The way forward

There were plenty of central bankers and economists with glum faces at Jackson Hole, Wyoming this week as speakers reviewed the challenges ahead. So far the global economy has not responded to various rescue plans, with GDP slowing and national debt rising across a whole slew of economies.

Before we look at the daunting challenges ahead,we should review what has already been achieved. We avoided a global banking collapse, an accompanying deflationary spiral and a depression similar to the 1930s. There have been a few side-effects, but do not underestimate the importance of avoiding a deflationary spiral.

Deflationary Spiral

In times of uncertainty, households and corporates save at higher than normal rates. Savings contribute to economic growth when channeled through the financial system into new investment, but in a financial crisis they are applied to pay down debt, causing a savings-investment mismatch. Any amount saved that is not re-invested in the economy, whether it used to pay down debt or buried in a tin at the bottom of the garden, causes a fall in national income.

If 2% of every trillion dollars earned, for example, is used to repay debt, then people who would have supplied 1 trillion dollars worth of goods and services will only receive $980 billion in income. That doesn’t seem so bad, but if 2% of the reduced income is similarly applied to repay debt, then income available contracts to $960.4 billion. And keeps contracting each time income is recycled. In extreme cases the above scenario could be replayed many times over before the behavior ends, causing a sharp fall in national income. Repetition of the above cycle twenty times, for example, would reduce available income by a third. That is a deflationary spiral. Something to be avoided at all costs.

Side-effects

The proven antidote to deflation is to run a fiscal deficit: government expenditure in excess of revenue helps to offset the savings-investment shortfall. Stimulus programs, however, have been badly managed, with no thought as to how the burgeoning national debt would be repaid. Mountains of national debt were incurred to head off the deflationary spiral, but there is very little to show for it. Deficits spent on school halls, public fountains, checks in the mail and tax cuts offer no means of repayment. Investment in infrastructure projects that offer a market-related return on investment — that can be used to repay the debt over time — have so far been scarce.

The result of a weak fiscal balance sheet is instability. High unemployment, low consumer spending, restricted consumer credit, and a falling housing market are all consequences of increased uncertainty.

Also, private capital investment remains scarce despite super-low interest rates and cashed up corporate balance sheets. For the same reason that cashed up banks are not lending to small business: uncertainty. Both banks and business face an unpredictable environment, with the possibility of further falls in employment and consumer spending, restricted consumer credit, a falling housing market, unsustainably low interest rates, and the threat of increased taxes. Uncertainty equals risk, and any CEO worth his/her salt would scale back on expansion plans until they have a clearer picture of what the future holds.

Unemployment will remain high and GDP growth low until capital investment is restored. The problem is: how?

Possible solutions

The answer may sound simplistic, but we need to reduce uncertainty to provide business with a stable foundation on which to plan future investment. There are four possible solutions, but none of them are pretty.

The first is austerity: cutting government expenditure to match revenues. Austerity is important but on its own is likely to deliver even lower growth than at present — and risks a deflationary spiral. Cutting government expenditure while private savings are being used to pay down debt, without an equivalent cut in tax revenues, would court disaster.

Raising taxes is another popular option: getting everyone to pay their fair share. Though the notion of fair share varies widely depending on who the speaker is — and who pays their campaign contributions. Revising the tax code to achieve a more equitable distribution of the tax burden may contribute to long-term stability — a fair tax system is more likely to stand the test of time — but increasing tax revenues to repay national debt would also risk a deflationary spiral.

A third solution is massive public works programs similar to those undertaken by China during the GFC. Infrastructure projects directly stimulate local business and increase employment while also delivering savings in unemployment benefits. Government infrastructure investment, however, has a checkered history. Cost overruns and failure to meet revenue projections make private sector funding difficult to obtain. And government funding would further increase the national debt.

The fourth option, a soft default on existing debt, through inflation, is obviously tempting. Debasing the currency by selling Treasurys directly to the Fed, for example, would:

  • Reduce national debt in real terms;
  • Create a surge in investment demand for real assets as a protection against inflation — lifting stock prices and the housing market;
  • Bail out the banks, who are threatened by shrinking housing prices; and
  • Give currency manipulators a sizable haircut on their existing Treasury investments and discourage further “pegging” against the dollar. China and Japan collectively hold more than $2 trillion in US Treasurys (Washington Post), accumulated to suppress appreciation of their currencies against the greenback and create a trade advantage.

An unwelcome result, however, would be a massive spike in inflation. At some point the Fed would have to raise interest rates sharply, effectively slamming the economy into reverse, in order to cure inflationary expectations. So we could defer the recession for now, in the hope that the economy is on a sounder footing when it re-visits us later.

The way forward

While each of the options has their downside, a combination of the first three seems to offer the best solution. Funding infrastructure investment through a combination of private sector funding, austerity cuts and increased taxes could avoid the  risk of a deflationary spiral, with minimal increase in the national debt. It would also facilitate direct channeling of private savings into investment, reduce wasteful government expenditure (through an austerity drive) and could be used to justify a more equitable distribution of the tax burden (if we all benefit we should all expect to pay).

The fourth option, a soft default through inflation, should be seen as a last resort. And is probably why QE3 was not put forward at Jackson Hole last week. Once you awaken the (inflation) dragon, he can prove difficult to slay.

