“ Go for the Bomb “

You may have noticed a relatively new term being used in the financial media recently “Financial Repression” is the latest buzz word being bandied about.  But it really isn’t a new idea and just means robbing savers to pay government debts.

Traditionally there were two routes open to government to pay down enormous deficits, one was to hyperinflate or repudiate on debts.  To hyperinflate the government would simply print enormous sums of cash (Weimar Germany) thereby destroying the native currency in process paying off debt with worthless cash.  The method is highlighted by the tale of German farmers who is the 30’s would sell a wagon load of potatoes, fill the wagon with cash, then drive it to the bank to pay off the previous large note of the farm.

The government in much the same way uses inflated money to pay back previous dear debts.

The second traditional path was to just default on the debt.   The debt was eliminated by refusal to pay.   Many times this refusal to pay drove the market price of the debt down. (Think African nations default on World Bank Bonds) to a couple of cents on the dollar.   The defaulting nation thus buys back the debt for a song and expunges the debt.

The 3^rd method is the currently referred “Financial Repression”, which uses a combination of inflation and low interest rates within a jacket of capital controls to take savers money gradually over time to pay government debts.

The first aspect of this program is Federal Reserve control of low interest rates upon savers and investors.  The Federal Reserve manipulation of interest rates insures  the loss of value 3 of 4% per annum, gradually debasing the currency and aiding in the repayment of debt.

The second force that is unleashed is that of inflation.  Remember Bernanke’s recent speech where one of the key things the Fed was attempting to do is create inflationary pressures to prevent Deflation and Depression.  Inflation is the government’s friend, it pushes people into higher and higher marginal Tax brackets thereby increasing government revenue.  At the same time inflation reduces the debts the government owes.  Recent Q.E. moves indicate this inflationary bias.

The third part of the government‘s agenda is capital controls whereby an investor’s ability to get their money out of the country into hard currency is curtailed.

Capital controls may take the form of confiscation of certain financial assets such as gold which the government did earlier in it’s history.   The prevention of the populace from converting it’s dollars into gold would lock you into an investment tied to a declining dollar and make you a sheep ready for shearing.

Another form this control of assets could take could be mandatory exchange of retirement account assets such as 401K’s or IRA’s into government zero coupon bonds or treasury bond backed annuity schemes.

One face of this repression could be “Mandatory Safety” rules put on banks, insurance Co’s, credit unions to invest their funds in government debt this could be masked with the illusion of protecting depositors-policy holders from “low quality” investment in the private market place with different tiers of assets and corresponding safety levels, much as what is “supposedly” mandated by the Basel Accords on banks.  By regulation the government could nudge financial institutions to load up on government debt.

One insidious aspect of this repression is that while savers would be forced to accept below inflation returns-Financial institutions would still be able to make healthy profits because banks make their profits on the spread of what they take in and pay out.  Because banks are able to obtain funds at zero cost, they are able to lend out at very low rates and still make a healthy return.  Banks and hedge funds also use substantial leverage to magnify gains several times.  The fact that our banking system is a fractionalized reserve banking system also multiples profits for banks.

In looking at the current funding situation the treasury is in it can be argued that it is almost a requirement that the Fed keep interest rates low forever.  Nominal debt due to current deficits is increasing at a rate now of a trillion and half plus per year.  While most of this debt is very low interest rate debt, it is of short duration that is short term in nature.  The overwhelming majority of the Treasury’s Debt structure is short term which means interest rate increase on the short end would have dramatic effects on total interest outlays.  It has been calculated that at a point when the average for interest on T-Debts reaches 5 to 5&1/2% (Historically Normal Interest Levels), the entire tax collection on the U.S. economy would not be enough to pay total interest on the debt.  It must be remembered that current budgetary deficits would be adding 1.5 trillions plus of new debt each year into a situation where the U.S. could not pay interest on all the debt that was previously created.

So in reviewing the options available to the government – Default , Hyperinflation or Financial Repression the later option seems the most likely solution.  It is probably a question of whether repression is utilized as a pre-emptive measure or as a desperate Hail Mary Act.  The hour is late, the game is down to the last few seconds, the two minute warning is here the total debt clock is winding down. Tick, Tick Tick!!!!!!

Swirling In The Whirlpool!

The term Liquidity Trap was first used in 1936 by Keyenes in his General Theory to describe a  situation where interest rates reach the zero-bound level.  At this point monetary policy has no effect on economic activity.

