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Government Safety Nets Are Made With Fiat Money

Gary North
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Reality Check (Nov. 20, 2012)

For every dollar of increased debt in the American economy, the gross domestic product rises by about 8 cents. From 1947 to 1952, GDP rose by over $4.60 for every increased dollar of debt, both public and private. From 1953 to 1984, it dropped to about 63 cents. From 1985 to 2000, it dropped to 24 cents. So, it is clear that we have reached the point of diminishing returns, or we are very close to it. The massive increase in total debt that is required to make even a marginal increase in GDP is now too high for the government or private agencies to get any bang for their bucks.

Nevertheless, the increase in debt at the federal level continues to escalate. Even though there will be no payoff in terms of rising productivity, and in fact will probably be a decrease in productivity, each $1 trillion increase in federal debt is accepted almost without debate by Congress. Congress has no idea of what the increased debt is doing to the private sector. Every dollar that goes to the federal government is a dollar that did not go to increase the nation's capital base. We are starving the private sector's capital markets, and this is unlikely to change in the next fiscal year.

We are facing an international economic slowdown at the same time we are seeing central banks increase their purchases of government debt. There is a symbiotic relationship between the governments, by which I mean national civil governments, and their central banks. The governments continue to run massive deficits, and increasingly the central banks are moving into the market, buying up the debt with newly created money. Investors are buying a decreasing percentage of government IOUs. Excess reserves by the banks are high, which means that they are not lending to the general population. Economic growth is therefore slowing.


In a recent article by multimillionaire hedge fund investor Kyle Bass, we learn that total global credit has grown by about 10% per annum over the last decade, which is contrasted with global population, which has grown in about 1.2% per annum. Global real GDP has grown by about 4%, but most of this growth has taken place in China and the underdeveloped world. It has not taken place in the Western industrial nations.

Over the last 10 years, central banks around the world have increased their monetary bases by at least $10 trillion worth of currencies. The total was about $3 trillion 10 years ago; the total is about $13 trillion today. This is a massive increase of what used to be called high-powered money. It is no longer high-powered money, because commercial banks are increasing their holdings of excess reserves at the central banks, rather than lending the newly created money into circulation. If they had lent the money into circulation, we would be experiencing price increases of something in the range of 50% or more per annum.

Central banks have become the primary purchasers of new national government debt. The private sector is no longer gobbling up all the debt which the government sector produces. The national governments are dependent upon their central banks to buy their IOUs with newly counterfeited money. The central banks now serve as lenders of last resort. This was always the official justification for central banking. This was the story which the central bankers gave to the national governments. Of course, the real purpose of central banks is to protect the largest commercial banks. It is the enforcing arm of the banking cartel. But that was never what the promoters of central banks told the politicians who were asked to vote for the creation of a central bank monopoly in each country.

You have probably heard the following. From the first year of the United States, which began in 1789, until 1981, the total increase of debt by the federal government was about $1 trillion. Of course, a good chunk of this was from monetary inflation, especially in World War II and then again in the 1970s. From 1981 until 2001, the government added an additional $4.8 trillion. Over the last 10 years, from 2001 to 2011, the debt increased by almost $10 trillion. It is now increasing by $1 trillion a year. I'm speaking here of on-budget debt, not the real debt, which is the present value of the unfunded liabilities of the United States government.


I think it is clear that we have gone way beyond the point of no return. There is no possibility that the federal government will be able to repay these debts, let alone meet the responsibilities of Social Security, Medicare, and Medicaid. It is statistically impossible.

Nevertheless, Congress ignores this, and continues to run massive deficits. The financial media have ignored this with respect to the unfunded liabilities of the federal government. The financial media argue that the on-budget deficits can be taken care of by economic growth. We will somehow grow our way to such an extent that will be able to meet the interest payments without suffering reductions in capital investment.

There is no thought in any place of influence that the federal government should ever repay all of its debt. It did that in 1837; it never did that again. The assumption is that the government needs to have a large debt, and that this is good for the economy. The economic system needs a constant increase of working capital. But working capital exists only in the private sector. Increases in the federal deficit do not fund additional output. On the contrary, they restrict output, because the money that is used to buy the government's IOUs cannot be used to make capital investments.

This being the case, we are now in a situation in which the system of ever-increasing federal deficits are demanded in order to keep the overall economy stimulated. It is funded by means of increased counterfeit money issued by the Federal Reserve. The Federal Reserve keeps creating money, and it uses the money to buy federal debt. The debt gets larger, but productivity does not increase. We cannot grow our way out of the escalating debt, because the rate of growth in the overall economy is not sufficient to fund each additional dollar of debt.

We have therefore entered the phase sometimes called "Banana Republic." The federal government borrows the money that it needs to make interest payments on the debt. So, the debt keeps getting larger.

