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After Black Friday,1929, the United States was the most powerful nation in the world; a newly opened agricultural giant, a mining titan, and an industrial powerhouse with hard-working, well-educated people flooding in from the countryside, clamoring for work. New railways ran passenger trains over 70mph, while electricity, telephone and radio swept into the remotest corners of the nation, allowing efficiencies formerly only dreamed of. –And GDP had fallen 25% while industrial production was cut in half. Why was this? Tune in for part 2 of the special Sinkhole Street edition: of “Island Economics” When we last left our Castaways they had created a cooperation-o-meter called a “Palmie”: a more efficient system of barter that let everyone promise to do work in the future, write the amount in a Ledger held by Mr. Howell, and receive a Palm Promise as a token which they could easily trade among themselves. (The Great Sinkhole Part 1) This worked wonderfully until the Islanders began to realize that there were too many promises: the Ledger had gotten divorced from the underlying reality and needed to be re-calibrated. As the recalibration would have reduced the newfound wealth and power of Mr. and Mrs. Howell, they took The Ledger and fled to Hobnob Greens golf course. The “Book Crisis” led to a “Book Holiday” where they were no longer issuing Promises except to Ultra-Prime Promisers, and then only on expensive terms. With no one Promising anymore, cooperation was brought to a standstill and the Island threatened to fall into a “Great Sinkhole”, what non-Island areas call a “Recession” or even a “Depression.” Let's see how they're doing: When Mr. Howell first realized the books were in trouble, he didn't think much of it. The Ledger was still balancing, the Work was still being done, bonuses were still being paid; what could be the problem? He and Mrs. Howell issued platitudes about how The Ledger was “robust”, employment was high, and that industrial capacity on the Island had never been stronger. However, the other Islanders were unconvinced and kept knocking on the door at inconvenient hours demanding they do something. Since August when “The Book Crisis” began, GDP had fallen sharply, unemployment hours had risen, and issuance of Promises was shrinking fast--with all trends accelerating. The Islanders weren't working nearly as hard, if at all anymore. Worse, with fewer Palmies being paid in the slowdown, interest on The Ledger wasn't being paid to the Howells. Some Islanders had defaulted on sizable Promises, and although there were 11 month's supply of huts on the Island, the Islanders had stopped building altogether and just sat around living in them! Something needed to be done. The problem, it seemed, was too few Palmies. Like the ECB on December 19, Mr. Howell simply offered 500 Billion Palm Promises to the Islanders and went back to bed.(1) This Central Banking stuff was easy. However, the Islanders refused to sign The Ledger and promise themselves 500 Billion times. For some reason they thought that 17 years was long enough to promise themselves. With production of coconuts falling due to the slowdown, even the existing Promises looked like they might take 40 years to be fulfilled, not 17. This is similar to the present P/E ratio of the S&P 500, which if measured on real earnings—which are falling sharply—is trending up from recent lows of 17 back toward the highs of over 40 in 2000.(2) That is to say, at present rates it will take over 17 years of hard work and consistent earnings to equal the present value of the stocks. --That's a lot of promises. Noticing that things aren't as easy as they used to be, the Island Confidence number fell almost 10 points in January to 56.3.(3) And as the Islanders grow less confident, they are beginning to retire old Promises faster than they're making new ones. Some—not getting enough in return for their labor—have failed to keep their Promises altogether, similar to the 30%-and-rising default rates on credit cards, or the 990,000 houses presently in foreclosure.(4) Remember what Palmies are: they are a Promise to work. Once the Promise--the Debt--has been either repaid or repudiated, a Palmie vanishes. If Promises stop being issued, then as the normal monthly debts are retired, the number of outstanding Promises on the Island will gradually fall. Already expansion rates are approaching zero--the very edge of the Great Sinkhole--just as the cash in our system, as measured by M1, or M',(5) is shrinking, even though Mr. Howell has been writing up new promise vouchers by the billions or even trillions, as seen in M3. These promise vouchers are no longer getting out of his hut and into the economy. Promises now risk being extinguished faster than they are being created because the Islanders no longer feel confident in anyone's ability to make good on them. Isn't that is what started the problem in the first place? MaryAnn began to ask how she could make such huge promises on such a small Hut, so far in the future. No one has answered that question. Uh oh. Mrs. Howell jumps into action: if they don't act fast, Mr. and Mrs. Howell will be voted out of their position as keepers of The Ledger. She decides the problem is that all the Palmies are stuck with the Howells and not getting to the other Islanders. As part of her campaign, she begins to hand out new Promises and redistributes the Promises they already