United States of America

In the footsteps of the Roman Empire?

 

Japan-USA Revisited

 Part 1

 

daan joubert

 

History...is, indeed, little more than the register of the crimes, follies, and misfortune of mankind.   [Gibbon: Fall and decline of the Roman Empire. Vol 1, Ch 3]

 

When history is updated to look back at the present, many will say that by April, 2008 it was premature to think that night was falling on the American Empire; that the US, like Rome and so many other Empires before it, will succumb to the ‘ . . . crimes, follies and misfortune of mankind’. This essay will attempt to explain why the author believes that dusk is already settling in over the US, with the fall of night to follow in due course. Even if the process requires many years, it will not nearly be as long the period spanning some centuries that Gibbon wrote about.

 

In the process, a number of disparate yet complementary subjects will be examined.

 

 

1. An enigma

 

Wikipedia states that “An enigma is a puzzle, something mysterious or inexplicable  . . .”.

 

Even when considering the often loose treatment of the truth by politicians and their fellow travelers, it is to me an enigma that the following two statements quoted below could have been made as recently as in May 2006. They are taken from a report on the announcement that Hank Paulson would succeed Snow as Secretary of the Treasury:

 

Paulson called the U.S. economy "truly a marvel, but we cannot take it for granted. We must take steps to maintain our competitive edge in the world." http://www.npr.org/templates/story/story.php?storyId=5439048

 

Competitive edge? With a ballooning deficit on the current account?

 

Welcoming Paulson to the Cabinet, Bush praised the economy under his own watch. "The American economy is powerful, productive and prosperous, and I look forward to working with Hank Paulson to keep it that way." http://www.npr.org/templates/story/story.php?storyId=5439048

 

In contrast, and to place these quotes into perspective, two extracts from the author’s earlier essays. These position serious question marks behind the above statements.

 

The first is from an essay published at Gold-Eagle in December of 1999 and includes a chart that displays US consumer expenditure relative to disposable income from 1959 to 1999. Of interest are the trends on the chart and the comment from 9 years ago.

 

The chart below shows the growth in total disposable personal income in the US together with the amount of that income that finds its way into the markets for goods and services as consumer expenditure. The third line on the chart, relative to the scale on the right hand side, is the ratio of consumer expenditure to disposable income.

 

 

 

 

 

 

Figure 1

 

Data are monthly values from the beginning of 1959, so that the history spans 40 years. During this time the US had its periods of growth and stagflation and, since about 1982, Wall Street enjoyed one of the greatest bull markets ever – a bull market that accelerated since 1993 when the US economy set off on a period of rapid and sustained growth. This extended bull market made up for the 16 years from 1966 to 1982 when the Dow Jones moved essentially sideways, just below the level of 1000 points, including the [oil  shock fueled] bear market of 1973-74 when the Dow declined by 40%.

 

Sustained growth in total disposable income and expenditure of course goes hand in hand with an expanding economy as well as a growing working population. While the two main variables present a view of this growth, the graph of their ratio is much more interesting. It tells us how comfortable the population of the US have been at different times with different levels of consumer spending, relative to the amount of money they have in their pockets. The degree to which American consumers are keen to spend, or not, are of course a major determinant of US economic growth.

[http://www.gold-eagle.com/gold_digest_99/joubert121399.html]

 

 

The conclusion was that the US had settled into a trend of rising consumer spending that had started in the early 1980’s and then speeded up in 1993 (the Clinton years!), that was clearly unsustainable; sooner or later the trend had to end. A benign, for the economy, if improbable end to the trend would be for increases in spending to keep pace with rising income. More likely, though, once households confront the reality, would be for them to use part of their income to reduce debt, a step which would have terrible consequences for an economy where two thirds or more had come to rely on consumers buying to their hearts’ content. Anyone who believed, back in 1999, that the trend was sustainable might also think that the Laws of Economics are flexible and easily could be bent to suit the demands of central planners. However, the final outcome of this trend is so clear and self-evident that immutable natural laws may well apply!

 

 

Figure 2

 

The above similar chart, updated to October 2007, shows the trend was sustained until  early 2007 and had achieved an even higher ratio of spending to income. No wonder the US household savings rate went negative and no wonder the use of all kinds of credit became, by any measure, truly excessive.

 

The second example is from a more recent essay; it draws explicitly on natural laws that apply to all systems – be they natural, social or economic.

 

Engineering and the nature of feedback

We now come to the promised insight that should provide a clincher for anyone who still hopes for a soft landing. While nothing in the economy is impossible to exclude, there is grave doubt whether a soft landing can be engineered – or a catastrophe averted without force majeure appearing like mushrooms all over the economic landscape. 

