I rarely agree with every word of an American Thinker article, but I did with this one

[fpb]

And the situation is the same in the UK.

The Credit Problem
By Joseph Y. Calhoun, III
A long wave of credit stimulation has been allowed to obscure the underlying problem of capital accumulation in the United States. We are paying a price, but not solving the problem.


The political class simply cannot be trusted to provide solutions. They are too interested in retaining power for the sake of power. They do not have the guts to say what needs to be said for fear of alienating some group of supporters. They do not have the integrity to stand on principle and advocate unpopular but necessary policies. They are too beholden to special interest groups to do what is right for the country rather than what is right for their campaign contributors. It is high time that politicians were held responsible for the damage done by policies intended to benefit the few at the expense of the many.


In this election year, the greatest concern for most Americans is the economy and there is good reason for that. Unemployment, foreclosures and prices are all rising. The stock market, home prices and the dollar are all falling. Economic growth is still positive but well below potential. Americans are rightly worried.


In a recent market commentary, Bill Gross called credit the mother's milk of capitalism. That sentiment, echoed by our politicians and policy makers, is the source of our problems. It is not credit but capital that is the lifeblood of capitalism and the US doesn't accumulate enough capital to support the growth to which we've become accustomed. The savings rate has ticked somewhat higher over the last few months, but for years we've saved too little and spent too much. The difference to date has been provided by foreigners such as the Chinese who now own over $1 trillion of US debt and Middle Easterners who own even more.


In their efforts to revive the credit markets, the Federal Reserve and their political enablers may have averted an economic crisis in the short term, but the long term implications have yet to be reckoned. Bear Stearns, Fannie Mae and Freddie Mac, deemed too big to fail, were given access to the public purse rather than face the consequences of excessive leverage. The cure for excessive private indebtedness has been deemed to be more public indebtedness. Private actors will reap the benefits if these transactions turn out profitable while the public will pay the price if they don't.


Large financial institutions were encouraged to take on too much leverage and take too many risks by a Federal Reserve that held interest rates at artificially low levels for far too long. Rather than allow these companies to suffer the consequences of their actions our leaders are working overtime to ensure they continue to take imprudent risks in the future. The Fed has allowed overleveraged institutions to borrow funds at attractive rates with dubious collateral. Savers are punished with low interest rates while speculative actors are encouraged to find new avenues for their speculation. Oil prices would seem to indicate they've found a new outlet for their speculative impulses.


Likewise the individuals who borrowed too much to buy homes they couldn't afford. I feel for the people who face foreclosure but why should those of us who were prudent be forced to bail out those who weren't? The recently passed housing bill will allow both lenders and borrowers to forgo the consequences of their actions. And again, if everything works out the lenders and borrowers will benefit while failure is assigned to the taxpayer. It would be better for the foreclosures to proceed and former homeowners to become renters again. The real estate market would face a further increase in inventory but prices could finally fall to market clearing levels. That would make housing affordable for those who have saved and acted prudently.


Over the last 50 years (at least) but especially the last 30, every economic problem has been buried under another layer of credit and government intervention. The Federal Reserve and Congress have worked together to promote an economic environment where failure is deemed a threat to the "system" and all economic ills are "solved" by reducing the cost of credit. The result is plain for all to see. The US has moved from creditor to debtor nation. Debtors are bailed out through the tax code while savers are consigned to a prison of low interest rates. It is no surprise that we must import capital to cover our debts when we encourage debt and discourage saving.


The long term problems facing our economy will not be solved painlessly. Nor will they be solved by providing more of the same policies that got us to this point. While the Federal Reserve sits at the center of our problems the institution itself is not at fault. They have been given an impossible dual mission to maintain economic growth and to limit inflation. Having control only over the money supply, it is beyond the capabilities of the Fed to create growth. Inflation and credit expansion do not add anything to the amount of resources available or the capital stock. The Fed cannot create universal prosperity by creating more money. Inflation consumes precious capital by misdirecting resources into non economic investments. If you have any doubts about that, think of all the empty houses sitting around the country which attracted so much investment over the last decade. The capital devoted to housing was diverted from more productive uses and is now being destroyed as banks are forced to write off the bad loans.


