Economic Stress Report

We've just gathered sufficient data to provide an update on the Economic Stress Report we introduced last month. According to our analysis method, the following States are on our watch list. We present them here in order of highest to lowest severity:

South Dakota
Ohio
Kansas
Arizona
Washington
New York
Maryland
Florida
Alabama
Connecticut

Of those States on our watch list, the following have suffered bank closures - another sign of economic stress - since December 2007:

South Dakota (1 closure)
Kansas (3 closures)
Washington (2 closures)
Maryland (1 closures)
Florida (5 closures)

With this information, we've updated our predictions from our last post:

One: the list has seen some reshuffling since our last post, but the star of the show is still South Dakota. We take this opportunity to do our happy victory dance: the State, as we predicted it would, recently suffered its first bank closure of the 2007 Depression. However, we strongly suspect that many, many more closures are in store for the State. When that will happen is anyone's guess, but we can't think of one good reason why South Dakota won't be seriously hit by both bank closures and general economic distress. Using Florida as the benchmark, South Dakota should have seen around twenty bank closures already.

Two: we still expect that Maryland is going to be hit hard by both unemployment and bank closures. Again using Florida as a benchmark, Maryland should have experienced about five bank closures. Considering the State's mere placement on our analysis, we would be very surprised indeed if at least something bad doesn't happen. The safety net of Government spending can only last so long; when both the Federal and State Governments are finally forced to curtail their spending, Maryland is going down hard and fast.

It seems we might be able to provide updates approximately monthly, but the duration might be longer or shorter, depending on how our data accumulation progresses.

World Bank Forecasts Contraction

The World Bank has predicted that the world economy will contract by 2.9% this year. Although we suspect the Bank is being overly optimistic, it is good that some institution of repute, such as the World Bank, is talking about the ongoing contraction of the world's economy. People of the world need to get message that times, they are a'changing.

The 2.9%, as we mentioned, is ridiculously low. To back up our assertion, we present an interesting tidbit buried in the Bank's release: the stunning collapse in private capital investment. According to the Bank's press release, private capital has dropped "from $707 billion in 2008 to an anticipated $363 billion in 2009." That is, a drop of over 51%.

Our observation is this: if indeed private investment has dropped by 51% worldwide, we have serious doubts that the world economy is going to drop by only 2.9% this year. In fact, we suspect that the actual drop will be closer to 29% than 2.9%. Although investment drops faster than an economy - as there is legacy capital economies can burn through - the collapse of new capital will make itself felt.

One could argue that world Governments will move to pick up the slack, as it were, but we think not. Governments are not nimble; they cannot react as quickly to economic conditions as can private investors. At the end of the day, more investors will have jumped ship - taking their money with them - than Governments can replace with fresh capital. The end result will be a much greater economic contraction... we expect it will be both shocking and demoralising to many in the world who pinned their hopes on the fabled "green shoots."

Expanding Government, Declining Economy

USA Today reports "Benefit Spending Soars to a New High". 'Benefits' being the euphemism for 'Welfare', now that there is no shame in being on the dole. In any case, state and federal welfare payments are now one-sixth of Americans' income.

As the Depression grinds on, there will be considerable pressure from all sides to maintain and expand 'benefits'. These 'benefits' will have to come out of taxpayer pockets, one way or another. Since visible taxes will probably not be raised enough to cover the swollen 'benefit' roles, there will be some of that hidden tax coming down the pike - inflation.

Redistributing income, up to a point, may have some merits. But if the productive elements of society - most of whom are having a fairly rough time of it lately, too - are overburdened with increasing taxes, there will be further decline in economic activity.

As we have discussed repeatedly before, there is a range of government spending in an economy which is optimal, and spending below or above that range is destructive. At present, government spending at all levels (according to the helpful folks at usgovernmentspending.com) is a 45.2% share of the economy as a whole. This is up from a 37% share in the last fiscal year.