 

Engineers know that systems do not operate in isolation. All systems have an effect on the environment and what happens in the environment in turn affects the system. It is a closed cycle that means the system, through its operation and effect on the environment, indirectly also affects itself. The feedback effect via the environment or even through the operation of the system itself – if that is in the design – can be of a positive or negative nature.

 

Negative is almost always good; positive is almost always bad.

 

Negative feedback counters a trend that the system my have away from stability, towards some condition of excess; positive feedback accelerates such a trend. The principles of positive and negative feedback can be easily and simply illustrated by examining what happens when someone takes a shower.

 

At first, when the person steps into the shower, one assumes that the temperature of the water had been adjusted to the desired level. Over time, the temperature can change for a variety of reasons, which are not important. The reaction to a change in temperature – feedback – in principle can be positive or negative.

 

The normal reaction, typical of negative feedback, is to use the taps to counter the trend; if, say, there is a fall in the temperature of the water, one would open up the hot water tap a little further, or close the cold water tap some – or a combination of the two – until the desired temperature has been restored. Similarly, if the water becomes warmer, the cold water tap can be opened further or the hot tap closed a little, or a combination of the two.

 

Doing so, with due regard for the lag between changing a tap and the effect at the shower head, achieves the stability that is the domain of negative feedback.

 

Now imagine that the person in the shower is an avid adherent of positive feedback. Let the initial temperature again be adjusted to a desired level. Now, when the temperature of the water deviates from that ideal, the reaction is different. If the water begins to feel too warm, the hot water tap is opened further and/or the cold water tap is closed – or both – positive feedback in action. 

 

This action raises the temperature even further, which elicits another reaction, similar to before. Again the hot water flow is increased or the cold water tap is closed even more, or both actions undertaken. It is not too difficult to imagine the end result – if the person in the shower persists beyond reason with the positive feedback – a badly scalded exterior, perhaps even requiring hospitalization if the thermostat in the water heater has been set high enough so that the water is near boiling.

 

Engineers rely on negative feedback to prevent machines and systems from being trapped in runaway conditions where their destruction is assured. Even economists know about negative feedback in the economy – expressed as the law of marginal returns. This law is an elegant way of saying that trends in the economy become self-limiting as conditions tend towards saturation. It is the operation of this law that to a substantial degree provides the negative feedback so necessary to maintain an economy as a whole within desirable limits of stability.

 

Exactly as happens in engineering and under the shower.

 

An example of positive feedback in an economy

 

An example of what positive feedback can do to an economy is found in Japan in the run-up to the market collapse in 1990. In ‘A Japanese Tale’ it is recounted how, for reasons that seemed eminently logical at the time, the Japanese government instituted measures that created a climate in which a massive and eventually unstable property bubble was the unintended consequence.

 

It will be very interesting to see what happens in the US when property prices finally fall to where many home mortgages are under water. It would be quite surprising if US home owners do not follow the Japanese example and stop paying their installments.

 

Japan has shown that positive feedback can be equally as destructive in an economy as in any mechanical system or engine.

 

 

Negative and positive feedback in the credit cycle

We now return to the subject touched upon in the opening quotation by von Mises.

 

A major credit binge, inevitably accompanied by all manner of excesses and imbalances, always ends in a period of economic healing, in the form of recession or even depression. According to von Mises, the end of the credit induced boom comes about in one of two ways: either the banks become so concerned about the massive issuance of debt they had engaged in that they reduce or even stop their lending, or borrowers become debt weary and abstain from obtaining further loans; perhaps even begin to repay existing loans.

 

Logic and self-knowledge inform us that should the banks live up to their reputation for being prudent and conservative, they will curtail the amount of lending before the credit boom assumes real crisis proportions. Therefore, when banks act prudently, an incipient credit boom is nipped in the bud with little or no indication that the economy was on the way to become over-heated. In this respect, timely action by a central bank to maintain stable growth through the use of interest rates – reducing rates when the economy cools off; increasing rates when it gets too exuberant – plays an important, even essential, role in maintaining the economy on an even and healthy keel. 

 

In a credit economy, banks that lend prudently, with an eye on risk, and a central bank that employs monetary policy with good effect, provide the absolutely essential negative feedback required to sustain stability in an economy.

 

Read the above paragraph again and ponder its significance. 