78 thoughts on “The way forward

  1. [...] expansion and was followed rapid contraction as the private sector diverted income to repay debt. Debt contraction is catastrophic, however, and can cause GDP to fall by up to 25 percent as in the Great Depression [...]

  2. [...] options to revive the economy and further quantitative easing grows ever more inviting despite the inflationary outcome. With presidential elections looming in 2012, the White House will also be doing their best to [...]

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  4. jOSEPH WALSH says:

    The uncertainty in business confidence preventing investment is NOT due to uncertainty re: consumer demand which has declined only mildly, or due to lack of capital since banks are recapitalized and corporations are flush with retained earnings. The uncertainty is a direct result of policy decisions in Washington which make costs and therefore revenues and earnings unpredictable. Specifically, Obamacare with unpredictable increases in health insurance due to new mandates and as yet unwritten new regulations, Dodd Frank with hundreds of yet to be written regulations potentially affecting lending to vendors and customers and affecting the future availabity of credit, threatened EPA restrictions on carbon dioxide and fossil fuels, restrictions on oil & natural gas drilling, and arbitrary rulings by the NLRB all create uncertainty and raise risks to capital investment. Threats to increase marginal tax rates inhibit risk taking by small business owners and entrepreneurs who risk their own income in capital investments.

    • Colin Twiggs says:

      If this is only a mild decline in consumer demand, I hope we never see a severe one. High unemployment, declining house prices and high gas prices all lead to a fall in consumer spending and uncertain returns on investment.
      I agree that banks and large corporations are flush, but small business are doing it tough.

  5. Dean says:

    Hi Colin:

    Interesting and concise grasp of the main issues.

    Though not a true Keynesian believer, I note that Keynes argued that governments should engage in necessary infrastructure spending to help offset the decline in private income & expenditure, in order to create some initial traction for the economy.

    He also said that to bring the scales back into balance, taxes should be increased once the economy begins to recover.

    This is where Keynes’ theory falls apart.

    When faced with reality, i.e., human beings pursuing their own self-interest and private agendas, it all beaks down.

    It is much easier for governments to spend our money, but they do not have the political will to raise taxes to rebalance the books, as they risk being voted out at the next election.

    This continuing lop-sided approach finally blows up after 30 years of abuse and we find ourselves in the current position, still wondering how this could have happened …….

  6. Mike Siroky says:

    Most Keynesian economists believe that tax increases by the Roosevelt administration contributed to the severe downturn of 1937-1938. This, of course, doesn’t mean they are correct, since the Keynesian model has taken some hard knocks from experience. But the 1938 recession is similar to our current situation so it bears some study.

    By the spring of 1937, GDP had regained their 1929 levels. Unemployment remained high, but it was considerably lower than the 25% rate seen in 1933. The American economy took a sharp downturn in mid-1937, lasting for 13 months through most of 1938. Industrial production declined almost 30 per cent. Unemployment jumped from 14.3% in 1937 to 19.0% in 1938, rising from 5 million to more than 12 million in early 1938

    Our current situation is even worse than 1937 since we have not regained pre recession levels of GDP. Any increase in taxes at this point carries the risk of further deflation, regardless of what else the government does. The entire Western economic system is in dire trouble due to past overspending, over-regulation and misallocation of capital (savings). The solution is both economic and political.

    My suggestions:
    1> The government should do nothing in terms of further stimulus. Spending on infrastructure may increase jobs in the building industry but it will reduce jobs in other industries. Anyway, are we sure that more roads and bridges are a better use of our savings than say research in nanotechnology or biopharmaceuticals? Misallocation of capital is what caused this crisis in the first place.Let the private sector allocate the savings to the best and highest use as judged by future return.
    2> The Obama administration has so mismanaged the economy that confidence in government action is at an all time low. A completely different, non statist approach is needed but cannot come from this administration. Recovery must await an Obama resignation or the next election.
    3> In the meantime, Congress should begin debating changes to the tax code such as to broaden the base and lower marginal rates and limiting the power of the DOJ, EPA and NLRB to interfere with business. Even talk of such change will cheer the capital markets and perhaps start some investment flowing.
    4> Debasing the dollar is not a solution since China and Japan hold huge amounts of US debt denominated in dollars. Any wiff of US inflation will accelerate the the world wide rush into commodities increasing things like the nominal price of oil and hold back any recovery.

    • Colin Twiggs says:

      Hi Mike, I understand your concerns, but I don’t agree with this statement: “Any increase in taxes at this point carries the risk of further deflation, regardless of what else the government does.”
      Any increase in taxes that is applied to reducing debt, would risk deflation. But any increase in tax that is then spent by the government on goods and services, whether capital investment or otherwise, would not.
      Regards, Colin

  7. OzWaz says:

    If humans had control over the weather it would be in the same mess. It’s not the process that the problems it’s genes carved by evolution.

  8. roncer says:

    I would like to suggest that you have a look at Armstrong’s articles.

    http://www.martinarmstrong.org/economic_projections.htm

    Best to you…………..

  9. JP says:

    You make way too much sense…

  10. Nick says:

    QE3 won’t work. QE1 and 2 didn’t work so more of the same is mot the answer. The whole Keynes model doesn’t work which is why we are where we are now.