The rate of increase in the share is a whopping 22%! If the share were to increase at that rate for just another two years, the USA would end up two thirds of its economy (mis)managed by the State - a comparable level to Eastern Europe in the Soviet era. And probably with similar results.

Of course, the Nation's leaders are emphatically stating that since recovery is around the corner, there will be no need for further increases. We beg to disagree on the recovery part. Recovery is not around the corner. Whatever spin may be being put on 'the numbers' - they are in fact truly terrible.

In the face of Great Depression II, Mr. Obama's administration will not be able to resist expanding 'benefits', as well as bailing out and nationalising banks, insurance companies, car makers, airlines, airplane makers, and God-only-knows who else.

We believe, with some confidence, the deeper Uncle Sam dives into the economy, the worse the economy will perform. Since the leadership seems infected with some sort of intervention mania, we also anticipate that the lack of recovery will promote ever-larger bailout and 'recovery' schemes. These in turn will hurt the economy even more. We can't anticipate how long these destructive cycles will continue, but probably long enough to turn the USA into a dramatically poorer nation.

Punishment by Debt-Based Money

Debt-backed money evolved to facilitate economic growth in response to the braking effect of precious metal money and its inherently inelastic supply. Unfortunately during a depression, debt-backed money is destroyed as old loans are paid off or defaulted upon and new ones do not take their place, and thus can be even more restrictive to economic activity than precious metal money which is not destroyed. National Governments' and Central Banks' current furious pace of borrowing is an effort to replace private debts with public ones and keep the money supply from shrinking.

Will this public debt binge work? Only if the expanding public sector can engender sustainable growth. As we suggested in previous posts, there is a range of optimum government spending above which is too much, and below which is too little. Another factor is the quality of that spending. Government spending can be considered to be quality when it provides services that are actually useful (for example electric power) in contradistinction to wastes of resources (such as luggage inspection).

Yet another factor is whether any further consistent economic growth is possible at all. If it is not, and there are many reasons it may not be, then having debt-based money will be especially ruinous. Debt is a magnifier of both profits and losses. Now that humanity finds itself on the right-hand side of Peak Just-About-Everything, private debts are increasingly being realised to be more untenable than previously imagined, and servicing public debt will exact an increasingly heavy toll on an chronically shrinking economy. This toll will likely exceed the imagined benefit of maintaining the debt-based money supply.

Raising Taxes in a Depression

President Obama, in his budget proposal, aims to raise income taxes in 2011. Leaving aside all issues of whether taxes are a productive use of the people's money, there is the question of the consequence of raising taxes in a Depression.

In the US, the last time this was tried was 1931. The federal government at the time was running a huge deficit due to collapsing tax revenue, and there was a universal political consensus at the time, that budgets must be balanced. Spending was cut in some areas. The States, however, were desperately short of funds and received expensive bailouts from the federal government that caused overall expenditures to rise. The solution seen at the time was to raise taxes.

The consequences of that, as every student of history knows, were devastating. Mr. Hoover, the president at the time, became so unpopular that shanty towns springing up were named "Hoovervilles," and newspapers were called "Hoover blankets."

We are not fond of government deficit spending, and would prefer to see fewer bailouts. However, to raise taxes to fund bailouts - taking dwindling funds from the productive population and giving it to the spendthrift elements, is just about the worst thing that could be done in this environment. We are not optimistic about the wisdom of the Congress, and it seems history is doomed to repeat.

Sovietisation Revisited

A recent article in The Sunday Times (UK) discusses creeping dependency on the public sector. In previous posts we have discussed the problem of government spending in a declining economy, and the concern that government's share of the economy may go past the optimum.

It is clear that, at least in large parts of the U.K., things have probably gone well past the optimum. In Northern Ireland, for example, the state controls 77.6% of spending. We are reluctant to 'push the red', but it is looking like the U.K. is heading for economic collapse along the lines of the Soviet Bloc in the late 1980s and early 1990s.