The concept holds that near zero interest levels there is effective equivalence in the holding of cash with that of government or corporate debt.  With little difference seen between bonds and cash, people will demand cash and continue to put all of their assets in cash as the future is unclear.  Keyenes termed this Liquidity Preference, cash demand therefore is infinite.  Consequences for the economy are that there is little or no capital investment in either machinery or labor which result in one consequence in increasing unemployment.  As cash soars unemployment increases which discourages spending (Aggregate Demand) so money velocity decreases and comes to a halt.  This situation only encourages more saving into cash and a closed loop effect begins (Money Hoarding) which leads to a greater downward spiral in the general economy (Deflation and Depression) once entered, the Liquidity Trap is very difficult to exit.

Suggested solutions in the economic literature suggest fiscal action such as (Q.E.),  the buying of various assets by the Fed or the Government, Bonds, Long Term Corporate or Government is suggested along with Corporate Equities.  Intervention in the Foreign Exchange Markets on a massive scale is also suggested along with Government spending and Tax Cuts as bromides to be considered.

Gasoline War

In looking at the effects of gasoline price increases on the general economy there are several factors at play.

The referenced chart shows dollar expenditure increase at various price levels.  This chart assumes regular grade prices while many new models recommend premium gas to operate their vehicles at peak efficiency, this would skew the numbers even higher.

The effects of gas price increases would be subject to the multiplier.   When considering total economic effects at a multiplier of 3 the net reduction of aggregate purchasing power on items other than gas would be $236.25 per month or $2,835 per year.  It should be remembered that these increased expenditures are on an after tax basis.  That is, you are paying more for gas with money you have already paid Federal Income Tax on, State Income Tax on and Payroll Tax.  In addition you are paying State and Federal Excise Tax on the gas as well as State Sales Tax.  Remember you are paying all these State and Federal additional Taxes on money which you paid Income Tax on already.  Business’s that purchase fuel for their operations have some relief in that they can deduct the cost of fuel from the bottom line “They purchase gas on a Pre Tax basis while consumers purchase it on a After Tax basis.”  A factor to also consider is that a business will pass along to the consumer any additional cost, so it is the individual consumer that pays all these Taxes and increased cost.

One should also recognize that the majority of gasoline sales are on credit cards whose balances are rolled over on a monthly basis with consequent interest charges.  The increased interest expense due to increased gas price would amount to billions of dollars.  This would all be subtracted from aggregate expenditure on other items which would have a negative effect on employment levels.

What we pay for in a gallon of regular gasoline? Retail price $4.00/gallon

So at Retail Price: $4.00/gallon

Taxes: $0.56
Distribution & Marketing: $0.36
Refining: $0.56
Crude Oil: $2.52


So on 100,000 gallons a month at station, 
$400,000.00 - Revenue

 Government no costs (all net): $56,000 -Taxes

 Distribution & Marketing: $36,000.00 - Retailer Nets about   3% per gallon: $12,000.00 approx.

 Refiner: $56,000.00 (very high capital costs)

 Crude Producer $252,000.00 -An integrated domestic oil company can capture profit at all stages of production and distribution when integrated on both vertical and horizontal basis.

Note: Government gets a free ride on others invested capital it puts no money up while Oil Production Co. must invest billions of capital.  Capital risk of "Dry Holes" is shouldered entirely by Oil Co. - Small costs for Arab's ; Heavy risk for off shore producers.

A History of Home Value

This is for national figures in the aggregate!   In high boom areas (such as Santa Barbara) the high was much higher thus the equivalent bust will be bigger – Notice as dire as these numbers look they do not even approach the declines of the 20’s and the Depression which were well below the historical trend.  History shows in the bust of large booms  almost always prices go below the trend line – Thus Shiller is very optimistic.

Total Credit Market Debt as a % of GDP

(In 1945 to 1950 were boom times, but no debt due to fact it was paid for by forced savings from war years.  Notice the angle of income has now become parabolic, always seen before collapse!)

Thus if deleveraging is going clear the system of debt it needs a more severe contraction than the Depression provided. – Note Total Debt has continued to expand not contract.  There is an ocean of Debt out there that will never be repaid.  It will at some point become impossible to service that Debt, at that point it will be renounced devaluation appears the only road to deal with it.  The question is will it be gradual or take place at once. – Chart A represents the U.S.   But this is going on a world wide basis. – It Cannot continue indefinitely.

Arthur Laffer: “Get Ready for Inflation and Higher Interest Rates”

June 11, 2009

by Will

Writing in the Wall Street Journal, Arthur Laffer, chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen”, has written what I think is a very perceptive essay on Get Ready for Inflation and Higher Interest Rates.  As one who remembers the 1970′s quite well, I think he is “on target” in this assessment:

It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.

If it could be worse than the economic situation we had during the Carter administration, I would say we certainly do not need to be taking the course we are now taking with the economy!