The villains in this story are the inhabitants of our political institutions. They seek to buy our votes with our own money and when they find that is not enough, they turn to the Federal Reserve and the banking system to create more. Rather than raise taxes to pay for the goodies they promise or the wars they deem necessary, they depend on debt and inflation. They do not create jobs, but destroy them. They do not create equality but exacerbate the divide between the haves and have nots and manipulate the divide to accrue more power. They do not create capital but rather destroy it. They are not special but mere mortals susceptible to the same failings as all men. They are self interested actors acting on a stage of their own design in a play written for their own benefit.


It seems evident that the housing bubble that is the source of the current economic malaise was caused by Federal Reserve policy. Does it not seem perverse to turn to the same institution for a remedy? How can they be expected to prescribe a remedy when they obviously don't understand the malady? It would seem more logical to proscribe the manipulation of interest rates for any purpose other than to achieve price stability. While a gold standard or some other real asset backed currency would be preferable and less susceptible to political manipulation, setting a single goal for the Fed is preferable to the current situation. Higher interest rates are obviously needed to reduce the inflation evident to everyone except the government statisticians. Higher interest rates would also encourage saving and discourage further debt accumulation.


It also seems evident that the government budget deficit is a result of excessive spending rather than a lack of taxation. Tax revenue has been remarkably stable as a percentage of GDP for many years, ranging between 18% and 21% regardless of tax rates. Right now it stands at 19%. Furthermore, other countries, such as Hong Kong, are able to collect nearly the exact same percentage of revenue with much lower tax rates. Hong Kong has income tax rates, personal and corporate, of less than 20% and generates a budget surplus while spending over 15% of GDP on government services. Hong Kong also doesn't tax capital gains or dividends. We do not need higher taxes to generate the revenue needed for essential government services. We do need to decide what is essential.


In particular, it is illogical to raise taxes on capital when the basic problem we face is a lack of capital. If anything, taxes on capital should be further reduced to encourage accumulation of the capital needed to fund our growth. As for income taxes, it is time for Americans to assess the wisdom of taxing the very thing we wish to generate. If it is logical to tax cigarettes to discourage smoking, what is the logic for taxing income? A consumption tax coupled with repeal of the income tax would realign incentives toward a more rational economy based on thrift and savings rather than conspicuous consumption.


Because we keep re-electing the same politicians, we have no one to blame but ourselves. It is time to get angry.


Joseph Y. Calhoun, III is chief investment officer of Alhambra Investment Management.

FPB adds: Mr.Calhoun fails to underline one important fact. He speaks briefly of "the wars [that American politicians] deem necessary", but moves on without paying attention to this most expensive and least productive of all government activities. Actually, the collapse of the Bretton Woods system, the growth of systemic instability in the international markets, and the shift from capital-based to leverage-based investment all happened in the late sixties and early seventies, when America went to war in Vietnam with all the wrong tools. (For instance, it was insane to send a conscript army to fight what was essentially a colonial campaign; all across America families would be asking for what reason their children were sent to die for the sake of the political stability of a distant country that could neither help nor hinder the USA in any way. Successful colonial campaigns were nearly always fought by professional armies; France created the Foreign Legion almost wholly for this purpose.) But the main point is that the mountainous war expenditure broke the Bretton Woods system, forced the US to borrow heavily, and drove a wall between the US and their allies that would never be pulled down again. Since then, American military expenditure has been wildly out of line with what other countries spent. Today, for instance, America has as many aircraft carriers as the rest of the world's nations put together; even the British Empire at the height of its naval power only insisted on having naval power equivalent to the two nearest great powers. The bad effects of this immense source of expenditure are manifold, but a certain one is its impact on the American budget.

Comments

[becomethesea.livejournal.com]

ARGH! I've been angry for years!

Economic policy was a huge reason for my support of Ron Paul, but alas. I am now undecided between McCain and Obama, though neither has given a straight enough answer on the economic crisis of the housing/credit industry, and what either plans to do about it, for my liking as a voter. And, of course, we still have Congress to consider to keep things tied up as they are...

