How Much Socialism Does It Take to Collapse An Economy? – Part 2

The Road to Economic Ruin

In Part 1, I asked if the economic havoc wreaked by socialist dictators can be replicated in a capitalist democracy. I also stated that while Venezuela exports oil to fund their social programs, we, in part, export dollars to fund ours.

But what if the price of our main source for funding our social programs drops dramatically, will we experience the same problems as Venezuela did when the price of oil plummeted?

If the U.S. dollar plummets in value we will not be able to import goods in the quantity that we do now unless it’s at inflated prices. As inflation increases, foreigners will not want to hold dollars that continually decline in value relative to their own currency. They will decrease purchases of U.S. debt used to fund our social programs. Instead of buying treasuries that yield little interest, they will dump their dollars for something that will at least retain its purchasing power.1

We have been in this situation before. Under the Bretton-Woods system the U.S. government spent more than it took in. But the dollar was tied to gold at a fixed price, so governments and individuals could redeem their dollars for gold if they saw their dollar holdings decreasing in value due to government spending. In fact, they redeemed dollars for gold at such a rate that, in 1971, President Nixon had to close the gold window and remove the dollar from its tie to gold. The dollar became a fiat currency.

Today, without the option to redeem dollars for gold at a fixed price and with U.S. Treasury interest rates at historic lows, it makes sense for foreigners to use their dollars to buy America’s assets putting even more upward pressure on prices.

So, why not raise interest rates on government bonds to attract foreigners to buy our debt? When inflation raised its ugly head after Bretton-Woods’s demise, Fed chairman Paul Volker raised the federal funds rate as high as 20% in 1981 to combat an annual inflation rate that had risen to almost 15%. By 1983 inflation had fallen to 3%. The cost to control inflation was a painful recession in which unemployment rose to 11%.

And that is one of the reasons the Federal Reserve doesn’t raise rates now – fear of a recession. However, critics of the Fed correctly claim that continuing the low interest rate policy will only make the inevitable recession and resulting economic pain worse.

But there is another reason the Federal Reserve doesn’t raise interest rates – it can’t afford to. In 1981 the U.S. debt to GDP ratio was at an all time low of 31%; now it is over 100%. We have so much debt that we cannot afford an interest rate significantly above zero. Our national debt is over $20 trillion. We owe foreign governments over $5 trillion. Raising interest rates would increase the cost of servicing our debt beyond what we can pay.

The Federal Reserve is in a prison of its own making. If they raise interest rates the economy will go into a deep recession. If they keep rates low they risk out of control inflation.

Tipping Point

The U.S. dollar will experience a serious devaluation when the creditors of the United States lose confidence in the dollar because they have become convinced that the U.S. will never get its fiscal house in order.

When everyone wants to dump dollars at the same time, the resulting sell-off will crush the value of the dollar in relation to other currencies and could induce an inflationary spiral.

Can the U.S. Dollar Maintain its Status as the World’s Reserve Currency and Safe Haven?

Some economists aren’t worried, claiming the United States cannot default on its debt because our debt is denominated in dollars and we can always print more of them. Notwithstanding the moral implications of such a statement, this assumes that the dollar will always be the reserve currency and that other nations must always accept it as payment.

But creditors may decide to dump the dollar even if it means taking a loss. The process may have already begun. China recently announced the launch of a Yuan-denominated oil futures contract. These contracts will be convertible to gold. This is significant because oil exporters under U.S. sanctions will be able to get around them by avoiding oil contracts denominated in U.S. dollars. Not only does this move signify a possible crack in dollar hegemony but also undermines political influence the U.S. enjoys because the dollar is the world’s reserve currency.

In other words, an economic catastrophe probably cannot be avoided simply because the dollar is the world’s reserve currency, at least not for long.

Others argue that it will be a long time before the U.S. dollar loses its status as the reserve currency because there is no better alternative to replace it and that the dollar is still a safe haven when troubles ripple through the global economy. Therefore we still have plenty of time to turn our economic ship around. Besides, many other nations with large economies are in worse financial shape than the United States.

