The real economic reality

12/05/2009 by Philinje.

This article is the single best description I have found of the current situation, which is not just a crisis but an ideology:

http://www.gold-eagle.com/editorials_08/kutyn051109.html

Even if your eyes glaze over when you hear about debates regarding Keynes vs. Mises, this boils it all down to the basics, and answers the question of how gold will do in the case of deflation. Here it is reproduced in its entirety:

Keynes vs. Ludwig von Mises and the Death of Capitalism

John Kutyn

Recently, massive amounts of fiscal and monetary stimulus have been injected into the global economy by governments and their central banks incurring debt. With U.S., Asian, and British economies and financial markets showing some signs of stabilising, there are those that claim that we are witnessing a clear empirical demonstration that Keynesian demand management can stabilise the market economy and protect capitalism from its own excesses.

Keynesian thought claims that financial imbalances and an economic contraction that results from excess debt can be corrected by going even deeper into debt, with central banks now predicting the end of the current recession by the end of 2009.

Countering this view is the Austrian school of economic thought that holds that the problem of excess debt cannot be cured by additional borrowing, but requires a major recession that liquidates unsound investments. Given the extraordinary levels of debt in the global economy, Keynesians correctly point out that such an approach would not only devastate public finances, but that the resulting job losses, bankruptcies, foreclosures, and general loss of living standards would be politically and socially unacceptable.

The key question is whether Keynesian demand management will work, because if it does not, an Austrian style collapse will occur, only from a much higher level of debt with government finances destroyed by the Keynesian approach.

In the U.S., interest rates are at record lows, government loans and guarantees are now estimated at almost $13 trillion to deal with the recession, the central bank debt has more than doubled to $2 trillion, and it is estimated that the government fiscal deficit will be about 12% of GDP. It is only reasonable to expect that such extraordinary measures should have some positive effect.

Keynesians claim the ability to see “green shoots”, indicating that their way will save world capitalism. These “green shoots” are driven by ideology and not reality, and can only be seen by Keynesians. Housing starts, having collapsed from 1,823,000 to 358,000 is a “green shoot” because they have not collapsed to zero. A slowing in job losses, even as hours worked collapses at a 9% rate is another “green shoot”. Keynesians have even examined the nations banks to find even more “green shoots”. In spite of rising loan delinquencies, foreclosures, and falling asset values, Keynesians see the creative ability of banks to post profits by creative accounting as a sure sign that banks can use the same creative ability to withstand even greater loan delinquencies and foreclosures.

Housing re-sales consist 50% of foreclosed homes. With hundreds of thousands of foreclosures held off the resale market, with foreclosure filings continuing to reach record levels, and more than 20% of homeowners owing more on their house than the market value, foreclosures and falling house prices will continue to dominate the housing market. Yet even here, Keynesians have found another “green shoot”. One is truly amassed at the genius of Keynesians and their ability to find “green shoots”.

Keynesians have not only deluded themselves by a failed and illogical economic theory, but by leveraging the national economy to this theory, they are on the verge of destroying the capitalist economic system.

The Chinese are beginning to question the wisdom of the Keynesians. Perhaps they are now questioning the wisdom of American consumers going into debt to purchase Chinese goods so that the Chinese can purchase U.S. debt. The Chinese have expressed concern about the future value of this debt. They are calling for the end of the U.S. dollar as a reserve currency, and have recently established currency swaps with Argentina, South Korea, Hong Kong, Malaysia, Indonesia, and Belarus. The Chinese are adding gold to their official reserves, and pleading with the IMF to sell all their gold in order to increase gold reserves further.

The Keynesian’s rely on a functioning bond market to support their economic theory. There must always be someone willing to purchase government debt, no matter how much is required, and no matter how great the government deficit. Record low interest rates and $13 trillion in loans and guarantees have only resulted in a small slowdown in the rate of economic collapse. Take away the ability of the government to go further into debt, or raise current interest costs, and the economic collapse will accelerate dramatically.

The American economy cannot tolerate a stagnant or contracting state for very long. The economy does not generate sufficient cash flow to meet debt obligations, requiring strong economic growth in order to avoid a collapse of the bond markets. Should the economy not respond to the present stimulus, even the federal government may not be able to borrow. A collapse of the bond markets not only takes away the ability of the government to stabilise the banks and the economy, but the resulting high interest rates will bring America down both economically and politically.

Perhaps the Chinese sense this. In their quest for world domination, economic warfare may be cheaper and more effective than a military conflict. A fire-sale of their U.S. debt holdings at a time the U.S. needs to raise $3 trillion in new loans could substantially raise interest rates, and call into question who has the financial capacity and desire to invest $4 to $5 trillion in U.S. government debt.

To avoid an economic collapse, and prevent outside forces from taking advantage of it’s present vulnerability, America needs to fundamentally alter its financial system. This involves a controlled collapse of the commercial banks and the Federal Reserve Board. The creation of the means of exchange must be taken away from the commercial banks and Federal Reserve, and given to the Treasury. Money would be in the form of Treasury notes (T.N.). The first step would be to simply create sufficient T.N. to purchase all bank assets.

Bank deposit holders, no longer being able to use bank deposits as currency, would close their accounts in return for the T.N. the banks acquired in exchange for their loan assets. These T.N. would be held at banks established by the Treasury department with transactions occurring electronically. The Treasury now owns all debt obligations, presenting it with a number of policy options. One policy would then be to cancel all debt, and in a simple step solve the present debt crisis. Alternatively, all interest payments could be cancelled, with principle payments used to fund government operations, eliminating the need for government taxation. The commercial banks, no longer having any assets or liabilities cease to exist.

Having solved the debt problem and establishing a stable monetary base, America will be able to achieve economic prosperity unparallel in human history. This of course is too much for the Keynesians. They would rather go deeper into debt and continue their search for “green-shoots”.

Keynesians suffer from a severe case of self-deception. Not only do they not understand economic analysis, but also they do not have a clue about how the banking system really operates. Keynesians are firmly in control of the American government. Instead of altering the structure of the financial system and bringing about a controlled collapse of the commercial banks, they are providing unlimited public funds in a useless attempt to bail out the pyramid scheme known as commercial banking.

The case for owning gold is not driven by the fear of future inflation. As a general rule, debt repayments are deflationary in nature, while debt creation is inflationary. However, much of the recent debt created by the U.S. government has not been used to increase economic activity, but has been injected into the financial system. Public debt has been used to finance the losses of the financial system. This still leaves the economy in a deflationary bias, due to existing debt levels.

On one level, a deflationary economy is positive for the bond market, as it increases real interest returns. However, a deflationary economy results in falling cash flows and asset values, leading to debt defaults and write-offs. It is the collapse of the bond markets and commercial banks that will drive the price of gold. The Chinese appear to sense this. Keynesians will drive the American economy into the ground. The interesting question is whether the Chinese will take advantage of both Americas vulnerability and stupidity and act so as to accelerate the financial and economic collapse.

John Kutyn
May 11, 2009

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