Archive for December, 2012

Where’s the wealth fund?


John Maynard Keynes was an English economist and academic who lived from 1883 to 1946. He was hugely influential in the foundation of modern macroeconomics. This is the study of economics on a national and international level, as opposed to microeconomics which is the study of interactions between individuals or companies. His theories have given rise to the ‘Keynesian school’, one of the main schools of economics, though there are other competing ones such as the Chicago school and the Austrian school.

It is important to understand that, despite the fact that economists use highly intricate mathematical models and theories, theirs is not really a mechanistic science in the way that physics or chemistry is. People are not like machines where a given input equates to a predictable output. If there is one thing that we all know is that people are capricious. At times we move like great shoals of fish, seamlessly and in unison, and at other times it’s like trying to herd cats. We are given to extremes of emotion. We sometimes fall into a mania of overconfidence and greed and at other times we are paralyzed by fear and disillusion. Economics is really a social science, in that it describes both the initial actions of human beings and their reactions to economic incentives. At least, it tries to describe it and given the difficulty in doing so, a number of different theories have grown up around the study of these unpredictable creatures.

The Keynesian school is one of these theories. It follows Keynes’ theory of how to best understand it. His principal idea was that aggregate demand should be moderated by government action. Aggregate demand is an economist’s way of describing the economic cycle. When the economy is booming, it has high demand and when it is in recession it has low demand. Keynesian theory says that it’s a duty of government to act as a counter-cyclical agent to the economic cycle, so when the economy is booming, the government should draw down liquidity from the economy, meaning it should spend less than it receives in taxes and put the surplus aside into a rainy day fund. In practical terms this means that it should use the tax surplus to pay down national debt and once a reasonably small debt is left to facilitate the national pension fund market, say 20% of GDP, it should begin to create a sovereign wealth fund to put aside the surplus to invest abroad. At the same time, this drawing down of liquidity should moderate the boom.

The economic cycle will of course inevitably turn to recession. Then the government can make use of the surpluses it put aside during the good times. It can now draw down the money it had previously saved in order to stimulate the economy during the bad times. Given that the debt to GDP is at an ultralow level, there is plenty of room to maneuver, by raising debt, if required. It can now use this cash to, for instance, support the construction industry through a program of investment in infrastructure. It can build roads, bridges, hospitals and schools which provide direct and immediate employment to an under-utilized construction sector, while at the same time producing assets that have a positive value to the nation. This also has the positive effect of injecting much needed liquidity into the economy.

The problem is that the economy tends to run on a six to ten year cycle, but politics runs on a four or five year cycle. They are misaligned. A politician’s principle incentive is to get re-elected. So if during his tenure, the economy is booming, he damages his chances of re-election by ignoring calls to use the current surplus to spend on new social programs and new entitlements. It is very difficult politically to ignore calls for more spending on this or that new initiative while the national coffers are overflowing. ”It’s only fair”, his constituency and his opponent in the next election will say. A brave and principled politician would explain that the surplus needs to be set aside for the inevitable future downturn and should not be frittered away.

When was the last time you encountered a brave and principled politician?

So we now find ourselves where we are. No politician dared to put money aside during the good times because he was constantly watching his back, watching for his re-election chances. And thus no surplus was created. So now we hear the current crop of politicians saying, “Well, Keynes said we should be stimulating the economy during the downturn”.

True, but where’s the money you should have put aside in the good times to pay for this?

Keynesian economics is a two way proposition. You only have the right to call for deficit spending in the bad times if you had the balls to resist the call to overspend during the good times.

Wheres the wealth fund you should have created?


Update: Click on the image above to view a cool video on the difference between the Keynsian School and the Austrian School of economics.

Pick your poison


When you put yourself into the position that many of the western central banks have done with massive unsustainable national debt near, at, or well past 100% debt to GDP, you leave yourself vulnerable to any shocks that come along. And believe me, there are many shocks in the pipeline.

The main problem here is that central banks throughout the western world are dependent on private capital, via the bond market, to make up the difference between tax receipts and day to day spending. They have all been doing this for decades, so the annual deficit has each year added to the national debt which has grown relentlessly. This is why the debt levels are so high. The patience of the bond market has been sorely tested and will soon reach a breaking point. When this breaking point arrives, few will be prepared to buy any more treasury bonds and their prices will plummet. The interest rate, its corollary, will soar. The central banks will then find themselves in a bind.

There are three, and only three, ways out of this bind.

