that number going up. Many now judge the risk of a credit contraction unthinkable. To avoid it, so far they have used $10 trillion worth of quantitative easing - essentially 'printing' more money. They use this money to buy assets, typically government bonds, in order to put more money into the financial system and to hold interest rates down to near zero levels. So far, these measures have held off a credit contraction. Since '08, only the household sector has reduced its debt level. Business and government have more debt than ever. After 65 years, credit is still increasing in America.

But the real test is of the Fed's ability to stop the credit cycle is still ahead.

More to come...

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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