have. To help distribute things equally and make it more fair, she takes the economy in hand: she takes the job of fishing away from the Skipper and gives it to the Professor. Then she takes inventing away from the Professor and gives it to Gilligan. Gilligan stops collecting coconuts whose job is taken by the Skipper. Hairdressing is taken from Ginger and given to MaryAnn. Now that all the goods have been distributed fairly, the economy can work again. Right? But GDP still falls. Although well-intentioned, Mrs. Howell doesn't know anything about real work. Not only is Gilligan a poor inventor and the Professor's talents are wasted in fishing, but a lot is broken and lost in the shuffle. This is the effect of governmental interference and over-regulation, along with the inevitable inefficiency of redistribution. For example, in the US Welfare dept, more than half the budget is consumed by administration! Nevertheless, the good-natured Islanders are willing to keep trying, as she is so insistent it will solve their problems. As the election is still coming and the re-distribution went so poorly, Mrs. Howell tries again. Although his talents are under-used, the Professor has figured out how to catch more fish. Mrs. Howell also sees that the Skipper is collecting plenty of coconuts while the rest of the island is suffering. She creates a new program called “the Tix” and makes a Tick-mark whenever something is grown, built, or thought of. She levies a 39.6% “Income Tix” and—after taking half for herself--redistributes the remaining Tix to the other Islanders, thus making everyone rich. This is progressive taxation and income redistribution via social programs. Problem solved. However, the Professor and the Skipper for some reason are not enthusiastic about this plan of a 39.6% Top Marginal Tix Rate. They stop fishing and collecting coconuts spend their time lounging around the empty huts with Ginger and MaryAnn instead. Between the redistribution and the percentage given to Mrs. Howell, now less is produced AND less is delivered. Fewer goods are available and everyone is worse than before. GDP continues to fall. Mrs. Howell decides that since unemployment is now rising, they must need more jobs. She proposes an Office of Universal Health, and although they have but one Professor to provide the care, she doesn't undertake to train more, but enlists Ginger and MaryAnn to be administrators—if anyone needs to see the Professor, they will write their names down in triplicate and give a copy to Mrs. Howell so she always knows what's going on. In this way, everyone is employed. Genius! Although the Islanders are in favor of visiting the Professor when they need to, for some reason they are not in favor of Mrs. Howell's new make-work program. If only they would cooperate and do as they're told Mrs. Howell is sure everything would be perfect! After all, this can't be the Howell's fault—everything was going fine until MaryAnn started asking questions. Mr. Howell steps back in. If the problem is too few Palmies, then Mr. Howell doesn't have to just offer Promises for people to accept, he will simply create new Promises out of thin air and distribute them himself. On one Palm he writes “Good for a free visit to the Professor” and on another he writes, “Good for a free haircut,” on a third he writes, “Worth 100 coconuts.” After writing 800 new Promises for each Islander, he dumps them in the street. This is called “monetization”. It was the basis of Bernanke's famous “helicopter” speech of 2002 (5), and was suggested again with this Friday's $800 tax-rebate. Free Coconuts? Now here's a plan everyone can get behind. The Islanders happily scoop up the new Promises and go to redeem them. Except for one problem: there is still only one Professor to visit and there is still only one Ginger to give haircuts. There are still only 100 coconut trees and still only one beach with one Skipper as its fisherman. Although the Palmie says that it's worth 100 coconuts, quickly you need vouchers for 200 paper coconuts to get 100 real ones. This is known as Inflation: too much money chasing too few goods; or rather, more money chasing the same old goods. Although lagging and inconsistent, prices eventually increase in direct proportion to the new money—the new promises—that are issued. What is the problem? Why are none of these plans working? Why have people lost faith in The Ledger and now even the Palmies? The answer is simple: too much consumption and not enough production. Too many promises and not enough means to deliver them. Too many entries on the books and not enough real goods to convert those paper entries into usable items like food, energy, and health care. It doesn't matter if it's a credit crisis in credit, in the currency, or in the long-term cost of Social Security, the problem is the same: too much promised consumption without any means to provide it. This is what Greenspan meant when he said, "I fear that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver.” (7) Put another way, Mr. Howell's ledger says there are a million-billion coconuts on the Island. A quick look in the all-season coconut storage hut shows there are only 100. We also know there are only 100 trees producing 10 coconuts per year. In short, you cannot eat the “coconuts” on Mr. Howell's ledger. They are an accounting entry, a fantasy—they don't exist. But no one KNOWS that they don't exist until they try to cash them out and convert them back into the world of real commodities. The Islanders don't believe in The Ledger and the Palm Promises because they know that there are already more promises than can be fulfilled, and in our system as well as theirs, Promises—i.e. debt vouchers—are money. The Islanders won't promise more because they're finding it hard to deliver what they've promised already(8):