A New Normal – Monetization of U.S. Debt

Nothing signals economic trouble quite like monetization of debt.

“If the Fed wants to lower interest rates, it creates money and uses it to purchase Treasury debt. If the Fed wants to raise interest rates, it destroys the money collected through sales of Treasury debt.”2

The Fed does not consider its purchase of Treasuries to be monetizing government debt unless the purchase of securities is permanent. Quantitative easing (QE), which included the purchase of mortgage backed securities as well as Treasuries, has resulted in $4.5 trillion created by the Federal Reserve.

But does anyone believe the Fed will follow through with any meaningful reduction of its balance sheet? Ben Bernanke has stated that reduction of the Fed’s balance sheet will not begin in earnest until interest rates are well on their way to normalization. The world has seen the U.S. go through three rounds of quantitative easing already without being able to normalize interest rates. They are still at one percent.

Janet Yellen announced on September 20, 2017 that the Fed intends to begin reducing its $4.5 trillion balance sheet in October. But the amounts are miniscule, 0.2% per month. Furthermore, Fed officials are on record as saying they don’t expect the Fed’s balance sheet to return to pre-2008 levels. In other words, the new normal actually does involve monetization of debt.

Signs of Trouble Ahead

The stock market is overdue for a crash. The current bull market is the second longest ever. The current economic expansion is the third longest of eleven since World War 2. Raising interest rates will pop the housing and stock market bubbles that the Fed’s low interest rate policies have inflated. Having propped up the stock market for over eight years, the Fed is not going to change course now. Any claims by the Fed to raise interest rates look more like self-deception or a bluff than implementable policy.

At the first sign of trouble, just like in 2008, the Fed will likely want to step in and attempt to stimulate the economy.

But the Fed is in a bind. They want to raise interest rates so that they will have a weapon to employ (lowering rates) when the next recession hits. If they raise interest rates too quickly causing a stock market crash, they will be blamed. If they are unable to raise rates for fear of recession, then per their own statements, they will not reduce their balance sheet and it becomes clear that the U.S. monetization of debt is permanent.

How then will the Fed fight the next recession? Interest rates cannot be lowered much from one percent unless they go negative. The Fed fears deflation above all else so they will try to stimulate the economy with more quantitative easing and will achieve the same dismal result.

Not only will QE4 not stimulate the economy, it will indicate to nearly everyone that quantitative easing will never end and that the dollar is in trouble. The Treasury will only find buyers for its bonds at higher interest rates. If the Fed tries to reduce its balance sheet by letting its bonds expire, the treasury has to sell that many more bonds to pay back the Fed, putting upward pressure on interest rates in order to sell the bonds it needs to run the government. If the Fed sells bonds on the open market they compete with the Treasury also causing rates to rise.3

What’s the Big Deal?

So what’s the big deal if the Federal Reserve unwinds its balance sheet and lets interest rates rise so people have incentive to buy U.S. bonds? They cannot for two reasons, 1) we can’t afford the higher interest payments, and 2) it will pop the stock market bubble fueled by low interest rates. People will put their savings in safer investments than the stock market if they can earn decent interest, thus decreasing demand for stocks.

Well then, if the Fed thinks we need more economic stimulus when the next crisis hits, why not employ another round of quantitative easing? After all, we’ve gotten away with it thus far.

Inflation, Inflation, Inflation!

Inflation is an increase in the quantity of money in circulation. Rising prices result from inflation, they are not in themselves inflation. Why is this distinction important? Because one cannot fight rising prices unless one attacks the root cause.

The identity equation of the Quantity Theory of Money, MV=PY, shows how the quantity of money affects the economy. In this equation, M is the money supply, V is the velocity of circulation (the number of times per year the average dollar is spent), P denotes the price of one unit of output and Y denotes the total output of the economy. PY is the same as nominal GDP from the viewpoint of the production or seller side.

Economists often assume that the velocity of money, V, is constant. They then use this equation to show that the price level changes proportionally to the money supply.

