Insanity: doing the same thing over and over again and expecting different results.
—Albert Einstein There is a common colloquial expression, “hair of the dog,” that originated centuries ago and originally referred to treating a rabid dog bite by placing hair from the dog in the bite wound. Today, this phrase is predominantly used to refer to alcohol that is consumed with the aim of lessening the effects of a hangover; it is believed by some that you can cure a hangover by drinking from the same bottle that “bit you” the night before.
Now, say it is September 2008, and you wake up with an enormous hangover and you decide to follow this age-old advice. You drink the same alcohol that got you sick in the first place, and when the first drink is not met with much success, you polish off the entire bottle and start to feel pretty good and that maybe this is working. There is one problem—the next day you wake up hungover again and this cycle continues day in and day out for four more years!
Some days you feel good—but a lot of days you’re dragging and feeling sluggish.
Every time you think you should stop, you contemplate how severe the hangover that started four years ago would be now. So you continue, and now even the slightest feeling of a headache makes you itching for happy hour. Congratulations—you’re the U.S. economy!
Our counterfeiter-in-chief, Ben Bernanke, has concocted an identical poison for the U.S. economy. Following the real-estate bubble debacle, he put the United States on the path of “hangover” avoidance. Instead of allowing the economy to deleverage, Ben chose to kick the can down the road—which is, by the way, the most insipid and trite saying we’ve got going today. It is much more accurate to use my own description of Bernanke’s strategy, which is, “He’s trying to avoid a hangover by attempting to stay drunk forever.” How’s this working for him? What a surprise . . . not so well. The economy is actually feeling just like you did in the scenario—
sluggish and limping along. Yes, there are days when the economic data look slightly positive and we anticipate a recovery, but then very soon the data turn south and we realize that we are headed straight toward that hangover and seek comfort in monetary intoxication.
So addicted is this economy that at the first hint of deflation, the market, in Pavlovian fashion, clamors for the next round of QE (or quantitative easing)—that is, the continuation of massive counterfeiting, when you’ve already printed so much money that interest rates are at zero percent. It seems that Mr. Bernanke has lost faith in the free market’s ability to rebuild itself; instead, he has resorted to placing the economy on what is tantamount to a vodka drip. Bernanke thinks he can wean the
economy off the easy-money bottle at any time.
To hear Ben avow his plan for easing the economy off Fed-induced low interest rates one would conclude that Ben has delusions of a painless detox, where the economy sobers up at a cushy celebrity rehab clinic.
Unfortunately for Ben and the economy, there is no painless recovery.
Austrian Trade Cycle Theory versus Keynesian Toys and Candy
There is no painless detox for this easy-money hangover; the only way for the economy to heal is to go through the natural deleveraging process that comes with deflation. This is something I will emphasize throughout this book. A refusal to accept deleveraging is a crucial ingredient to the formation of bubbles that grow more intense with each lost opportunity to heal. Let’s review the trade cycle theory to address the normal process an economy uses to heal after a Fed-induced inflationary bubble.
Famed Austrian economist Ludwig von Mises developed a theory to explain the boom-and-bust cycle that results from the extension of credit brought about by central banks’ manipulation of a fiat currency. Murray Rothbard, in his noted book America’s Great Depression,1 updated Mises’s theory that I would like to elucidate.
The entrepreneur is a business forecaster, he is trained to stay in tune with messages that the market sends in determining the capital investment that should be expended.
Business cycles vary, and it is common for individual businesses and even industries to make errors in judgment and over build. However, when you get a cluster of businesses and industries making erroneous capital expenditures at the same time, it is always a result of monetary intervention. Here’s why . . .
When banks print new money and lend it to businesses, they receive a false signal that there is an increase in saved funds available for investment. This newly created money masquerades as savings and leads to the eventual misallocation of capital.
Businesses invest these funds and bid up prices of capital and other producer’s goods and overbuild. The overbuilding percolates downward and affects the consumer market in the prices of wages, rents, and interest. If this were a result of a genuine increase in savings, all would be fine, but since this is due only to bank credit expansion, demand eventually returns to old proportions and we experience the bust cycle. The business investments made during the illusory boom were wasteful and need to be liquidated.
Rothbard goes on to explain that “a favorite explanation of the crisis is that it stems from ‘underconsumption’—from a failure of consumer demand,” 2 but this is not the case. In essence, the market receives false price signals and inflation becomes concentrated in just one, or a few, asset classes. Capital is then siphoned from other, more viable uses and into that sector of the economy where specious demand is most evident. Bubbles form and eventually burst under their own weight. This occurs when nearly everybody seems to own the asset, the asset has become too expensive to purchase, and there is a massive overhang in supply.