[cerebresque.livejournal.com]

Can't say I disagree with a word of the article, either.

[fishlivejournal.livejournal.com]

I'm not qualified to comment on most of this, but one point:

The USA introduced PAYE income tax during WWII, and by doing so was able to pretty much fund the entire war. Income tax works because it is coming out of every pay check rather than a lump sum at the end of the year (which was the situation beforehand). Unfortunately, company taxes don't work like this - many starting businesses go bankrupt when they have to pay their first tax bill. If businesses also worked on a PAYE system, they would be more able (and possibly more willing) to pay their share.

[stigandnasty919.livejournal.com]

M nice idea, but probably not viable. The nature of business is that calculating monthly profits to tax would be very difficult and possibly very expensive. With utility bills often charged quarterly and suppliers paid monthly in arrears etc, a monthly tax bill would be quite diffiuclt to calculate.

Its actually an advantage to businesses not to go down the PAYE route. Saves them money on their overdraft as everything is paid in arrears. A business which goes out of business because of their tax bill is one that was failing anyway, they had simply failed to recognise it.

[stigandnasty919.livejournal.com]

I have to agree with most of this article. But I have to say that I think things are wrong at a deeper level with the US economy.

Ironically, the American economy is currently being propped up by high oil prices. Indeed trade in Oil is one of the things that has kept the American economy safe for the past few decades.

All oil is traded in Dollars. As a result all countries in the world need to keep reserves of dollars. Those reserves are like un-cashed cheques drawn on the American current account and the fact that they go round and round the world from one country to another means that the US economy has a ‘float’ of billions of dollars never expected to return on the country. Sure the oil producing countries will be cashing in their dollars from time to time, but the constant demand from other countries more than makes up for this. This factor has been one of the major reasons why the American deficit is as low as it is and the value of the dollar as high.

If the USA was a company, the outstanding cheques (foreign reserves of Dollars) would have to be included as liabilities on the balance sheet. But since the USA is a country it works under different rules. Rules it itself sets. The ‘float’ provided by the world oil trade is an advantage no other economy has and many look upon with envy.
And here is the ironic thing, the higher oil prices are, so long as the volume of trade is not impacted, the better for the Federal Reserve. More dollars in circulation, the lower national debt.

But imagine what would happen if the currency in which oil was traded was to change. Say oil producing countries were to decide that they wanted to be paid in, for example, Euros. There would be a headlong rush across the world to sell Dollars, (they would not be needed to the same extent), and transfer their main foreign currency reserves into euros. The value of the Euro would doubtless go up; the value of the Dollar would plummet.

It would be as if a huge number of outstanding cheques on USA PLC were suddenly cashed. With the ‘float’ created by the Oil market gone, the real national debt of the US would be revealed as reserves were cleared and returned to US, imports of goods and raw materials would soar in price and the US would almost certainly suffer unprecedented inflation and job losses.

And this is not beyond the realms of possibility. Many of the Oil producing countries are not on great terms with the US and resent their trade being used to artificially bolster the US economy, indeed a number of have already announced their preference to move onto a Euro oil market. Venezuela, Iraq (before the invasion, very shortly before the invasion), Iran and Korea, all of them have at one stage threatened to move their oil trade into Euros. It’s a move that has been openly discussed by OPEC and so must be taken seriously as a possibility.

And here is where I fully agree with the article. Politicians in the US have treated this bonus they get, this free gift from the Oil trade as something permanent. Rather than reducing the deficit while times are good, they have used it to the n’th degree. Stretched it to the very limit, leveraged it to give presents to those who support them in the form of tax cuts or support for certain industries. This has been an opportunity, like North Sea Oil in the UK, to build long term prosperity and stability into economies. To reduce the national debt for good.

But economic policy does not seem to ever look beyond the next election. Instead it’s a game of pass the parcel, our leaders acting for short-term gain and popularity and hoping beyond hope that they are not the one in power when the music stops and, to mix my metaphors, the economic balloon bursts.