But Fed economists evidently don’t believe V is constant (It’s not). After a crisis, the powers that be seem to think that business and consumers incorrectly lose faith in the economy and don’t spend enough. In other words, when V falls (less spending), the Fed believes it must come to the rescue and increase the money supply to prevent a decrease in nominal GDP. What they fear most is price deflation. But, unlike the Fed, the average Joe knows what he is doing. He is in debt and broke, that is the reason for the decrease in spending (V).

That is why QE hasn’t caused much price inflation of general goods, though methods of measuring inflation hide some of the price increases. The average person or business doesn’t want to go into more debt so the velocity of money remains low. But QE hasn’t stimulated the economy either. What it has done is transfer wealth from the bottom to the top by generating asset price bubbles in housing and the stock market. I have often mentioned these wealth transfers but how they happen deserves repeating:

Increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price rises as such. Moreover, the beneficiaries of the newly created money–i.e., money “out of thin air”–are always the first recipients of money, for they can divert a greater portion of wealth to themselves. Obviously, those who either don’t receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the real pool of funding.4,5

Armed with the false belief that deflation is the worst possible outcome (and evidently with the belief that they must arm-twist financially broke Americans into spending) the Fed believes they can stimulate nominal GDP (PY in above equation)  by increasing the money supply (M) to make up for decreased spending (V). Austrian economists would counter that the equation balances naturally by allowing prices (P) to fall (inflated bubbles pop). With lower prices, people will spend more and (V) will return to normal.

The Fed’s plan hasn’t worked. The “recovery” from the Great Recession is a sham. Stock and housing prices inflated, transferring wealth to a small portion of society, but real economic growth is low and wages have stagnated.

Not only that, but instead of people’s bank accounts being filled with dollars that are worth more due to falling prices if nothing had been done, they are worth less because of the Fed’s “money printing.”

However, the inflationary effects of QE will eventually show up. At some point people will realize the government has gone too far. Both foreign and domestic holders of U.S. dollars will spend them before they become worthless. When spending (V) returns to normal or above, that along with the increased money supply due to quantitative easing increases the value of MV in the identity equation. But MV, by definition, must equal PY. Since the new money from QE was not put to productive use, but mostly into inflating the price of existing assets, Y (production or real GDP) was not increased by QE. This means that the price (P) of the goods and services we use every day must increase.

Inflation will take off. If we don’t want to end up like Venezuela, the Fed will have to admit defeat, raise interest rates and send the economy into a recession that will be far worse than if they had never implemented their easy-money policy.

Here’s the question – will the Fed be as stubborn as a socialist dictator and stay the course when crisis comes? If the Fed responds to the next recession with QE4, in my opinion, it will be “game over.” They will sacrifice the dollar and our economy with it.

So, will the path we are on predictably and inexorably lead to a currency collapse? Yes, but the Fed can change its path. I read years ago one man’s observation that when an economy reaches the critical point, rich Western nations choose deflation over inflation. I believed it then. Now I’m not so sure.

Finally, how much socialism does it take to collapse an economy? It only takes the amount necessary to direct an economy away from its natural course into the precarious position we now experience. Without quantifying how much socialism is required, it is safe to say that we have enough, especially since the government has a monopoly on money in the form of the Federal Reserve.

(Part 3 will offer some possible Christian responses to these grim prospects for our economy.)

Notes:

  1. This is not inconsequential. As of September 2016. foreigners held 30% of our public debt — $6 trillion in treasuries. But they also held $5 trillion in corporate bonds and another $6 trillion in mutual funds, ETFs and other portfolio assets.
  2. Federal Reserve Bank of St. Louis, “In-Depth: Is the Fed Monetizing Government Debt”
  3. Peter Schiff, “The Fed Is Going to Sacrifice the Dollar,”
  4. Frank Shostak, “Defining Inflation,” https://mises.org/library/defining-inflation.
  5. In the case of QE, the first recipients and primary beneficiaries of the newly created money are the too big to fail financial institutions such as Goldman Sachs. See the complete list of primary dealers here at the New York Fed.

References:

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