    The west needs Less government intervention not more. Simple flat taxes, less legislation, less crap in the way of entrepeneurs who are the only real way out of the mess.

    my Solution would include

    Reverting to a Gold backed currency
    Reduce defense spending and stop dicking around in other countries problems
    Move economies away from being dependent on commodities not available locally (For example run cars on ethanol which can be made in lots of small refineries using normal household waste rather than the corporate approach, mandate small cars that use less fuel, and less commodities to make, push some of the wasted defense spending into development of efficient batteries and thorium reactor technology – the list is endless – the solutions discovered become the engine for growth for the next 30 years much in the same way the Moon landings spun off this periods technologies)

    Finally, you need to measure economies in different ways than the GDP etc crap – for example, deflation is actually natural in developing economies, cars are cheaper now than ever before, computers are, TVs, phones etc etc we expect that improvements and innovation should make things cheap but somehow also expect that bread should keep rising in price. We are already at a stage where a broom costs as much as an electric screwdriver. Remember Inflation is the Government stealing your savings

    Anyhow – that’s just a start

    • Colin Twiggs says:

      Great post. I agree with a lot of what you say, but reflect on this: QE1 and QE2 did not work as well as expected, but where would we now be if they had not been implemented at all? In the last (1930s) banking collapse, US GDP fell 27%. Why did we get off so lightly this time? I am a strong advocate of small government and minimal intervention by central banks, but we have to fix the gaping hole in the ship before we can plot a new course. My piece was focused on how to stay afloat, rather than which direction we should take in the long-term.

      Thorium reactors and/or nuclear fusion are about as close as we can get to clean, safe nuclear energy (other than solar power), but they are still unproven technologies that require further development before we know whether they are commercially viable.

      Deflation is a natural phenomenon, as advances in technology lower the costs of production or raise crop yields, but this should not be confused with a deflationary spiral resulting from a banking collapse. The collapse after a real estate/stock market bubble can leave banks insolvent when asset prices fall below loan values. Banks call in exposed loans, resulting in forced sales and driving down asset prices even further………..Which leaves banks more insolvent, forcing them to call in even more loans……Which drives down asset prices even further. The result is a self-reinforcing, downward spiral that can cause a major collapse in asset prices and bring down the entire banking system.

      If you want to fix the economy in the long-term, the fractional reserve banking system would be a good place to start. I would like to see substantial increases in bank reserve ratios, up to about 25% of total assets, over time. The present house of cards is over-leveraged and amplifies the severity of the boom-bust cycle.

      Regards, Colin

      • Stefan says:

        a gold backed currency (like in the state of utah) could only be the first step to get out of this mess. I,m not i favor of gold backed currencies because gold himself has a intrinsic value as a commodity and so gold is not the solution. We need freemoney (and more regional money) with negative interest rates to sitmulate the consumer spending for what reason whatever. The interest you get from your bank for your money does not compensate for the purchasing power we lost in an average fiscal year. So interest rates are really a farce to keep the system going. If you accelerate the circulation of money you accelerate the economy at the same time and this is what we really want. Money has to rotten with the time as well as agricultural commodities and this would give us the ability to a good prospering economy (see my post for more explanation).

      • Colin Twiggs says:

        We had banking collapses (1907 and 1930s) while on the gold standard, so this may be an improvement but is not a cure-all. If you want to save the capitalist system, you have to control bank creation of new debt by raising reserve ratios while restricting securitization.

  11. Peter says:

    I appreciate the logic and clarity of your newsletter article. The only thing missing would possibly be a comment on the unfortunate political dimension to the problem. I mean that politicians continue to want to be popular, especially prior to elections; and hence defer the hard (unpopular) decisions that must be made. Hence in the USA the democrats are unlikely to take the initiatives and decisions needed at this time while it becomes more and more obvious that decisions need to be made and hence confidence will be further eroded. Another dimension is the role of the media, which seems to be fairly controlled by big buidness, but occasionally speaks out the truth of the situation. Your articles are way up in my assessment of what needs to be considered.

    Peter G

    • Colin Twiggs says:

      Thanks for the feedback. I have covered the political system elsewhere, but we should be aware of another threat: the presence of large voting blocks that prevent politicians from taking action to fix the mess we are in. The aging population, for example, means that the percentage of older voters is growing and likely to vigorously oppose any move to cut retirement or medical benefits.

  12. Daplee says:

    Very enjoyed reading your stuff..
    One of senior trader shared with me that he doesn’t think global economy going one way or another, i.e. no rapid expansion nor recession. The present market gyration is a result of thin market. Come September 1, the big boys will be back and there will be order to the markets.
    Adding further from his comments, in my opinion, I am still very bearish for USA. This BIG boy only holding two of majors stuff – Hi Techology & Medical Sci Techology. After a BIG boy couldn’t afford to pay out the “welfare” for feeding the poors. The family of this BIG boy be selling the above major treasure assets and collapsed completely. I truly believe that the history is changing the United States be just “America” …It’s so scary when looking at the yield rate on 50 years’ US Treasury bonds!! Unbelievable!! Who’s wanna be placing the wealth on such low yield product for 50 yeras!!