[fpb.livejournal.com]

I think something of the kind happened to the pound in 1914. When Britain went to war, it did not even imagine that among the most permanent results of the war would have been to make everyone divest from pounds and invest in dollars. Indeed, the impact of the massive inflow of funds from Europe to Wall Street in Autumn 1914 was such that for a long time there was a danger that the unprepared Americans might collapse under their very success. Well, I guess it took them only 94 years.

[stigandnasty919.livejournal.com]

This is a cycle that repeats itself over and over again. I suspect we are approaching another tipping point. I wonder which currency will take over from the Dollar if that happens. The Euro or the Yen?

Since you mentioned WW1, I wonder how you, as an historian, about the idea that WW1 was the first 'oil' war? I've seen it mentioned that one of the factors which may have precipitated the war was the decision by the navies of both the UK and Germany to switch their fleets from coal to oil power.

War was also declared just before a railway link, joining Germany to the Persian oil fields, could be completed. I have also read that the first British unit to be deployed after declaration of war was sent to Basra.

It all sounds a little to much of a conspiracy theory to me, but rather more convincing than the idea that the assassination of a fairly minor royal could plunge the whole of the western world into war.

(In my original post I mispelt plunge as plinge - I almost left it as plinge has such a pleasant sound to it as a word - I will almost certainly be trying to invent a meaning for plinge at some time during the day and use it in a meeting or casual meeting with my workmates)

[fpb.livejournal.com]

This implies that England wanted war. That is totally belied by the facts. Three parties wanted war: Germany, Russia and especially Austria, that did everything in its power to avoid a peaceful settlement. Even so, Germany could have avoided Britain's involvement (Britain, with big troubles of its own in Ireland, absolutely did not want to be involved in an European war) if they had kept their paws off Belgium. Oil was certainly a factor, but one has to remember that until well after the war, most energy generation and most transportation by land and sea was powered by coal, of which all the belligerant powers except Italy had far more than enough. Neither of the two world wars was "about" oil; they both were about the Austro-Prussian itch to dominate the known universe.

[stigandnasty919.livejournal.com]

It was a theory that sounded like too much of a revisionist conspiracy theory to me - but interesting to see how early oil became a factor in international afairs.

I was interested in what you said about the Austro-Hungarian Empire. Thinking back, my knowledge of WW1 is based arround children's history books and various literary accounts of the Western Front. I know next to nothing about the Austro-Hungarians - could you recommend a good source. There was a BBC series many years ago about the Crowned Heads of Europe just before and during WW1, but it was pre video recorder and conincided with rugby practice so I didn't get to see it.

[fpb.livejournal.com]

I think that any general history of WWI would show that Austria used the murder of its Crown Prince (and by the way, the murder of the heir to the throne would be no joke at any time; imagine what would happen if Prince Charles were shot to death and the trail led to a neighbouring country) to try and settle accounts with Serbia, which it regarded as a dangerous neighbour. Serbia was an ally of Russia, and Russia - in spite of the bloody lesson taught by Japan nine years earlier - not only prepared for war but insisted that once mobilization had started, there was no way back - which was nonsense. Germany could have held back Austria - which was not insane enough to go to war against Russia without a strong ally - but, to the contrary, handed it a blank cheque to do what it wanted, and showed in every way that war would please them mightily.

Germany, however, was guilty at a deeper level; for a couple of decades before WWI, it had been the wild man of Europe, unsettling and threatening, clumsy, arrogant, and pretentious. Europe had spent fifteen years or more in an atmosphere of unspecified but urgent demands backed by constant shows of force. That these shows of force had been ineffective had not made them less frightening. Once Germany went to war, the whole world felt as if "Well, this was what they wanted, after all!"

[fpb.livejournal.com]

I posted on something like this subject: http://fpb.livejournal.com/169933.html

[stigandnasty919.livejournal.com]

Thanks Fabio - much appreciated. I've read a lot of History over the years, but somehow seem to have missed out the european history of the turn of the 19th/20th centuries.

[affablestranger.livejournal.com]

Yes.