Economies can only function properly if there are many decision makers. If economic decisions are concentrated in the hands of the state, inefficiencies are too great for the system to gainfully employ the population. One need only to look at the history of the Soviet Union to see the failure of that direction.

If these were saner and more rational times, perhaps Britain's demise could serve as a warning beacon to nations contemplating expanding their public sectors. Unfortunately, the siren song of 'stimulus, stimulus, stimulus' sounds too loudly in the ears of the citizenry.

Keynesianism Can't Save the Economy

As TIME magazine has noted, "we are all Keynesians"... again. Mr. Keynes has certainly made quite the comeback from the graveyard, and his reanimated fingers are slipping back into the modern economic pie. This is taken as a 'good thing,' a point which we won't belabour. However, if the shuffling zombie of Mr. Keynes were able to take stock of his economic surroundings, he might notice things are a little different now, than in the 1930's.

In 1930, according to usgovernmentspending.com, the United States government's direct spending was 13.22% of the national economy, up from 11.29% the year before. By 1939, at the bottom of the 1929 Depression, government spending was 20.66% of GDP. Not a whole lot by today's standards, as 2008 saw direct spending of 36.59% (guesstimated on the site), but about double the percentage of 1929. Doubling government spending was indeed a shock at the time.

As a vignette of Mr. Keynes makes clear, shock value was very important to him. He was all-around an economic shock jock, as his disciple Paul Krugman puts plainly. Shock is what makes Keynesianism work: the shock of a sudden expansion of government spending in the private economy.

We seem to remember a quote from President-elect Obama (although we cannot remember the source) stating that whatever Mr. Krugman wants, Mr. Krugman will get. He's the Nobel laureate, after all... and he's screaming, "spend!"

Right now, though, the so-called 'economy' of the United States is already about 40% government spending. The "jump-start" effect that Keynesianism looks for may require a doubling of government spending in an economy. At the same time, the United States economy is shrinking rapidly... so the end result of a proper Keynesian shock could leave the U.S. government as 100% of the economy, give or take.

Does this new Congress, or the President-elect, or both, have the political will to turn this country into a new Soviet Union? We truly do not know, but if the economy became the government's, the United States would be as Red as Red could be.

The Impact of Government in a Shrinking Economy

Volumes have been written on the effect of government spending on economic growth. Observers of nearly all political persuasions (anarchists and totalitarian communists aside), believe there is an optimum point of government involvement in an economy. An economist by the name of Richard Rahn came up with his eponymous curve which attempts to use empirical data to plot growth rates in GDP versus government spending as a share of GDP. Unfortunately, Mr. Rahn's methodology's scientific efficacy is debatable, but it is intuitively obvious that there must be some point of optimum (if it isn't intuitively obvious consider this: in a state where there is virtually no government spending, economies collapse as crime and piracy run rampant - e.g. Somalia; and when government makes virtually all the economic decisions you end up with another kind of failed economy - e.g. the Soviet Union).

All other things being equal, the spending of governments would tend to fall along with the economy in the 2007 Depression. As income declines, so do tax receipts. States of the USA have to balance their budgets (more or less) and so must cut spending to match the decline of taxes. The US Federal Government (along with most other national governments) has no such restraints, and much is being made at present of how much deficit spending to make to 'help' the economy. Could too much government spending go past the point of 'help' and into 'hurt'? How much of the economy can be in the government's hands without collapse setting in?

The EU government spending as a percent of of GDP has tended around 50%, while by comparison, the USA has tended around 40%. If the OECD economies contract by 50% and government spending does not shrink along with it, the percentages will rise to 100% and 80% respectively. Obviously, this is well past the optimum.

At some point into the 2007 Depression, governments will likely be forced to shrink. This will not be a matter of libertarianism, but of practical economics. Painful choices will be made, some of them critical. Health care, education, national defense, police, fire departments, food stamps, pensions? Where will the axe fall?