    I am now focusing on the following countries in my basket;
    1) Denmark;
    2) Switzerland;
    3) India;
    4) Australia
    5) South Africa &
    6) Dubai
    7) China

  13. Karsten White says:

    ‘best solution’

    HAHAHA. How absurd you are. The best solution would be a new monetary system, a world wide revolution and a government free localized civilization with decisions made by consensus that can learn to live in balance.

    But you think a ‘govern’ment (govern=control) that spends a little less of the fruits of our labor, but takes more in taxes and inflation (tax=extract, oppress; inflation=tax) and spends it on projects that have no demand in the free market (public works) is the ‘best solution’. Ay, caramba! You need to go to an imagination workshop.

  14. Graham Stubington says:

    An excellent article

  15. Bruce Cavender says:

    We need to simply be honest with ourselves and spend no more than we take in.

    To consistently do anything else is to go in the wrong Direction.

    Our destination will be determined by our Direction.

    Direction is more important that speed.

    Bruce

  16. QE1 (USA & UK) + QE2 + low interest rates + other stimulants = enough for the savers (for retirement not dependent upon a state for top up benefits) taking more than their fair share of bailing out the global economies. I agree in the 1st 3 options being the next steps oherwise for what is it worth ever putting in 40h + 220d a year into society if it just gets washed away by bankstas & government corruption (credit booms & falsified expense claims). People would consider giving up on contributing to society for effort put in is diminished unfairly and unjustly. It’s these sort of scenarios that can topple a fiat currency scheme. I myself hav considered hannging up the work coat and returning back in 10 maybe 20 years time to work on the basis of significant inflation would mean I could stack shelves in a supermarket for the same money as a qualified professional job. I also see the housing boom in the UK has delivered undesirable social aspects whereby young men & women have no ability to afford homes due the the economic disasters Blair / Brown & Bush created via a credit frenzy. This means long term disposable income has been shafted for these young people, if the bottom of the pyramid is unstable then the building must come down. What have they done, these 3 unwise dudes are strongly frowned upon, the senior politicians where flipping property and it makes you consider that they where in it for themselves with no regard for the trail of disaster they left behind. Oh, and hasn’t Bush got oil investments, printing money from 2002 = higher oil no matter what the IEA tries to do. Good for Bushes investments but not so in fostering a stable progressive economy. This is the problem when you put 1 guy at the top, all other donkeys nod in agreement to anything for fear of being moved on, flawed govenment structures my opinion….as well as flawed banking and regulation. A feeling of doom now persists in all directions which isn’t good for the short term. Only a shake out second crash rather than a correction could ever bring true equlibrian back to society and from there a steady progress to recovery, everybody is always trying to foolishly fast track.

  17. Paul Anderson says:

    The german industrial group contesting bailout plans of the EU to the high court has the idea,
    A split in the Euro – those that follow the rules and those that can not
    Save banks not countrys
    Some pain is to felt by all (austerity for the poor and higher taxes for the rich)

    • Colin Twiggs says:

      I seem to recall an old Chinese curse that goes “may all your wishes be fulfilled”. When the Germans congratulate themselves for splitting from those lazy bludgers sunning themselves around the Med, and the new deutchsmark soars into the stratosphere, they will suddenly wake up with “Swiss-disease”. Swiss exports are no longer competitive and tourism is dying because the strong Swiss Franc has priced them out of the market. The Germans will suffer the same fate if they unhitch from the rest of the EU. The PIIGS are the only thing keeping the euro competitive.

    • Daphne says:

      Hello Paul, Had u worked with PacDunlop some years ago?? if yes, pls drop me a note. Regards,Daph

      • Stefan says:

        german economy is competitive but a german has a different point of view what working means than a spanish worker. I lived may years in spain and i speak the language as well. So i know spanish mentality and this mentality is lightyears away from german mentality. So you can,t connect this two different points of view with a common currency. Nobody from our government ask us if we like the euro or not and i tend to vote for our german mark. If the german taxplayer has to give money to greek and others this is the wrong direction, because if you make the party then you have to pay for the music and not your neighbors

      • Colin Twiggs says:

        Thanks for your viewpoint. The German economy has much to admire, but it also benefits from a weak euro that creates an export advantage. A split from the rest of the EU would cause a fall in exports as the new DM strengthened.

      • Stefan says:

        1. we are one of the great export nations thats true but helps that to create jobs in germany ? Partial but most jobs are created abroad because german multinationals don,t pay taxes in germany and use the foreign currency (for instance USD) to produce the products in the USA so they can pay their workers with the USD with no need to exchange to Euro again.

        2. we are one of the great export clowns worldwide giving good german products to the USA in exchange of green paper that is not worth the value in which it is denominated. The unleashed money creating process of the federal reserve bank (really is a private banker oligarchy which was ceded by bribe 1913 from president Wilson, see federal reserve act, so the USD is not a public controlled currency it,s a private owned curreny of some powerful families) makes that money and goods that serve as an underlying for the money are wide out of balance. Maybe we in germany think it,s a good thing that we export so much but we betray ourselves. What do we do with all the greenbacks when the USA is bankrupt (china and japan in a greater scale) ? Dooms day was postponed in august but there is not much time at all anymore if we do not abolish the existing economy system. Anyway the US debts can,t be payed.

      • Colin Twiggs says:

        I don’t see too many jobs being created in the US, so where is the surplus currently being invested? Through the ECB in Italian/Spanish bonds?