 

If one had to rely on the consumer in pursuit of all the things the heart desires to set the limit to the credit boom, the economy is bound to pass beyond the point of safe return. By the time the consumer realises that he has moved into unsafe credit territory, it is too late. This proclivity to employ an excess of credit is exacerbated if the consumer can purchase goods where installments begin much later after the purchase date. The retailer can smile with satisfaction at the way sales are going, but consumers find when installments come due that they can no longer keep financial head above water.

 

Then, new credit is sought with which to service existing debt, over and above spending to maintain a desirable life style. When that becomes the rule and not the exception, the economy enters a realm of complete excess and instability that demands the more severe healing process of a depression to achieve eventual full recovery; a mere recession is no longer adequate medicine.

 

At the time when von Mises penned his thoughts on the dearth of credit, the banks had a strong incentive to be prudent. When a bank made a loan, it assumed all the risk for the money that is lent. If a loan defaulted, the bank suffered a loss. There was thus a good and compelling reason for the bank to investigate the credit worthiness and integrity of a person applying for a loan. When in doubt, rather than assume too great a risk, the bank would decline to make the loan. Also, there was a limit to how much credit a bank could extend and it was only common sense to make the limited capability to lend available to borrowers of good repute.

 

In this way, risk acted as negative feedback; it mitigated against a runaway credit boom – and yet, even with this negative feedback, over-exuberance and optimism in the economy still on occasion resulted in such a destructive credit induced boom.

 

Today things have changed substantially; banks and the many new issuers of credit no longer themselves carry all the risk of bad loans; the factor that used to enforce prudence. Introduction of the Asset Backed Security (ABS) enables the lending institution to pass the risk on to someone else, namely to the investor who purchases the ABS and the entity that insures the instrument against default on the cash flow inherent in the instrument – the interest due and the repayment of the capital.

 

In engineering terms, this means there is no longer any negative feedback to control the extent of the lending by banks and other institutions and thus to keep the volume and the quality of debt within safe limits.

 

In fact, and horrifyingly so, the opposite is true; the more credit a lending institution can extend the more profit it makes.

 

In other words, instead of enjoying the safety of a self-limiting force, positive feedback rules. Rather than inducing prudence, there is an incentive to market credit aggressively to all comers; to extend as much credit as the market can absorb, using any and all loop holes and marketing gimmicks. With no risk element to compel lenders to keep matters within safe limits, the growth in debt is destined to be off into the blue yonder.

 

Much like the Japanese property market in the 70’s and 80’s.

 

[I leave it to readers to consider, if they were to be in charge of a bank, with the objective of maximum profit, what their policy would be in respect of staff spending valuable time checking the credit-worthiness of borrowers, or refusing the loan if it would seem that the borrower may not be able to perform as expected. From that speculation, extrapolate on the integrity of the ABS’s they have sold. Assuming what they find is true of a majority of lending institutions, they can then wonder about the capacity for survival of the small number of credit insurers, if claims proliferate when the economy runs into a headwind.]

 

Because of risk, investor peace of mind has to be secured either by a guarantee from the seller – not very likely, except in rare cases, such as by Fannie Mae and Freddie Mac – or by means of insurance from one of the credit insurers. The ABS practice thereby assumes a cloak of respectability and apparent safety – which may well be valid for normal times, but becomes a meaningless farce when a major discontinuity in the credit market should happen and nearly all holders of ABS ‘investments’ run to the credit insurer for relief; all of them at the same time.

 

[Snip]

 

The US credit engine is in positive feedback induced run-away mode. There is really no way to release the steam and so it must end in disaster. [http://www.freebuck.com/articles/daanj/060328daanj.htm]

 

Consider: a warning from 1999 that there is an unsustainable trend in the US that, unless reversed, was bound to cause a great deal of grief to the US economy once economic reality intervened, so that the trend was compelled to end. Secondly, an observation two years old that the US credit and financial system had entered into a mode of operation that, if persisted with, carried the seeds of eventual and inevitable catastrophe.

 

The enigma: if the disastrous trend in US household spending of at least two decades coupled to a catastrophic transformation in the financial system, representing a change from negative to positive feedback – a change largely intermediated by a loose monetary and regulatory policy and an explosion in derivatives; those entities that were assumed to ‘diversify risk’ – were obvious to a non-economist, such as the author is, why was such a horrendous situation allowed to develop at all, in the first place; secondly, why did eminent economists in academe, in government, in private employ, not come forth with unanimous warnings that the US economy was racing towards a major calamity?

