The invisible red line

IN THE BLUE CORNER… *

Professor Paul Krugman belongs to a rather elite group of economists: those who have received the Nobel memorial prize. In his case, it was for “his analysis of trade patterns and location of economic activity”, a no doubt fascinating but also highly specialised topic.[1]

Outside of academia, Krugman is best known for his outspoken views on contemporary US economic policy, in particular his view that the US monetary and fiscal authorities have not done nearly enough to date to stimulate the chronically weak economy into a strong recovery, notwithstanding TARP, zero rates, QE1, QE2, nationalising Fannie/Freddie, etc.

The crux of his argument is that the problems associated with excessive debt and leverage are best addressed through additional debt and leverage. While that may defy basic logic, don’t worry, Krugman has the equations required to prove this assertion. All you need is a PhD and you, too, will learn to cook up a free lunch.

IN THE RED CORNER… *

Texas Rep. Ron Paul has been a tireless advocate of sound money and fiscal conservatism for decades. In early 1982, following the 1970s stagflation and brief, parabolic rise in the gold price to $850/oz, he was appointed a member of President Reagan’s Gold Commission, tasked with studying whether the US should, and how it might, re-establish the dollar’s pre-1971 link to gold.

More recently, Rep. Paul has been advocating cutting fully $1tn from the federal budget as early as 2013. (Read that carefully: He is advocating an outright cut of $1tn, not merely a reduction in already authorised spending increases. In Washington-speak, ‘cutting’ means, ‘increasing by less, according to our own estimates, which tend to undershoot reality by a significant margin’.)

As such, in this debate between Prof. Krugman and Rep. Paul, we have the far ends of the policy spectrum represented: those who encourage more debt and those who don’t. What follows is my citation, translation and interpretation of what I regard as the most interesting parts of the debate. Before continuing, I recommend that my readers view the debate for themselves, which runs about 20 minutes and makes for entertaining viewing at times.[2]

DING!

Rep. Paul was first to present his views, emphasising his general belief in free-markets and limited government, and highlighting specifically his view that the Federal Reserve cannot possibly know how to set the level of interest rates more effectively than a free market in money could do. In doing so, Rep. Paul was channeling another Nobel prize winning economist, Friedrich Hayek, who argued in his famous Nobel speech, The Pretense of Knowledge, that power confers an illusion of knowledge on those in a position to wield it.[3]

Prof. Krugman responded that it is impossible to leave interest rates to the market because modern money is highly complex and requires management. As an example, he cited the repo (or repurchase) market, which comprised an important part of the so-called ‘shadow banking system’ thought by many to be responsible for the 2008 financial crisis.

I find this to be an odd line of argument, because the Fed is the banking system regulator and in the years leading up to the crisis it regularly compiled and published repo market data. The Fed was thus fully aware of the rapid growth of the repo market but failed to appreciate that an abrupt decline in collateral values for mortgage-backed securities would cause the interbank lending market to seize up. Krugman has thus offered up an example of regulatory incompetence rather than a reason for why central banks should set interest rates.

Krugman’s next point was that while he “believes in free markets” he does so only up to a point, because the “markets must be managed”. Of course this implies that Krugman believes that he and his fellow neo-Keynesians know where to draw the line between the “free” part and the “managed” part. No doubt he has the equations to prove this too.

As an example, he cites the occurrence of depressions: “Depressions are a bad thing for capitalism.” It is difficult to disagree with that statement, of course, but is this a valid line of argument? If we all agree that depressions are bad, then shouldn’t the discussion be about what causes them in the first place?

Let’s return to the point made above: if excessive money growth (via repo and otherwise) was a key contributing factor to the crisis, and if the Fed was in charge of the money supply, then shouldn’t we consider the possibility that Fed policy caused or, at a minimum, contributed to the crisis? You can’t blame ‘free-markets’ for causing the crisis when the market in question is one of the most highly regulated and when the Federal Reserve looks the other way while repo and other money-equivalents grew exponentially in supply for years.[4]

“WE DON’T NEED TO WORK ANY MORE. JUST PRINT MONEY!”