Keynesian economics always has argued that this increased government debt will lead to increases of national productivity. The whole idea behind the Keynesian redistribution of wealth is that this government-spent money would not have been used for productive purposes, but now that the government has access to it, the government will dutifully spend, and the spending will jolt the economy into another round of expansion.

We see that the deficits since 2008 have been above $1 trillion a year, but the recovery is anemic. The next fiscal year may bring a recession. This is what has taken place in both Japan and Europe. We seem to be heading in that direction.

Meanwhile, as investors seek safety, and therefore invest in fixed-income IOUs, interest rates have dropped to their lowest level in the postwar period. As a result, pension funds are no longer able to make sufficient gains on their investments to meet the actuarial responsibilities of paying off buyers of annuities in the future. They will not begin in the future, because the pension funds and the insurance company are making such low rates of return, that all of their assumptions regarding their possession of sufficient assets to sell in the market in order to fund their retirements of the policyholders have been smashed.


What seems astounding to me is that there is no sense of concern in Congress, and no sense of concern among the electorate. People assume that the government can solve all these problems, including the problems which the government has created. The voters assume that with sufficient creation of new money, the government can borrow whatever it needs essentially for free, and nobody will be hurt as a result. While it is true that pension fund investors and annuity buyers will be hurt, people think only of themselves as taxpayers in the present. They rarely think of themselves as recipients of payments in the future, which means payments that are based on the productivity of capital. There is no such capital, so there will be no such payments.

Pension fund investors have shrugged this off, and they refuse to face the implications of what stagnant pension fund income implies for their futures. They keep investing money on the assumption that there will be a positive rate of return, but there is no positive rate of return. The S&P 500 is lower today than it was in 2000. Interest rates are down to the lowest level in modern history. So, those pension fund assets are not increasing, and therefore there will be unemployed people who get only a fraction of what they expected when they finally retire.

For Congress to keep spending on the assumption, which is taught by Keynesians, that increased government debt produces increased economic output, is to pursue what is obviously a naïve myth. It assumes that investors can get back a return that will be far more than the increase in productivity supplied by the recipients of federal government welfare programs.

Congress is blind. This is understandable. Congress has always been blind. But voters are also blind. They keep electing people to Congress who are as blind as they are. There is no sense of concern, let alone any sense of outrage. The governments have promised future returns that they cannot possibly meet. Each year, the federal government runs up a bill of another trillion dollars on the on-budget budget. This is visible to anyone who reads the papers, or watches evening television, but nobody seems to care. There is no sense of the implacable nature of economic cause and economic effect. There is no sense of impending disaster as a result of rising indebtedness and falling economic output. The existence of a recession is always swept under the rug. The assumption is that the federal government, by means of an appeal to the central bank, will be able to fund the lifestyles of unemployed seniors for the rest of their lives.

The numbers do not register on the thinking of the vast majority of Americans. Americans have become accustomed to the government propaganda that tells them the government can intervene and solve any major economic problem. Governments have done this often enough, so the problems keep getting larger.

The government bureaucrats who make the allocation decisions are becoming increasingly confused about cause and effect in the economy. They allocate the borrowed money, but the economy keeps getting worse. This is especially true in Europe, but it is also taking place in Japan and the United States. Keynesian economics says that the economy must be getting better, because the deficit spending is so enormous. But the larger the deficit spending gaps, the more reduced the payoff of economic growth is in the overall economy. We now appear to be going into recession, despite the fact that the government is running deficits of over $1 trillion a year. This was not supposed to have happened, but it has happened.

I am in full agreement with Kyle Bass.

Very few participants are aware of the enormity and severity of the problems the developed world faces. Those that are aware are frantically trying to come up with the next solution to the debt problems. In our opinion (which hasn't changed since 2008), the only long-term solution is to continue to expand program after program until the only path left is a full restructuring (read: default) of most sovereign debts of the developed nations of the world. . . .

What has happened to people's economic understanding? They have been subjected, as their parents were subjected, to a barrage of optimism issued by Keynesian economists. These economists tell voters that there are no long-term problems, and that the government is capable of solving most of these problems. There is no sense of urgency, because there is widespread agreement that the government can and will intervene successfully in order to put a stop to any economic event that might prove to be a kind of seismic trigger.

This enormous optimism keeps people from taking steps to protect themselves. But Bass does not think this optimism will last another decade. Then the credit markets will find that the smart money was stupid, just as it was stupid when it poured money into the Mediterranean nations of Europe. Next time, the rich people who made these bad investments will come looking for help, but there will be no agency left to help them. The capital has been dissipated as a result of Keynesian economic policies.


A majority of investors and voters believe that the bailouts can and will offset any economic crises that may come down the pike. They assume that the power of government, when sustained by the expansion of the money supply by the central bank, is capable of offsetting the economic effects of prior economic policies. This is the economics of power, in contrast to the economics of cause-and-effect. It assumes that raw power can overcome bad investment decisions.

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