 

Return to the two quotes at the start of this section; they are typical of what politicians and their cohorts regularly stated and also of utterances of prominent economists who over recent years extolled the virtues of the US economy, despite an obvious dot.com bubble, a property bubble (visible to all who were not blind to see) and a credit bubble. One wonders if Paulson held his fingers crossed behind his back when he praised the US economy, or was the new Secretary of the Treasury really ignorant of the practices and underlying trends in the financial system, just about all of them pregnant with risk?

 

With president Bush, of course, one accepts that his vision of the world is not tainted by a substantial intrusion of reality.

 

Stated more generally, the enigma is how could it happen that the US ended up in this precarious if not disastrous situation? Was it deliberately brought about as planned  and purposeful obeisance to political expediency, or might it be the result of a covert policy? (see  ‘What a Dream’ http://www.freebuck.com/articles/daanj/020622daanj.htm )  

 

Perhaps an answer to these questions is to be found in the all too human condition of hubris – an endemic flaw in all empire builders – which, once rampant, can convince the powers that be that they are impervious to adverse effects; they can do whatever they want, anything that they believe holds promise of greater profit or more power, and the Law of Unintended Consequences will pass them by.

 

It is our will that this state shall endure for a thousand years. We are happy to know that the future is ours entirely! [Adolf Hitler]

 

As an observation on the imminent crisis (yes – all that has happened so far by the end of Q1 of 2008 is IMHO only the prelude to what lies ahead), the incessant harping on the sub-prime mortgage debacle, as the be-all and end-all of what has gone wrong and that once it is resolved the Goldilocks days will return, is surely disinformation, intended to conceal the extreme state of the financial system from the American public.

 

It would seem that lies, damned lies and statistics and statements by politicians might well be an accurate reflection of reality.

 

This is of course not the first time that a country has experienced all three of an equity, a property and a credit bubble, either in rapid succession or at the same time – Japan in the 1980’s is an excellent example. What America is going through now is merely the latest and one of the more prominent of the many example of the following quote:

 

Those who cannot learn from history are doomed to repeat it. [George Wilhelm Hegel]

 

- a most apt epitaph for the past 2-3 decades of US leadership.

 

 

The Law of Unintended Consequences

A most important example of this Law explains both the (apparent) success of the US economy over the past decade as well as the whole process that has now culminated in a witch hunt to determine what has gone wrong, how to fix it and hopefully, also, how to prevent its re-occurrence. Of course, all these efforts are bound to fail, over the long term and perhaps even over the near term, unless the proper cause of the mortgage and credit problem is identified and resolved.

 

Look again at the ratio of disposable income to consumer expenditure. In the 3 decades following WWII, the ratio started high and then declined almost consistently; it means that households initially used all income to make up for the lost years of the war. When the factories used for war production shifted to production of modern household items, there was ample pent-up demand. No wonder credit was employed at a high rate. Then by the late 1950’s, when incomes had improved and the nation’s homes were re-stocked with modern appliances, the ratio started to improve – people had most of what they wanted and were earning enough to meet household expenses without relying on credit.

 

No statistics were researched to support the speculation, but the sideways trend from say 1970 to 1985 – therefore much of the inflationary period – may well be associated with the period when households found it increasingly necessary to have both partners earning an income to maintain their standard of living without taking on more credit at the then high and for some time still increasing interest rates.

 

Then the trend changed; following the example set by the Federal Government with its budget deficits, spending consumed an ever increasing portion of household income. Then, following the Crash of October, 1987, there was a sharp change in this rising trend – one can speculate the shock of Wall Street’s collapse frightened many households into keeping spending relative to income constant for 5 years. This leveling off in relative spending surely contributed to some degree to the recession of the early 90’s.

 

Big changes started to happen in die mid-90’s when, under the Clinton administration, tuning of the CPI (and other official statistics) became much more prominent – a practice that is best explained by John Williams of www.shadowstats.com during an interview, at http://www.weedenco.com/welling/archive/li/v08i04lilogo.asp

 

“Can you give me a specific example of what you’re talking about when you refer to systemic manipulations?

