At the same time, government wages and benefits have dramatically increased.

Why is this significant?  Because all government payments come from taxes, which are ultimately derived from productivity in the private sector.  So as the private sector shrinks relative to the public sector, the burden on the private sector increases, and the overall stability and sustainability of the system decreases.

Of course, individuals who receive paychecks from the government pay income taxes, just as private sector employees do. So to an individual it may appear as though the distinction of government or private pay in unimportant. But that is an illusion. At the end of the day, 100% of government-based pay has to come from somewhere, and the only place it can come from is taxes. The only method the government has to increase its payroll is to increase taxes.  (Even borrowing money just means increasing taxes later.)

By contrast, private company pay comes out of private earnings. A company can increase its earnings by becoming more efficient, producing more products, producing higher-margin products, expanding into new markets, etc.  And every dollar a private company generates creates more than a dollar of value in the economy.

Why is this?  Economics 101: someone was willing to voluntarily pay that dollar for some good or service.  That means, to that individual, the good or service was worth more than the dollar, and to the manufacturer of the good or service, the dollar was worth more than the manufacturing materials and effort.  So both sides benefited from the exchange.

By contrast, virtually nobody believes they are receiving more benefit for their taxes than what they pay.  If they did, they would voluntarily pay more taxes (to increase the benefit).  You may think taxpayers should value the benefits higher, but empirically they do not.  Hence, to the taxed individual, taxation is actually a destruction of value.  (Measuring the value created through the use of the taxed revenue is difficult, and reconciling any potential value creation to the government beneficiary against the destruction of value to the taxed individual has been proven to be impossible.)

So what does this all mean?

Private wages can effectively increase forever–limited only by the creativity and toil of people in the private sector.  But government wages can only increase as a function of increased taxes, which in turn depend upon those private wages.  So when private wages decrease, and public payments increase, the system can quickly become unstable.

Economist David Henderson of the Hoover Institution at Stanford University explains it nicely:

People are paid for being rather than for producing.

Which sounds great if you’re the one being paid.  But not so much if you’re the one doing the paying.

Under this program, people will receive $3,500 to $4,500 when they trade in a car and buy a new car that gets better gas mileage than their trade-in did. That covers approximately 500,000 new cars.

If you are thinking of purchasing a new car, this may be a nice additional incentive.

Of course, the skeptic in me notes the irony that the Federal Government is working to boost demand of an industry in which it now has a major financial stake. (Where are the $500 rebates for trading in an older computer, or television, for a newer model that uses less power?)

There seems to be no end to the efforts to rescue dead business models and dying industries.

It’s a pretty ignominious accomplishment. And since the year is not yet over, and the US continues to spend, the debt is continuing to pile up. Based on current spending projections, this year’s debt is expected to hit nearly $2 Trillion by October.

How much is $2 Trillion? It’s about $6,500 per person in the US. For a family of four, that’s about $26,000 in debt accumulated this year.  That’s on top of all previous debt, as well as any consumer or household debts.

But does it really matter? It isn’t like the taxpayers will ever have to pay this debt, right?

Wrong.

The US government’s credit rating is so good it is considered “risk free” by most of the world. The people who loaned the US this money absolutely expect to be paid back. If they are not, it will rock the worldwide financial markets so strongly it will make the recent financial crisis look tame by comparison.

The only ways the US government can pay back that debt are 1) by raising taxes and / or lowering spending, or 2) by devaluing the US dollar through inflation. Higher taxes means less money to hire employees, and less money for those employees to take home and spend.  Inflation makes the dollar worth less relative to other commodities, goods, or services. But while it makes the US debt effectively smaller, it also lowers the value of everyone’s existing savings, investments, and retirement funds.

Given the politics of Washington, DC, which do you think is the more likely scenario?

Moral hazard is a the observed phenomenon whereby, because something is insured, it becomes more likely to occur.  If a bad event (e.g. breakage or theft) will cost a certain amount, then if that event is insured, it will cost a bit less.  This makes the bad event less bad–which is the point of insurance.  Unfortunately, it also means that the insured person will not work quite as hard to prevent the bad event from happening, or, in extreme cases, may even cause the bad event to occur.

A silly illustration: if a grocery store could somehow insure every dozen eggs for $1000 against breakage, “Moral Hazard” is the insurance industry’s way of recognizing that there would somehow be a lot of broken eggs.

The industry tries to adjust for this in several ways.  One is by charging different premiums to different people depending upon their beliefs about the customer’s risk.  That’s why 16 year-old boys pay more for car insurance than 45 year-old married men.  Insurers also try to make sure there are other reasons the insured would not want the event to occur.