The discussion then turned to contemporary US debt dynamics. When asked just how much additional debt the US could safely accumulate, Krugman responded without hesitation, “We’re not anywhere close to a red line.” Given that the US total government debt to GDP ratio has now risen through 100% and continues to grow rapidly, that struck me as a breathtakingly audacious statement. Krugman did then qualify it, saying that debt/GDP in excess of 130% might be problematic.

Well how on earth can he know that? How could anyone? And has it not occurred to him that, at the current rate of growth, the debt/GDP ratio could easily increase to 130% in just a few years’ time? Using his own words and figures, does 100% and rising really qualify as “not anywhere close to a red line”? Hardly.

Rep. Paul was quick to pounce on Krugman’s assurance that we had nothing to fear from the continuing rise in debt. He pointed out that other countries are not obliged to hold dollar reserves in exchange for exporting goods and services to the US. They have the option to diversify into other currencies or into real assets, such as natural resources or even gold. If we are so certain that other countries will hold our dollars and finance our debt indefinitely at low interest rates, then, as Paul says, “We don’t need to work any more. Just print money”!

While a humorous comment to be sure, at base it is deadly serious and, together with Krugman’s comment about the US not being “anywhere close to a red line”, represented the single most important topic of the debate. This is because, if the US finds it cannot finance itself at low rates, the entire discussion about whether or by how much to grow the debt becomes irrelevant, as it will be impossible.

The US is more dependent on foreign financing than ever. Yet the US economy is on the weakest fundamental footing since the 1930s. It is also smaller as a share of global GDP than at any time since the early 20^th century. It is thus understandable that many countries are already seeking alternatives to the dollar for international trade. The “red line” might be dangerously close. Indeed, I believe that it has already been crossed, unseen by the economic and policy mainstream, which also failed to see how signs of weakness in the US housing market were leading toward a huge financial crisis.

WHERE KRUGMAN IS RIGHT

To understand where the (invisible) red line lies, we need to consider the one area where Krugman is correct: there is simply no way the US economy can grow from here without expanding the money supply and adding debt. Either the Fed keeps printing and the government keeps spending, or the economy will contract. That is the sober, unpleasant reality of the current starting point. And with the debt burden so enormously large, if the economy contracts, debt servicing costs will become prohibitive and eventually there will be a general, economy-wide debt default, public and private.

Now there is minimal support in Washington for a general default, so it is rather obvious that the other road is going to be taken. The Fed will continue to print and the government will run deficits. However, while the economy will continue to grow in nominal terms, if only weakly, there is little in these policies to make it grow much if at all in real terms. Indeed, if the federal government’s share of the economy continues to grow at the expense of the private sector, then beyond a certain point, real growth will become impossible, as the public sector must tax the private in order to grow. But if the US economy cannot grow organically, then it is going to have to find this growth somewhere else.

How is that going to work? Well, Krugman points out in the debate how Great Britain managed to pay down its colossal debts in the decades following WWII. But he neglected to mention how this was done: first, Britain devalued the pound by 30% in 1949. But even that wasn’t enough. In 1967, the UK devalued the pound by another 14%. In the early 1970s, the pound declined further. In 1975, the IMF (read: US, Germany, Japan) provided the UK with emergency lending assistance.

So yes, Great Britain managed to reduce its debts as a share of GDP, but this was done overwhelmingly through resort to currency devaluation, with a bit of foreign generosity and even capital controls thrown in to boot. Is this what Krugman is advocating for today? That the US, the issuer of the world’s pre-eminent reserve currency, should just devalue and, if necessary, seek a bailout from its foreign creditors, including such friends as China and Russia?

The idea is too absurd to contemplate. There is just no way that a reserve currency can remain so when the issuer resorts to devaluation and seeks bail outs from its creditors. The dollar’s loss of reserve status is simply inevitable at this point.

When financial markets begin to understand that something is inevitable, what was regarded as a long-term risk is apt to become a short-term risk in short order, with obvious implications for interest and exchange rates and asset valuations generally.