One of the prime examples of how the system has really degenerated over time is the CPI. There was a very deliberate effort in the early 1990s under the auspices of Michael Boskin, who at the time was the head of the Council of Economic Advisors, in conjunction with Alan Greenspan, who, of course, was Fed Chairman, to “fix” the CPI. The story, very simply, was that CPI was supposedly overstating inflation. The pitch was that if people go out to shop and find that buying a steak is getting expensive, they buy hamburger instead. Therefore, their cost of living is really less than it would be if they always had to buy a fixed basket of goods, which is what the CPI was originally designed to measure. That was the whole purpose of the CPI, to measure the change in the cost of a fixed basket of goods over time. You’d have a steak, a loaf of bread, a gallon of milk, whatever. You’d price them out one year and then you’d price out exactly the same goods the next year. You’d look at the difference in the cost and that was your annual rate of inflation. It was a measure of how much the cost of a consistent and constant standard of living was going up. What Boskin and Greenspan argued was, “We should allow for substitution here because people can buy hamburger instead of steak, when steak goes up." The problem is that if you allow substitutions, you aren’t measuring a constant standard of living. You’re measuring the cost of survival. You can keep substituting down and have people buy dog food instead of hamburger. It happens. But that’s not the original concept behind the CPI. The reason substitution of the items in the CPI basket became a hot topic in Washington at the time—and it was talked about very openly—was because the CPI was (and is) being used to adjust Social Security payments to compensate for increases in the cost of living, and tamping it down would hold down Uncle Sam’s outlays.

 

Squeezing retirees to slow the growth of the deficit—

Right. In fact, that was why there was a political furor over the proposal that it got killed at the time. Everything died down and the notion seemed to be forgotten. But then during the Clinton Administration, the Bureau of Labor Statistics, on its own, changed the weighting method for the CPI. It had been constructed using arithmetic weightings, which meant doing things the way most people would add and subtract and divide. The BLS changed it to a geometric weighting, which has the “benefit” that if something goes up in price, it automatically gets a lower weight, and if it goes down in price, it automatically gets a higher weight. That change was implemented over a period of several years. The rationale was that it was a way of approximating the substitution effect. But it isn’t. I mean, it is just a pure mathematical game. In the second Bush Administration, they introduced what they call the chained, or C-CPI-U, as an alternate CPI measure. And this measure, the C-CPI-U, is a direct measure of the substitution effect. It is running a half a percent-to a percent below the official CPI—which itself is running, oh, about 2.7% below where it was before the weighting changes were made in the Clinton Administration. All in all, if you were to peel back changes that were made in the CPI going back to the Carter years, you’d see that the CPI would now be 3.5%-4% higher. The difference that it makes is significant: if the same CPI were used today as was used when Jimmy Carter was President, Social Security checks would be 70% higher.

 

This is where the unintended consequences kicked in.

 

A lower CPI made the GDP look good. However, an artificially lower CPI cumulatively introduced a growing lag in household income, hitting hard at retirees (through Social Security and reduced investment income due to low interest rates made possible by the ‘low’ CPI) and also at working people through smaller wage increases. The only way to maintain living standards with both partners already working and a rising cost of living, is to make new credit – which was easy to do, given that the low CPI made low interest rates possible. The ‘low’ inflation also assisted in another way: it loosened the brakes on the money supply, triggering serial asset bubbles and resulting in a ‘wealth’ effect that made the taking on of additional credit an easy decision to make.

 

A whole mess of economic cross currents resulted from the tuning of the CPI and while it made government look good, it opened the doors for much of what went wrong since.

 

Current solutions – pumping liquidity at an alarming rate, finding ways and means to reduce the number of foreclosures, stricter regulation of financial markets etc. – are not going to solve the basic problem; households do not have enough income to maintain the standard of living to which they are accustomed.

 

And households are 70% of the economy. When they are no longer able – for whatever reason – to keep on borrowing, they have to reduce spending and that step has a direct negative effect on the GDP.

 

The obvious solution is twofold: either increase the income of households much faster than (real) inflation, with a big jump in income immediately; alternatively, lower the cost of living by reducing prices substantially, or a combination of the two. The first option would be inflationary, while the second would be deflationary; exactly what Bernanke, the Helicopter Fed, has sworn to avoid at all costs. 

 

IMHO the odds strongly favour an outcome in which a real cause of the problems will not be addressed; that increased regulation and a bail-out of major financial institutions  will be pursued until it is found that the problem persists. If this is what happens, then there is little hope that the situation will be prevented from becoming much worse.

 

[As an aside, in 2007 there was a big hulla-balloo in the US about tainted pet food from China. There is suspicion to believe that the Government’s immediate concern was less to do with dogs or cats dying a horrible death than the fact that so many retirees buy pet food as the only way they have to afford sufficient protein in their diet. If a number of cats and dogs booted the proverbial  bucket, the news might hit the headlines for a few days, perhaps a week or two. But let half an old-age home succumb to botulin infected pet food from China and the news and follow up developments will dominate headlines for weeks.]

 

 

Keep in mind the saying about a rock and a hard place . . .

Bernanke and other high-powered folks surely will get to learn how it feels.

 

[To be continued]

© 2008 daan joubert

daanj@telkomsa.net