I had occasion to visit Lloyd’s in London a while back, and I learned that there are only two types of insurance that Lloyd’s will not place.  The first is life insurance, because the purchaser is betting someone will die–and in a world of moral hazard, Lloyd’s are uncomfortable with that idea.  The second is a pure financial guarantee.  In other words, they will not make someone financially whole simply because they lost money.  They must instead insure the events that might cause them to lose the money (fire, theft, etc.).  Over hundreds of years as the world’s foremost insurance marketplace, Lloyd’s has found the moral hazard associated with pure financial guarantees to be too great.  That’s because if all that is at stake is money, and the insurance will make one financially whole, then there is no alternative reason to prevent the loss event.

Which brings us to the FDIC.

The Federal Deposit Insurance Corporation insures depositors who put money in a US bank against loss, up to a certain limit.  Another way of saying this is that they insure the banks against loss, so that the banks will be able to repay their creditors (the depositors) in the event that the bank loses money.

This is a financial guarantee.  They are not insuring against an underlying event; they are making a pure financial guarantee–the type you could not buy at Lloyd’s in London.

But it gets worse.

The FDIC charges the same premium to all participating banks regardless of their perceived risks.  Of course, the “risks” involved are basically the risks associated with the bank’s loans.  So the bank is free to make any loans it likes, and it will not see a change in premiums.

The result is that all banks face the exact same downside potential, regardless of their business decisions.

Since banking is a somewhat competitive market, banks will try to get a higher return by charging more for the loans they make.  This force moves them toward making bigger and riskier loans, where they can charge higher fees and interest.

Under ordinary market forces, this would also increase their downside potential, which would be a force reducing the risks banks take in their loan decisions.  However, with FDIC insurance, we’ve eliminated this force, leaving only the force toward making riskier loans.

The result is that banks compete against each other by making riskier and riskier loans.  They may not realize they are doing this, but that is the market they are in.

The result is a steady increase in the risk levels of bank loan portfolios.  And that can only lead to one conclusion: a collapse in the loan portfolios of many banks.  Specifically, it leads to a collapse in the portfolios of the most competitive banks.  In order to be competitive they took on the risky loans.  And because they are successfully competitive, they are also the largest banks.

Does any of this sound familiar?

Interest Rates Are Just Another Commodity

Like many products, interest rates are subject to market forces.  Banks borrow money from depositors and loan it to borrowers at a higher rate.  In order to induce depositors to give them money, the banks pay interest to the depositors.

If not enough people are saving, and lots of people want to borrow money, then the banks need to pay a higher rate of interest to savers, and are able to charge a lot of interest to the borrowers. This makes savings more attractive, and borrowing less attractive, and over time moves people away from borrowing and into saving.

Conversely, if lots of people are savings, and not many people are borrowing, then the banks don’t need to pay as much interest to savers, but will have to make their loan products more attractive to borrowers by charging less interest. This makes borrowing more attractive and saving less attractive, and over time moves people to borrow and consume rather than save.

So in a free-market interest rates automatically stabilize to an appropriate level based on the amount people are borrowing and saving.

Market Signals

This has a big effect across the marketplace: When interest rates are low, that is a signal to the market that capital is cheap, and that capital intensive projects make sense. When interest rates are high, capital is precious, and should be preserved.

By artificially raising the interest rate, society will under-capitalize projects at the expense of overall economic growth. By artificially lowering the interest rate, society will over-capitalize projects, which will feel like great growth early on, but will wreak havoc when society runs out of capital prematurely.

The Current Recession

So what does it mean when the government lowers the interest rate? Effectively the government is creating an incentive for people to borrow and consume rather than to save. This lowers the savings rate, and increases overall debt.

And that is the core of the recession (depression?) we are seeing right now. Interest rates have been held very low for a long time, causing people to borrow and spend rather than save and invest. This trend is reflected in all of the savings rate data and household debt data of the past 25 years.

So what is the monetary policy we’ve been seeing? A continued reduction in the interest rate to near zero, in an attempt to get people spending. The trouble is, we’ve run out of capital. We hit the wall on what banks could safely lend.

Under a free market, interest rates should have risen a long time ago, and should be relatively high now. After all, banks clearly need more capital, and their loans are clearly risky (thus requiring a higher interest rate to make the entire portfolio profitable).

Instead, rates are remarkably low. The Obama administration, like the Bush administration before it, is telling people to get out there and spend money, including taking on more debt if necessary.  The Obama administration’s Dr. Christina Romer was interviewed by David Gregory on Meet the Press March 15, 2009:

Mr. Gregory:  Final point here.  What is the responsible thing for consumers to do at the height of this global crisis?

Dr. Romer:  That, that’s an excellent question.  I think we know that consumers have lost a lot of wealth and that normally what you’d say is they should be saving more.  I think the truth is consumers have also not done a lot of spending for the last 14 months.  So what I would predict and I think would be a perfectly reasonable thing is you go out and you buy that car that you’ve been thinking about for 14 months and you do some of the spending.  And then over the long haul I’m hoping we’ll come back to probably a higher savings rate, because we know we were at kind of a historic low before this all happened.