Krugman’s red line already has been crossed. The question now is how long it takes for financial markets to notice. Naturally, those investors that notice sooner, rather than later, and take appropriate action, stand a chance to protect their wealth through the turbulent times ahead.

TO INVEST OR TO INSURE?

Other factors equal, the greater the perceived uncertainty, the greater the demand for insurance relative to investment or, looked at slightly differently, the greater the preference for ‘defensive’ over ‘offensive’ investment styles. As more and more investors come to recognise that the red line described above has indeed already been crossed, the ‘price’ of insurance should rise relative to the ‘price’ of productive assets and defensive investment styles should outperform offensive.

What appears straightforward at first glance is, however, anything but. Cash and government bonds are not a valid form of insurance in a world in which their supply is growing exponentially relative to the underlying productive potential of economies, including that of the US, the provider of the reserve currency and of benchmark government bonds. In this world, insurance must take a different form.

Consider the following: if you take out an insurance policy on your house in some nominal amount, but due to inflation that nominal amount declines relative to the value of your house, then you are going to need to take out more just to maintain the same level of real cover. Alternatively, if you take out insurance on your house, but when you call it in you discover the insurance company is insolvent and can’t pay out, then you overpaid for your insurance.

The trick is to purchase insurance that protects against inflation on the one hand and default on the other. Real assets are the only providers of such insurance. Their prices may be volatile when denominated in fiat currency units, but if owned on an outright, unencumbered basis, they can neither be arbitrarily devalued, nor can they be defaulted on. They thus represent a form of financial insurance superior to that provided by the financial system itself, subject as it is to devaluation and default.

Red-line investing really just comes down to finding ways to avoid the risks inherent in the current financial and monetary system. Income-generating assets are fine as long as their sources of income are not subject to material devaluation or default risk. Certain kinds of infrastructure come to mind. But beware when infrastructure is leveraged. A claim to a productive real asset may seem to provide a form of insurance, but if the company goes bankrupt, that asset is forfeit to the creditors. In that case, it is better to be a creditor than a shareholder.[5]

In an important sense, money itself is credit. It represents a social claim on future consumption. It may bear no interest, as formal credit does, but it is a form of credit all the same. Today, central banks create fiat money as a liability on their balance sheet, holding assets against it, normally their government’s and other governments’ bonds.

Real money, however, is not at the same time someone’s liability. It is not something that can be diluted or defaulted on. The world’s fiat currencies do not qualify as real money in this important sense. Precious metals do. They are relatively scarce, indeed finite, and are not subject to default.

The gold bull market may look rather advanced to some. Silver has also done much catching up since 2009. But as with all prices, these must be evaluated in relative terms. Has the price of gold kept up with money supply growth? No. Has it kept up with the growth of government debt? No. Has it kept up with the declining US share of the global economy and accelerating shift away from the fiat dollar reserve standard? No. Has it kept up with the ongoing loss of trust and credibility in financial and monetary institutions? No. Has it kept up with the growing probability that the only way to restore trust and credibility in future will be for governments to re-link their currencies to gold explicity, in the form of a new global gold standard?

That last bit may sound a bit far fetched to some, but when you begin to connect the dots, it becomes increasingly difficult to deny that the developments citied above do not, eventually, lead back to gold. That is the core contention of my new book, The Golden Revolution.

[2] Link: http://www.bloomberg.com/video/91689761/

[3] This speech can be found here.

[4] The Fed controls only the narrow money supply directly, by adding or draining reserves. Broad money is created by the banks, when reserves are lent out. However, while the Fed cannot create broad money, it can force its contraction by draining reserves. So the Fed could have limited broad money growth in 2003-06. But it chose not to, ostensibly because the rate of consumer price inflation (CPI) was low. This then begs the question as to whether the Fed should be targeting CPI or targeting money and credit growth instead, a topic I address at length in my new book, The Golden Revolution (John Wiley and Sons, 2012).

[5] For a thorough discussion of the risks of bankruptcy and how investors can take advantage of it, please see “Why Bankruptcy is the New Black”, The Amphora Report, April 2012. The link is here.