1/ An individual, who finds himself in debt, can do the responsible thing which is, try to reduce his spending, raise his earnings and accept the fact that he will have to grind through this for many years in order to repay his freely accepted debts. On a national level this means raising taxes, reducing entitlement spending and biting the bullet, accepting that things will be tight for years until the debt is down to a manageable level. All the while begging the forebearance of your creditors to allow you the few years breathing room needed to bring tax receipts and spending in line. This is the path that Ireland has chosen. The absence of demonstrations or riots in the streets of Dublin shows that the Irish people have accepted this grim burden.

2/ Another individual may say “There is no way I can pay this, I’m filing for bankruptcy”. On a national level this means defaulting on the debt, saying to your bond holders that they have to accept pennies on the dollar, or nothing at all. Take it or leave it. Along with shafting their bond holders, they are now in a position that they can no longer go to the bond market in order to finance their deficit (the difference between what the government spends each year and what it receives in tax revenues) which means they have to suddenly bring their spending and tax revenues in line so that they do not need to go to the bond market to make up the difference. This means that tax rates soar, entitlement spending plummets and no national consensus is there to accept this new reality. Hence, riots on the streets and stories of extreme hardship abound. This is what Greece has done.

3/ The final option is monetisation. This option is not available to individuals, only to sovereign governments with control of their own currency, so not Ireland or Greece, being tied to the Euro as they are. Monetisation is basically printing as much money as the government needs and ignoring the need to get spending in line with tax receipts. This is the most dangerous choice as it inevitably leads to hyperinflation as the market is swamped with currency with no actual value to back it up. I’m looking at you America.

So there are the three choices, pay the debt, repudiate the debt or inflate the debt away. There are no good choices, only varying degrees of bad.

Pick your poison.

Pushing Granny off the cliff

Granny 2

Margaret Thatcher once said that anyone who can manage a household budget can manage the national budget.

Now, we keep hearing about the US national debt expressed in terms of the ratio of Debt to GDP which at around $16T, is now about at the 100% mark. But the Debt is owed by the US government and it does not have the entire GDP running through its coffers, what it has are tax receipts which are considerably less at currently around $2.1T and ongoing spending of about $3.2T. The interest that the US pays on this debt was $454 billion in 2011 and since it is increasing rather than paying down its total stock of debt each year it can be viewed as akin to an interest only loan. US unfunded liabilities are around $238T


So, let’s follow Maggie’s advice and convert these figures to layman’s terms by lopping eight zeros off the end so that they look something like a household budget.

The annual income is now $21,000 which is about what someone on minimum wage would earn. The members of this household are having a tough time at the moment and their annual outgoings are currently $32,000 and they are making up the difference by bunging $11,000 on to one of those ‘low teaser rate’ credit cards every year. So they are borrowing over half as much as they are earning.

They have been in the habit of borrowing to subsidise their lifestyle for many years now, though it’s gotten a lot worse these last few years. The end result is that they now owe $160,000. This means that their debt to income ratio is 762%. They are paying about $4,540 each year out of their earnings just to cover the interest on this ever increasing loan which will go up another $11,000 or more this year. Their effective interest rate is around 2.8%.

For now.

But the looming problem on the horizon is that granny is about to enter a nursing home and has no savings, so the bill for her living and medical expenses are going to be about $2,380,000 over the course of her remaining life.

This profligate family’s lenders are one day going to pull their heads out of the sand and work out the math on this situation. As we have seen with the PIGS, this realisation can happen very quickly and when it does, the interest rate demanded can rise very sharply indeed.


That nice Stavros family down the road saw their interest rate go from 5.5% to 12.5% in the space of a year and it is currently at 17% one year later. Their own family got in a spot of bother back in 1981 and saw their interest rate spike to 15%. But their total debt at that time was at a much more manageable level and they were able to placate their lenders with promises to mend their ways.


If it were to go to that level again, their annual interest payment would go up to $24,000 which is $3,000 more than they currently earn.

Yes, every penny they earn would be used to cover interest and they would still be $3,000 in the hole. So no money to pay little Johnny’s tuition, no money to pay the ongoing medical bills, no money to pay for the security company, no money to give to uncle Fred who has been out of work for a few years now. And as for granny, well, I hear the view up on Lovers Leap is great this time of year…

And you thought that it was that nasty Paul Ryan who was going to shove her off the cliff, what with his outrageous plan to “balance the budget”, pffffff.