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.

This is the growth of the Monetary Base, as reported by the Federal Reserve Bank of St. Louis. As you can see, the money supply has grown steadily over the years. But in the past 18 months it has more than doubled.

What are the implications of this?

www.nytimes.com/interactive/2009/07/02/business/economy/20090705-cycles-graphic.html

This graphs plots the relative amount of industrial output against the change in industrial output over a running 6-month period. As you move through the 9 images, you can see how various recessions have progressed.

It’s a neat visual, and shows some interesting patterns, but doesn’t provide much fundamental insight.

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?

Customers who refused to send copies of their personal tax returns to American Express have had their accounts closed with prejudice.  They lose any reward points they may have accumulated, are required to immediately pay off the balance of any revolving credit, and have a negative report sent to the credit rating agencies, which results in a drop in their credit score.  If they fail to immediately pay off the revolving credit in full, they are sent to collections and face additional penalties.

“Do You Know Me?”

In many cases, these demands have been sent to cardmembers of more than 20 years, who have never missed a payment, or carried excessive balances.  These are not delinquent cardholders.  They are ordinary people with accounts in good standing who were simply customers of the wrong company.

For years Amex held out that it was not a bank, and so it was not subject to the same regulation as ordinary banks.  This allowed them to offer financial services (including credit cards and investment products) which would not ordinarily be possible at a bank, and without the unpleasant government oversight.  However, when the banks were being bailed out, Amex changed their tune and applied to become a bank, in order to get bailout money.

It’s pretty reasonable for Amex to want to reduce their risks.

But it is also reasonable for consumers to want to reduce their own risks.  And choosing a vendor who may suddenly make unreasonable demands under threat is a risk many people may not want to take.

You have a choice of what company to use for credit services.  Choose wisely.  Choose someone else.

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.

But what happens when you get hit with two recessions back-to-back when you are starting a family, just buying your first house, and just beginning to build a career?  You can only reduce expenses so much, especially with kids.  And you don’t have much cushion.

Here’s an interesting little bit about the effect of the current and past recession on Generation X (born 1961 – 1981).

www.msnbc.msn.com/id/29497408/

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.