But that is exactly the wrong prescription for the long-term health of the economy, or its constituents.  Spending, borrowing, and consuming are not responsible actions in an economy overburdened with debt.  And “hoping” won’t get us a higher savings rate: higher interest rates will.

Though it may seem initially painful, the truly responsible course of action is to allow interest rates to set to their market levels, allow those banks which made remarkably poor business decisions to go out of business (instead of subsidizing them as we have been), and give the market time to readjust back to a healthy level.

Despite his solid reasoning and clear articulation, many of the other panelists and hosts openly mocked and ridiculed him.

This clip demonstrates two things: 1) the predictive power of the Austrian school of economics, and 2) the profound ability of otherwise intelligence people to ignore excellent arguments and instead believe what they want to believe.

Inflation is one of the least-understood concepts in economics.  And with good reason: in the US, we haven’t seen terrible inflation for the last couple of decades, so it hasn’t been all that important.

But we’re starting to see it now.

The Silent Tax

Inflation is a tax.  But it’s the tax you never voted for.  Inflation is the result of the government creating more money, then using the excess money to pay their bills.  If the government does this a little, you don’t really notice it.  But if they do it a lot, pretty soon there’s a lot of extra money floating around.  And money is like any other commodity: if there’s more of it, it goes down in value.

Think of the creation and destruction of money as a balancing act: money gets destroyed all the time, and so it needs to be replaced with new money.  Likewise, as the population increases, money needs to be created so that there is sufficient money to go around.

The tax effect of inflation is a funny one to understand.  After all, if everyone has more money, then did anything really change?  If everyone who had $1 were suddenly given another $1 to match the first one, and this all happened at the same time, nothing really would change.  Prices would double, but everyone’s relative wealth would remain unchanged.

But that isn’t how inflation works.  What really happens is that the money is created and paid to people who work directly for the government – as employees, contractors, or whatever.  So those people have money which previously did not exist, and they can use it to buy things that they previously could not afford.  The money works its way out from the government into the marketplace.  The farther you are down that chain – i.e. the farther you are from the government – the longer it takes the extra money to reach you.  In the interim, other people are able to buy goods and services using the new money.  Its worth noting that the money also dilutes as it moves farther from the government, so the effect diminishes, and is not as obvious to see.

So in a sense, the inflationary tax is really a tax on being less dependent on the government, and farther into the marketplace.  People closer to the government are the recipients of this tax; people farther from it, the payers.

Unfortunately, the US Government has been borrowing an extraordinary amount of money from other countries.  Sooner or later, they have to pay that money back.  One way the government has dealt with it in the past is to simply borrow yet more money, and use the new debt to pay off the old.  And this actually works, as long as the population of taxpayers is increasing at about the same rate as the acquisition of new debt.

The Baby Boomers

But now we have a problem, and it relates in part to the Baby Boomers.

You see, we’ve been increasing our debt level faster than the typical growth of new taxpayers.  The Baby Boomers represent a huge population bubble.  So as the Baby Boomers retire and start to draw money out of the system through social security, medicare, and other social services, they aren’t being replaced by new taxpayers fast enough to keep the system afloat.  This means either a dramatic reduction in social services for the Baby Boomers, or, more likely, a dramatic increase in borrowing to finance the Baby Boomers’ lifestyles.

And unfortunately, a dramatic increase in debt, on a per-taxpayer basis, is unsustainable.

One way to reduce that debt is to pay it using newly created money.  The US Government prints more money, uses it to pay down the debt, and voila!  Debt paid off!

But that means there’s more money floating around, and that means inflation.

Prices Adjust for Other Reasons, Too

Unfortunately, many people mistakenly think that rising prices are automatically inflation.  They are not. Prices fluctuate all the time – particularly prices of commodities such as oil, rice, corn, and copper.  A bad weather cycle can reduce crops, raising prices of certain food groups.  That is not inflation, that is simply the market working to adjust supply and demand.  Likewise, political, environmental, and technological factors can cause a rise or fall in energy prices, which in turn affect the prices of many other goods and services.  But that is also not inflation; it is the market setting prices to do what markets do best: namely, allocating scarce resources to the most valuable purpose.

Signs

Here as some signposts we might expect to see if inflation is coming:

• A significant rise in core commodity prices across the board that cannot be tracked back to a single set of issues.
• An decrease in value of the US Dollar relative to other world currencies.
• An increase in salaries and wages, particularly when coupled with a falling dollar.
• A continual “redefining” of inflation to eliminate items whose prices are rising most dramatically (in an effort to reduce the visibility of inflation).
• A continual “redefining” of the money supply to make it look like it isn’t increasing faster than the population.

Sometime in the future we’ll compare the official US government inflation rates with some calculations by an independent organization.