        The US debt can’t be repaid — I agree — other than with paper money.

  18. Stefan says:

    Dear Colin,

    i think it is time right now to put in practice a brand new worldwide econocmic system that has already proved in the past. The initial idea are from Silvio Gesell and the model is free money with negative interest rates if someone did not spent his money and desides to hoard his money. We already have a blueprint of this economic system in a book from a european economist (Andreas Popp – The Currency Countdown). I think this book i right now only available in german language which comprises the land and real estate speculation as well. If someone rich hoards money he will get interest from his bank and can do a very good living as a rich unemployed unlike the poor unemployed who has not so much choices. The only part of society who contributes to the all the others in a state are the middel class financing as well collapsing banks with there tax money. The wörgl miracle that free money is feasible to be the best regulator of the velocity of circulation of money. If people spend more money (voluntary or to avoid demurrage) it is good for the economy. And if someone gets no money from the bank as a funder with a good future product, the situation would be different if money lenders (rich people who want to avoid demurrage) and credit takers the first time are on the same level. To avoid demurrage if you have money you have a great interest to find a company you can found with your money. But the problem is in a system like this banks would be obsolete and as you maybe know interest rate is not comprised in the money creating process of banks. And american banks do very well creating money on the private islands of the queen of england (Jersey and Guernsey) and sure foreign currencies are allowed. That ist the only way i see a way forward because like it or not the system is collapsing gold, silver and platin shows the way.

    http://en.wikipedia.org/wiki/Silvio_Gesell

    http://en.wikipedia.org/wiki/W%C3%B6rgl

    Stefan

  19. Jason says:

    The problem is the federal reserve. The U.S. needs debt free money. The national debt is impossible to pay off because there’s always more money owing than in circulation. The fed is a criminal organization as far as i’m concerned and they are destroying America. You can’t print your way to prosperity.

    • Colin Twiggs says:

      The Fed is an SPV of the Federal government (like the ones Enron used to use) to bypass restrictions in the constitution on issuing paper money. When Treasury issues bonds or notes that are purchased by the Fed, they are effectively borrowing from themselves. Even the interest paid is channeled back to them as Fed profits. So when Treasury pays for goods and services with bank notes issued by the Fed, they are just pieces of paper with no backing.

  20. al says:

    Excellent post. Unfortunately, I doubt the Congress will have the guts and balls to come up with a combination solution like suggested. It would mean each side would have to give up something, which heaven for bid they do.

  21. Steve Taylor says:

    Hello

    Just wanted to say thank you for this newsletter which i have now used for 8 years. Very straight forward, blunt and gives a great basis for all trading platforms and getting new students up to speed in the true financial sector. Please keep going strong!!

    Steve Taylor

  22. Steve Bell says:

    Sorry, economics teaches us that the law of supply and demand is not given to manipulation. The only natural way for our economy to regain traction is to de-leverage, deflate and devalue. Why do people think they have an answer through manipulation of natural laws?
    It took us decades to realize we cannot put out every fire in the forest and not have long term consequences when brush builds up and the conflagration that results causes horrific damage.
    Sometimes we have to weather the storm (sorry about the mixed metaphors) and not try to fight the elements.

  23. erneat schmidt says:

    Very informative,always enjoy your info.

  24. The ads above this article included the book This Time is Different. Every financial crash in history has had similarities. An early crash in Florence in the 1340s followed accumulation of massive wealth by a few families. Rome ended in an orgy of powerful families grabbing control of larger shares of Rome’s wealth. The life was sucked out of Rome’s economy when incomes of the majority of Rome’s population were insufficient to maintain the level of consumption necessary to support a complex economy. Adam Smith is commonly cited as validating self interest as the driver of economies, but he was actually deeply suspicious of self interest of merchants and traders. What he described as a self-evident maxim was that “consumption is the sole end and purpose of all production”. If you want to understand an economy, focus on consumers and why they consume or not consume. The article talks about investment, but investment does not lead consumption, it follows it. The “dry” argument is that we have to deregulate and provide incentives for businesses, repeating Smith’s observation that “in the mercantile system the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce”. What ultimately underpins consumption is trust. What dries consumption up is when the general public loses trust in the system. There is plenty of research showing that the greatest destroyer of trust is inequality of income distribution. Through the middle half of the 20th century the US economy was the driver of the world economy and had an egalitarian spread of income. From the 1980s to 2008, income distribution moved back to the same level of inequality it had reached in 1929, with the top 1% of income earners receiving more than 20% of total income, compared to less than 10% for most of the middle half of the 20th century. Given the similarities, it will be an interesting study to see if the present US recovery takes as long as recovery in the 1930s. The present social structure in the US not only mirrors that in 1929, it has strong similarities to late Roman society, with concentration of wealth undermining the culture that had been Rome’s initial strength, leading to its decline. Australia is not immune to the trend towards concentration of wealth. A recent study reported that the wealthiest 10% own 60% of Australia’s wealth. The poorest 20% have only 1% of the wealth. Look back through the centuries and there is a recurring pattern of decline of formerly affluent societies associated with growing inequality of income and wealth that undermines the very culture that had been the source of that society’s initial strength. In the US the growing inequality of income in the last three decades has been exaggerated by tax cuts favouring mainly high income earners, resulting in mounting government deficits. And the same rhetoric that produced those deficits is being used to claim that US government spending, which is a lower % of GDP than other OECD countries, is too high. Meanwhile, as Joseph Stiglitz points out, sections of the private sector suck in inordinate shares of GDP for hugely inferior results: notably a health industry that provides excellent (though way overpriced) health services to the few who can afford them and substandard service for the large majority, and a finance sector which was deregulated so it could innovate and used its freedom to invent products that actually reduced benefits to consumers, while screwing higher fees out of them, ultimately creating the toxic time bombs that blew up the world economy. Things have not changed much since the days of Adam Smith, or of Florence or Rome. Meantime, economists continue to look for answers at the wrong end of the economy. If the majority of populations, who are also the majority of consumers, have the necessary level of trust and the necessary level of income, consumption will result and businesses will find the investment needed to take advantage of demand.