During the boom, business was misled to invest too much; “as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments are seen to have been wasteful.” Rothbard continues:
The “boom,” then, is actually a period of wasteful misinvestment. It is a time when errors are made. The “crisis” arrives when the consumers come to reestablish their desired proportions. The “depression” is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires.3
It is only through the rapid liquidation of the wasteful investments that the economy can purge its misinvestments. Some of these investments may have to be abandoned altogether; others will be shifted for other uses. “Always the principle will not be to mourn past errors, but make the most efficient use of the existing stock of capital.”4
Let’s put this theory to the test. As we discussed in the previous chapter, the Fed’s easy-money policies in the late 1990s created an enormous amount of money that funded speculation in Internet start-up companies. Venture capitalists leveraged the Fed-induced credit to make new investments in Internet companies. With money flowing and profits to be made, they often made imprudent business decisions.
Caught up in the frenzy to bring dot-coms to market, eager venture capitalists often failed to think through the business model. A good example of this is the now defunct Internet start-up company Pets.com.
We can imagine that the premise for Pets.com may have sounded promising when it was presented at the venture capital (VC) pitch meeting in San Francisco sometime in the mid-1990s. After all, the United States is home to 78.2 million dogs and 86.4 million cats,5 and all of these dogs and cats need to eat. And in case you didn’t know this already—pets don’t drive. I can imagine the light bulbs illuminating over the heads of the venture capitalists in the conference room as they marveled in the revelation that in fact “pets do not drive”—so how are they going to get their pet food? Why of course, they’ll have to buy it online. Sold—we’ll go public next week!
This was obviously the easy money talking, because once the dust settled they soon realized that although pets can’t drive, the people who own them do, and pet food is fairly expensive to ship. Pets.com went public in August 1998 to the typical fanfare that dot-com stocks were reveling in at the time. Sadly, 268 days and $300 million in VC dollars later, Pets.com went out of business, forcing pet owners everywhere to get back into their cars to buy pet food.
Pets.com and other Internet companies in the late 1990s were flush with cash. New- economy businesses utilized old-economy businesses for services such as advertising, media, technology, and recruiting, just to name a few. Both were given a false signal of savings and were led to misinvest.
When Pets.com and other Internet start-ups went out of business, they not only exposed their flawed business model but also exposed the malinvestments made throughout the economy. Pets.com and other now defunct Internet start-ups needed to be liquidated and abandoned—and, thankfully, they were. Liquidation and abandonment is a painful process; the economy will lose jobs and money—however,
it is the necessary process for the economy to rebuild. The advertising agencies, media companies, and recruiting firms will have to shift investments and downsize to accommodate the actual demand that is in the market now that the central bank credit has subsided. This is the natural cleansing process the economy uses to remove inefficient business models in favor of efficient models. Any attempt the government would make to stand in the way of this process and slow it down would divert funds from the functioning economy and slow down the recovery process. After all, how much of our money should the government spend on keeping businesses alive that don’t expand the productive capacity of the economy and don’t boost our standard of living?
Liquidation of malivestments and the recession that follows are capitalism’s reset button, or what economist Joseph Schumpeter referred to as “the gales of creative destruction”—tearing down inefficient business models in order to rebuild new and efficient ones.6
I mentioned before that I am the father of two young children, and anyone who has children has sat through their fair share of birthday parties. During these parties I can’t help my mind from converging on the Trade Cycle Theory. And so, I have concluded through my observation that there is a reason that a party ends and not begins with cake—because sugar to a child is like money to an economy. Every child is more apt to make poor decisions when they are riding an easy-sugar high. Parents intuitively understand that a child needs a time-out—a natural process to work through bad decisions.
Recessions, depressions, and time-outs are difficult—ask any child and they will tell you a time-out is no fun. Politicians find economic time-outs just as intolerable.
Instead of viewing a recession as a natural healing process, today’s politician views recession as an economic obstacle to their reelection. Unlike children, politicians employ economic advisors whose job it is to try to avoid time-outs. John Maynard Keynes once said that policy makers “are often slaves of some defunct economist”.7 That’s ironic because today’s policy makers seem to enjoy the Keynesian candy of their advisers, then become slaves to the flailing economy their advice serves up.
These Keynesian-bent advisers endorse deficit spending and easy money as the only remedy for an ailing economy.
Now, we can muse that perhaps children should garner their own “advisers” to jettison their time-outs. This team of “advisers” would mirror the economic teams today’s leaders use, in other words, consist of people who have no hands-on knowledge of kids. The team doesn’t have kids, doesn’t know kids, and doesn’t spend time around real kids, and when they were kids they didn’t have any friends.
But they went to an Ivy League school where they studied adolescents extensively.
Their comprehensive study of adolescents at play leads them to the conclusion that play utopia can exist with no time-outs and lots of candy. They have extensive mathematical formulas that support their research and are recipients of the Nobel Prize in this area. According to the “team,” if the child makes some bad choices, it’s nothing a bowl of candy and a trip to Toys-R-Us with Daddy’s credit card can’t fix. Now this all sounds great—to a five-year-old!