Therefore, people aren't going to Mr. Howell to sign up for more debt, to have more Palmies issued. Mr. Howell is sitting on billions in potential promises that no one will sign for and millions more in Ledger Promises that--like the 990,000 foreclosures—are vanishing as people fail on them. Promises that can't be converted; promises, frankly, that aren't REAL. They are estimations based on assumptions that could never reasonably happen. In short, they are lies. And The Ledger has been expanding for decades at the quantifiable speed of lies, that is to say, the inflation rate. The only way to make the Promises deliverable is to reduce the number of promises, increase the ability to deliver on them, or both. This is why it was never possible to solve the Social Security shortfall. If 10,000 retirees order pizza and there is only the capacity to deliver 5,000, the price of pizza will rise until 5,000 people go hungry. It doesn't matter if that price is half of today's price or 100 times higher—there are still only 5,000 pizzas. The same with every other commodity. If you want more of it, you must not invest in money or in savings regardless of the vehicle, but instead in production, in equipment that creates something. This is the error: Money is not Wealth. Production is. “Money” is only a marker, a token, a Promise. “Wealth” is the real thing. When the problem is too much Money and not enough Wealth, too much consumption and not enough production, will increasing the number of Promises on The Ledger, or promising more goods help? No. Will taking the existing promises and shuffling them between holders, on/off book, between Super-SIVs, between banks, between citizens, or even between countries help? No. Will it help for a well-meaning busybody to shuffle the same productive equipment from place to place? No. Will taxing the people who know how to use the productive capacity (usually called the “rich”) and giving it to people who have little experience with how to use it (usually called the “poor”), help get more promises delivered? No. Will it help to take the finished products away from those who work to produce them and give it to people who did not work to produce them? Will this create more goods or reduce the surplus in promises? No. A Deflation occurs when a previous boom has caused people to over-estimate, to over-value what they own. Numerically, asset prices are too high—higher than can be sustained if there is a change in expectations. The prices of things need to be marked down. Down? Why Down? Because there are only two ways to make the books, the record of production, match the reality of production: one is for decades of intensive labor to slowly increase the ability to produce until reality finally supports the accounting fantasy; or second, to pencil smaller numbers in the lines of a book, which takes mere months of price-discovery. You can keep the values on the books high, but it will take 18 years of Recession—and counting—as in Japan; or 10 years of acute hardship and even starvation, as in the US in 1929-39. If you mark the books back to reality and tell the truth instead, the adjustment can be as short as the now-forgotten Panic of 1907, or the Argentine Peso Crisis of 2001 which lasted only 3 tumultuous years. But why have a crisis at all? Why not avoid it altogether? I'm happy to say that you can. All you need to do is tell no lies and keep the books and the reality tightly together, as happens automatically under a commodity standard and a free market. If you don't; and if the monetary standard is left to men, then: "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises When will people have economic confidence again? When will they have faith in The Ledger? Only when they feel The Ledger again represents financial reality, and not before. So far no one has addressed this issue of one's freedom to create and trade without interference and punishment; of taking personal responsibility for one's own bad decisions and of punishing fraud; of true accounting transparency; or of marking the books back to economic reality. Until they do, you can expect the crisis of August 2007 to continue on, for 18 years and far longer if necessary. This is why revered economist Anna Schwartz recently said: "They [The Fed] need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence.”(9) Will the Islanders come clean with the books and tell the truth so they can get back to work? Or will they spiral into the Great Sinkhole of recriminations, escalating control, and rolling confiscations? Tune in next time for another exciting episode of “Island Economics”. References:
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In
1928, the United States was the most powerful nation in the world; a
newly opened agricultural giant, a mining titan, and an industrial
powerhouse with hard-working, well-educated people flooding in from the
countryside, clamoring for work. New railways ran passenger trains over
70mph, while electricity, telephone and radio swept into the remotest
corners of the nation, allowing efficiencies formerly only dreamed
of. 