    • Steve Bell says:

      While disagreeing with your statement about investment following consumption (it is layered to consumption after initial start-up cost), you are correct in pointing out that we need to focus on the demand side of the equation and not the supply side.

      To expect small business owners (55% of all employers) to hire and produce without assurance of consumption (that is, supply without known demand) is nonsense. And for large business to hire a US worker at the average price of $28 and hour when they can get overseas labor for an average of $5 an hour is also not something to imagine happening soon.

      The answer lies in the demand. But demand will not come until variable prices are in balance with assets that need to be devalued and wages that want to naturally become deflated. But try selling that argument to any worker or politician (“Take a pay cut for the good of the economy” isn’t going to be a catch phrase anytime soon). That is why it will be a long haul to a natural balance of economics in a global economy.

    • Excellent response, it ties in with my comment whereby I’m considering giving up work and returning back to the workforce in 10 – 20 years time when I can stack shelves for the same wage as my professionaly qualified skilled job, due to strong inflation. If everybody gets the same idea society could collapse along with the fiat currency system. See my comments above….

    • Colin Twiggs says:

      Your point on income inequality makes a lot of sense. It would be interesting to compare income inequality to political stability and long-term economic growth across a wide range of societies. My point regarding investment is that both investment and consumption end up as income — but savings in the form of debt reduction do not.

  25. Yehuda Schonfeld says:

    Dear Colin

    Thank you for the report .
    This is the first time i see a report dealing with the current situation in the markets.
    It is clear short understandable.
    Thank you again
    Yehuda

  26. Joe Escamilllo says:

    Colin’s commentary is written as if the world is run by accountants and bankers. It’s not. It’s run by men and women who control ships and airplanes and troops with guns– and will use them.
    The US is the biggest Mafia Don in the neighborhood, with the biggest guns. A Don’s credit rating is irrelevant. He won’t go bankrupt just because he owes too much to the Chinese laundry. He’ll simply hold up the Gulf gas station and take all he needs. The US did this in January 1991 (Gulf I) and got a 10 year bull market. It did it again in March 2003, and got a 3-year bull market. It will do so yet again and get out of its trouble by transferring it to its enemies.
    This is not by way of prescription, but by way of description. It must happen.
    When Britain was bankrupt after the Napoleonic wars, it raped India, and in 10 years was flush. Rome did Gaule. No empire in the world’s history allowed itself to cinch its own belt when it can do it to its enemies.
    The US spends 800 bil a year on oil. Europe about the same. If oil price is cut in half it’s a trillion savings a year, and the problems are over. Or rather, they have been transferred from the West to the East.
    In other words:
    If you can’t cut labor (they’ll vote you out), or stiff the banks (they’ll de-fund your party), you can only stiff your suppliers. Every turnaround specialist knows that.
    So:
    All the options Colin mentions are accountants’ options, where no cash and high debt means tough times.
    This doesn’t hold true for empires. They simply go and take what they need from someone else, then hire copywriters and speechwriters to explain post fact why it was necessary.
    Think about it.

    • Steve Bell says:

      You are throwing pearls before swines. We have elevated our soldiers to such an esteemed level that your are un-American if you criticize their efforts to export our “values” and needs. During WWII we did not worship soldiers because they were all of us doing a job. Today we think they are worth of hero-worship. Government propaganda got us on that one. Thank you Dick Cheny. (Maybe he should write a book.).

    • Colin Twiggs says:

      There is an element of truth in what you say. The US is certainly going to stiff someone, but they are not going to use guns or planes…. merely a printing press.

      • John Theodorou says:

        I think at first they will stiff the poor everywhere, with higher commodity prices leading to much political destabilisation around the world, as we’ve already witnessed lately. Next, it will stiff itself because there hasn’t been a country that has managed to print its way out of debt – even if the prescription was war. Finally there doesn’t seem to be be any room in your analysis for pesky things like peak oil, debt overload or climate change, which are certain to put the skids on things sooner or later. Can’t print oil, can’t print stable weather and you certainly can’t print your way out of debt.

      • Colin Twiggs says:

        If you think about it, you can print your way out of debt. Simply sell Treasurys to the Fed and you shrink external debt in real terms. Treasurys sold to the Fed do not increase the net debt owed by government — it is effectively lending to itself.

        This is a last resort, but we are dangerously close to it.