Keynesians peddle the same kind of snake oil that John Law (from the previous chapter) pushed. They argue with lots of intervention and lots of “candy” an economy can move along smoothly with no time-outs. Like Law, they argue that an increase in money leads to lower interest rates and full employment. So, if they were right, one would imagine that with all the printing they are doing at the Fed, we’d be at 0 percent unemployment—wrong! As I write, we have been hovering around 8 percent for more than 30 months. So what went wrong? If you ask a Keynesian, it’s because we need more deficit spending and money printing; apparently, those starched shirts at the Fed don’t know how to party. We need more than three bowls of candy to give this economy its sugar high; we need an endless stream of candy and more reckless numbers of trips to Toys-R-Us with Daddy’s credit card.
Even a Keynesian comprehends that money printing is inflationary, but they have us convinced that inflation is good. After all, who doesn’t love rising prices? Nobody wants prices to fall—that may mean we are heading into a time-out, and Keynesians don’t do time-outs; it’s just candy, spending, and party all the time! It appears to be a formula that only a child would postulate; unfortunately, it’s one that way too many politicians choose to advance. Time-outs are no fun. Every politician knows that, and if the recession coincides with their reelection, they are unbearable. Therefore, people in politics are willing to affirm the Keynesian fairy tale.
Unfortunately for the U.S. economy, the Keynesian-led spending spree that this country has been on for the past 80 years has left us over $16 trillion dollars in debt and counting. The easy money provided by the Fed is permitting the government to spend with little immediate consequence. Unfortunately, the Fed can’t continue to keep interest rates low in perpetuity; the market is eventually going to supplant Banana Ben’s authority and drive rates up, exposing their latest creation—the bubble in the bond market.
“End This Depression Now!”—The Game Show
Paul Krugman is the embodiment of Keynesian thought. He writes an op-ed for the New York Times, where he unabashedly espouses reckless government spending under the guise of fulfilling the centrally planned utopia of John Maynard Keynes. In his book End This Depression Now!, Krugman champions government spending as a means to bring down the debt-to–GDP (gross domestic product) ratio.8 This is tantamount to a person who works on 100 percent commission deciding to purchase products from themselves in an attempt to secure a large paycheck.
He relentlessly endorses that any kind of deficit spending is beneficial during a recession—“even if you paid people to dig ditches and refill them.” This statement encapsulates the Keynesian ideology and exposes how absolutely reckless and profligate they encourage government spending to be. I recently heard Paul Krugman on CNN not only support this ridiculous statement, but outdo it by indicating that “If we discovered that space aliens were planning to attack, and we needed a massive
buildup to counter the space alien threat, and really inflation and budget deficits took secondary place to that, this slump would be over in 18 months.”9
Apparently, Mr. Krugman has so little faith in the economy’s ability to rebuild itself he has resorted to proposing a faux “Space Alien Attack” stimulus plan. Mr. Krugman is held in exalted esteem in Keynesian circles of thought, and the best way he sees to stimulate the economy is to partake in a fabricated attack of space aliens in order to garner completely reckless spending.
It is fairly clear that his “Space Alien Attack” stimulus plan is futile at best and dangerous at worst, in its attempt to “End This Depression Now!” However, I would like to challenge Mr. Krugman on his “Ditch Digging and Filling Recovery Package”
versus my “Free Market—Let Deflation Take Its Course Recovery Package” (that I will abbreviate as Pentonomics) and see which plan can “End This Depression Now!”
Think of this as an economic reality game show.
Here are the rules: We are going to apply both recovery plans to the real estate bubble crisis starting in September 2008, after the collapse of Lehman, and see who can “End This Depression Now!”
I am going to allow Mr. Krugman to retain all the government managing tools—or the “acronyms”—TARP (Troubled Asset Relief Program), TALF (Term Asset-Backed Securities Loan Facility), all the QEs, even Operation Twist (even though it’s not an acronym—I’ll let him have it—see what a nice guy I am). Since Krugman and his fellow Keynesians are perpetually whining that the reason the “American Recovery and Reinvestment Act” failed was that it was too small, I am going to give Paul what not even Nancy (food stamps are a great stimulus) Pelosi would give him—$2 trillion dollars in deficit spending to get his “Ditch Digging and Filling Recovery Package” up and running.
I am not going to take any kind of stimulus for my “Pentonomics: Free Market—
Deflation Plan”. No bailout, no acronyms, no “American Recovery and Reinvestment Act”—nothing. We are going to apply both our strategies on today’s great recession and see who can “End This Depression Now!” Is everyone clear on the game rules?
Good, let’s start.
On your mark . . . Get set . . .
GO!
This is me applying Pentonomics to the economy after the real estate bubble burst—
fade in to me doing nothing . . . spinning my thumbs, looking around . . . bring in some music—the “Girl from Ipanema” is playing softly in the background. Time lapses . . . OK, six months has passed—how am I doing?
Right now, not so well—the economy, as you can imagine, is going through a free fall. Home prices have fallen 50 percent, unemployment is 30 percent, a lot of banks and businesses have gone out of business, and there are bankruptcies. I didn’t promise this was going to be painless. I hope you didn’t put any money on this. If you did—don’t worry, I’m optimistic! Let’s see how Paul is doing. . . .
Paul charges out of the starting gate; sweat streaming down his forehead, he races with his $2 trillion clenched firmly in his fists, and he barely goes a city block before