Some things never change. Here is Eugen von Böhm-Bawerk, one of the founding intellectuals of the Austrian school of economics, writing in January 1914, lambasting politicians for their complicity in the corruption of monetary policy:
We have seen innumerable variations of the vexing game of trying to generate political contentment through material concessions. If formerly the Parliaments were the guardians of thrift, they are today far more like its sworn enemies. Nowadays the political and nationalist parties ... are in the habit of cultivating a greed of all kinds of benefits for their co-nationals or constituencies that they regard as a veritable duty, and should the political situation be correspondingly favorable, that is to say correspondingly unfavorable for the Government, then political pressure will produce what is wanted. Often enough, though, because of the carefully calculated rivalry and jealousy between parties, what has been granted to one has also to be conceded to others — from a single costly concession springs a whole bundle of costly concessions. [emphasis mine]
That last sentence is a key to understanding the crisis that is unfolding in Europe. Normally, you would look at a country like Greece – with 175% debt-to-GDP, mired in a depression marked by -25% growth of GDP (you can’t call what they’re going through a mere recession), with 25% unemployment (50% among youth), bank deposits fleeing the country, and a political system in (to use a polite term) a state of confusion – and realize it must be given debt relief.
But the rest of Europe calculates that if they make concessions to Greece they will have to make them to everybody else, and that prospect is truly untenable. So they have told the poor Greeks to suck it up and continue to toil under a mountain of debt that is beyond Sisyphean, without any potential significant relief from a central bank. This will mean that Greece remains in almost permanent depression, with continued massive unemployment. While I can see a path for Greece to recover, it would require a series of significant political and market reforms that would be socially and economically wrenching, almost none of which would be acceptable to any other country in Europe.
Sidebar: Japan would still be mired in a depressionary deflation if its central bank were not able to monetize the country’s debt. As Eurozone members the Greeks have no such option .
However, the rest of Europe is not without its own rationale. To grant Greece the debt relief it needs without imposing market reforms would mean that eventually the same relief would be required for every peripheral nation, ultimately including France. Anyone who thinks that Europe can survive economically without significant market reforms has no understanding of how markets work. Relief without reforms would be as economically devastating to the entirety of Europe as it would be to Greece alone. Ultimately, for the euro to survive as a currency, there must be a total mutualization of Eurozone debt, a concept that is not politically sellable to a majority of Europeans. (The European Union can survive quite handily as a free trade zone without the euro and would likely function much better than it does now.)
Kicking the debt relief can down the road is going to require a great deal of dexterity. The Greeks haven’t helped their cause with their abysmal record of avoiding taxes and their rampant, all-too-easily-observed government corruption, including significant public overemployment.
In this week’s letter we will take a close look at the problem that is at the core of Europe’s ongoing struggle: too much debt. But to simply say that such and such a percentage of debt to GDP is too much doesn’t begin to help you understand why debt is such a problem. Why can Japan have 250% debt-to-GDP and seemingly thrive, while other countries with only 70 or 80% debt-to-GDP run into a wall?
Debt is at the center of every major macroeconomic issue facing the world today, not just in Europe and Japan but also in the US, China, and the emerging markets. Debt (which must include future entitlement promises) is a conundrum not just for governments; it is also significantly impacting corporations and individuals. By closely examining the nature and uses of debt, I think we can come to understand what we will have to do in order to overcome our current macroeconomic problems.
But first, two announcements. At the end of the letter is a link to the website for my 2015 Strategic Investment Conference in San Diego, April 29 – May 2. There is a terrific lineup, and you can sign up now and get the early-bird discount through the end of the month. Ours is simply the best speaker lineup at any conference in the country that discusses economics and investing. You really should make an effort to attend.
And I’m pleased to announce the launch of Mauldin Pro, our new service for professional investors. We’ve been working on this for months. You’ll likely remember a few Outside the Box editions featuring a brilliant young global macro investor by the name of Jawad Mian. Jawad has brought his excellent Stray Reflections letter to Mauldin Economics as part of our Pro service. In addition, we have Over My Shoulder and World Money Analyst, an interview series called Mauldin Conversations, and – perhaps the best part – our Pro Sessions. These will be a traveling series of seminars with SIC-level speakers, but in a more intimate setting. We’ll get together for a few hours of intense discussion and then relax with a drink and get to know each other. Our first session is being organized now and will be held in New York City. If you are a financial advisor, portfolio manager, or other type of investment professional, this service is for you. Check it out here.
Now let’s think about debt.
Debt Be Not Proud
Debt is future consumption brought forward, as von Böhm-Bawerk taught us. It is hard for me to overemphasize how important that proposition is. If you borrow money to purchase something today, that money will have to be paid back over time and will not be available for other purchases. Debt moves future consumption into the present. Sometimes this is a good thing, and sometimes it is merely stealing from the future.
This is a central concept in proper economic thinking but one that is all too often ignored. Let’s tease out a few ideas from this concept. Please note that this letter is trying to simply introduce the (large) topic of debt. It’s a letter, not a book. In this section we’ll deal with some of the basics, for new readers.
First off, debt is a necessary part of any society that has advanced beyond barter or cash and carry. Debt, along with various forms of insurance, has made global finance and trade possible. Debt fuels growth and allows for idle savings accrued by one person to be turned into useful productive activities by another. But too much debt, especially of the wrong kind, can also be a drag upon economic activity and, if it increases too much, can morph into a powerful force of destruction.
Debt can be used in many productive ways. The first and foremost is to use debt to purchase the means of its own repayment. You can borrow in order to buy tools that give you the ability to earn higher income than you can make without them. You can buy on credit a business (or start one) that will produce enough income over time to pay off the debt. You get the idea.
Governments can use debt to build roads, schools, and other infrastructure that are needed to help grow the society and enhance the economy, thereby increasing the ability of the government to pay down that debt.
Properly used, debt can be your friend, a powerful tool for growing the economy and improving the lives of everyone around you.
Debt can be created in several ways. You can loan money to your brother-in-law directly from your savings. A corporation can borrow money (sell bonds) to individuals and funds, backed by its assets. No new money needs to be created, as the debt is created from savings. Such lending almost always involves the risk of loss of some or all of the loan amount. Typically, the higher the risk, the more interest or return on the loan is required.
Banks, on the other hand, can create new money through the alchemy of fractional reserve banking. A bank assumes that not all of its customers will need the immediate use of all of the money they have deposited in their accounts. The bank can loan out the deposits in excess of the fraction they are required to hold for depositors who do want their cash. This lets them make a spread over what they pay depositors and what they charge for loans. The loans they make are redeposited in their bank or another one and can be used to create more loans. One dollar of base money from a central bank (sometimes called high-powered money) can over time transform itself into $8-10 of actual cash.
A government can create debt either directly or indirectly, by borrowing money from its citizens (through the sale of bonds) or by directing its central bank to “print” or create money. The money that a central bank creates is typically referred to as the monetary base.
Debt can be a substitute for time. If I want a new car today, I can borrow the money and pay for the car (which is a depreciating asset) over time. Or I can borrow money to purchase a home and use the money I was previously paying in rent to offset some or all of the cost of the mortgage, thereby slowly building up equity in that home (assuming the value of my home goes up).
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