  27. Reece marfitt says:

    Looking beyond the us and at the entire west as a whole there is a good mix of all 4 remedies taking place. I think the ecb was really worried about the euro when they raised rates as within the OECD after japan is the last place to expect longterm inflation given their demographics. the piigs are also the countries with the shrinking home markets and increasing dependency rates apart from Ireland which escapes the worst of it along with the rest of the English speaking world plus France and Scandinavia. I think that before this is over Germany will be called into question as it’s low unemployment rates and export surplus are viewed more like symptoms of the Japanese disease than economic power.

    • Steve Bell says:

      What in the world did I just read? Very rambling with nothing said.

      • rm says:

        the japanese have been in a Deflationary Spiral for 20 years after a credit and housing bubble. it is infinately easier for the population to pay down debts (loan + interest) in an expandand economy and ultimatle escape the Deflation spiral. japan had sub replacement birth rates, zero imigration and a much larger block of 55-65 year olds than 10-20 year olds resulting in a declineing workforce and ever increasing dependency rate. this has some positive effects (notably low unemployment and an export surplus as your home market shrinks) but results in lower spending and a decrease in population so far of around 10m. if you had been to japan in the 90s you would have marveled at the place all shiny and modern but with a declining population there has been little building since and now looks very dated. the 80s were not a good decade for arcitecture. this is known as the japanese disease

        the euro area is looking very like japan in the early 90s with the exseption of france, scandinavia and ireland.

        the us, uk, canada, australia and ireland all have expanding populations (expandind markets) and therefore will find inflation more than deflation in the future when compared to 90s japan or indeed the euro area today.

        germany’s low unemployment of 7% and export surplus of 9b/m are symptoms of a decreasing work force and declining consumer base.

        the english speaking world will escape this trap with ben and sir mervin while the ecb has followed the japanese move for move and all but gauranteed a lost decade(or 2) untill the baby boomers pass through the system(cold i know). deflation is the priority.

        on the same topic the russians and chinese arn’t far behind.

  28. The Constitution requires gold and silver coined money. We currently have no money. Federal Reserve notes used to be redeemable decades ago into lawful coined money. The notes are now irredeemable and are hence, no money. The national debt is bogus, immoral, unconstitutional. The Bible says there will come a person who will seem to offer a solution, that will ultimately fail. The so-called dollar is doomed to dissolve in a sea of paper (hyperinflation). A possible short-term solution would be to allow the states to coin money, but that will require an amendment. People need to acquire gold and silver to protect themselves. Put in a supply of water, food, guns, and ammo. Hard times are ahead.

    • Steve Bell says:

      Yes, the Apocalypse is right around the corner and prayer is the only thing that will save us and blah, blah, blah. Don’t you Bible thumpers ever get tired of ranting on about the end of the world? Read something besides a four thousand year old, five time translated allegorical tale and educate yourself.

  29. Gerald Eppel says:

    Excellent on paper…very tough to implement as you can see for politics! The mass vote is finally starting to get through to the politicians…time will tell if there is enough time. Time will rule the game and right now time is barely in our favour!

  30. Matt says:

    could any of the 4 options allow Obama to win a second term?

  31. Phil says:

    Nothing like a scary story before bedtime! :) Great article thank you.

  32. Denis Bourke says:

    Four issues:
    1. When we hear the mantra of everyone paying their ‘fair share’ of taxes the envious seem to have in mind numerous Warren Buffetts who boast about paying less tax than their secretary. Is the Inland Revenue taking up the challenge? What about looking through trust arrangements and the like in respect of these people – or do they in fact genuinely give away their huge incomes to charity? A form of self tax (tithe) that goes straight to the desrving cause, and avoids the squander of the public purse. Or is it really just plain envy? You earn more than me, therefore you should pay a greater proportion in tax to reduce you to my disposable level? The egalitarian utopia.
    2. Capital works are an ideal stimulant, espescially since there is so much delayed maintenance in infrastructure everywhere you look. But, with a re-newed highway or bridge, impose a small toll. Consider charging reasonable entry fees to museums and the like – just a dollar will do. And so on. These small amounts multiplied by the thousands of users will create a positive cash flow to pay back the outlay.
    3. Cuts in government expenditure inevitably mean public servants losing jobs. Make sure it is the unproductive jobs that go; the ones that suddenly appeared along wih the previous economic boom – the clerks that carry paper around, make the manager look important (I am so useful I need a secretary), and do a raft of unnecessary tasks that produce no added value, just added cost. These are some of the people who can be rechanneled to capital works in 2 above, or work schemes in the voluntary sector.
    4. Introduce tax/tarriff penalties to US corporations (same for those in other jurisdictions, UK in UK, France in France, my New Zealand in NZ) who outsource jobs to other countries just so they can screw down the cost of labour. If their customers back home have no jobs they can’t buy the cheap imported goods, so it is really a lose/lose situation.

  33. darryl conroy says:

    I enjoyed the deflationary spiral section, and add that the fractional reserve system of banking adds greatly to this event and that the “system” is naturally leveraged to growth so when it contracts the whole system comes into question…

    • Steve Bell says:

      I don’t understand your meaning of “fractional reserve system of banking.” Are you meaning that the federal reserve members are fractured or that only a fraction of the federal reserve system is adding something greatly? Very confusing to us lay people.

  34. Justin Towner says:

    Hi Colin,great article and I agree with a lot of what you say,except I have deep reservations about option (4)…and as GFC2 arrives out of the darkened tunnel like a run away locomotive in the night,I am fairly sure option ( 4) is a real possibility,because in fact it is the easiest for democratic governments to sign off on…however it comes with grave uncertainties of it’s own making. A) The US Fed in my opinion is boardering on international criminal activity by debasing it’s currency and forcing ( as you put it ) the bondholders to take a haircut…this is an act of vindictive and selfish government and is an act of provoction,damn the rest of the world,we will protect our own self interests to the detrement of the global community…great way to start a war. ….. B) In a theatre of hyperinflation due to currency printing the banksters are the first to profit and in many cases are the only to profit,as they use easy money to ignite and inflate the commodity markets and consequently all prices rise,however those that are doing it tough,ie the rest of the community….are still unlikely to spend as they exhaust their income and savings keeping up with inflation,and this always happens before wages catch up,this results in a further tightening of the housing sector,and proves to be an opposite force of inflation,you end up with a deflationary spriral within a hyperinflationary environment….the result is chaos.

    Regards, Justin Towner.

    • Steve Bell says:

      Wow, could you have said that with a few periods. You might want to get a style manual on writing and look up run-on sentences. How can you expect someone to understand your meaning when they cannot understand your writing? After the first three run-on sentences I just sort of tuned out. And what is with the …..? Take this as a critique, not an insult. Write to be understood, not just seen.

  35. Colombus says:

    You wrote: “Savings contribute to economic growth when channeled through the financial system into new investment, but in a financial crisis they are applied to pay down debt, causing a savings-investment mismatch. Any amount saved that is not re-invested in the economy, whether it used to pay down debt or buried in a tin at the bottom of the garden, causes a fall in national income.”
    I think this is not correct.
    Burning money is destruction and total different from (re)paying money.
    Paying to a bank (or company), either your debt or your saving money, is putting money disponible for new use.

  36. Hardy Franz says:

    Very interesting article, but lets place the blame where it belongs. Bernanke I do not think so. Bush YES. His deregulation = given the banks a casino license and a blank check to cover the losses.
    Also his tax deduction on the super rich is not jut wrong but immoral. None of this happened to their neighbor to the North in Canada and their economy is firing on all cylinders.

  37. Michael O'Callaghan says:

    very hard to make money today without working for it…………..

  38. Jan says:

    When companies and their owners are sitting on historical highs of cash and earnings and don’t empower Main Street to share in all that wealth, a voluntary redistribution of that wealth through taxes seems painfully obvious, doesn’t it? Sitting on all that wealth without empowering people to be productive in continuously creating that wealth is a very risky economic and social process.

  39. David King says:

    Hi Colin
    Interesting article, but my problem is that unless the leaders recover the confidence of the public all the plans will fail
    The public’s perception of problems is rarely addressed and they are essential to any plans success.
    Although it may be possible to sway the minds of the financial community with a financial plan most times the augment is over the heads of the general public
    When the leaders have been shown to be clowns you need new leaders for the public to believe in the rhetoric. A new leader with a stirring speech could do more than all the financial plans
    It has been obvious in the USA that the politicians own jobs are more important then the countries future as far as the leaders are concerned

  40. JP says:

    More than likely option 4 will prevail – which is already happening. I can’t help but think that this monetary policy experiment to which we are all guinea pigs will be one day written in the annals of economic history/infamy (along with Weimar Germany, Zimbabwe, etc) and Ben Bernanke will go down as the most destructive Fed Chairman in history (trumping his predecessor Greenspan which is no mean feat). QE has achieved absolutely nothing except a unanimous vote of no confidence in the US Dollar, as demonstrated by the price of gold and supposed “risk” currencies like the AUD. Everything else (S&P 500, GDP) has regressed to where it was pre intervention. We should have let the natural cleansing process of capitalism (bankruptcy/failure) prevail, rather than this monetary/fiscal/hyper Keynesian, inflationary experiment, which can only end in economic disaster.

  41. Bill says:

    There is an alternative version of the reason for the GFC, which you have touched on*, and revolves around the increasing price of oil. I understand that a component of the price of oil is driven by pure speculation but, if the other component is driven by supply problems, then how do we power our economy regardless of debt levels. In other words, how can growth be maintained with dwindling energy resources?

    *http://www.incrediblecharts.com/tradingdiary/2011-05-25_economy_gold_forex.php

  42. ben says:

    Well I’m afraid all 4 will be used with special emphasis on the last in the form of financial repression where interest rates are kept below CPI as recommended to IMF by Reinhart’s [of Rogoff and Reinhart's fame] recently commissioned report to the IMF which has been hidden in plain sight on the IMF website. The worst part of which is the recommendation that it should be hidden from public discussion by politicians and bureaucrats. I have read it and it makes me sick to see an economist recommend such subterfuge. The US is presently already doing it with inflation of 3.6% and 10yr treasuries under 3% and that’s if you believe official gov CPI figures which economist John Williams of Shadowstats.com says is understating inflation which is really just under 9%pa. Also US Congress is presently debating a new method of calculating CPI which will understate it still further. If you needed more proof of the corrupt political class you would be a fool.

  43. Peter says:

    Great article!

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