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Krugman's War Cry Won't Avert Depression

By: Michael Pento | Tuesday, August 16, 2011

Paul Krugman sounded the war cry this Sunday on Fareed Zakaria's program Global Public Square. After all, he asserted, only spending equivalent to another World War could lead us back to prosperity. That, and a healthy dose of inflation.

Krugman argued that inflation would address our debt problem by reducing our bill in current dollar terms and that the Second World War was a giant stimulus plan that actually worked. Thankfully, he added the refrain, "Hopefully we don't need a world war to get there," but I sensed a tinge of regret in his voice. After all, the Keynesian economist's favorite pastime is seeing people waste their lives digging holes in the ground or sacrifice their lives in war. Both acts create economic growth according to the topsy-turvy logic of men like Krugman.

The truth is that wars are a miserable misallocation of capital and usually leave financial ruin in their wake. The US did not boom in the '50s because we fought World War II, but because we resoundingly won. It was the byproduct of having an unscathed manufacturing base, solid infrastructure, an intact military, most of the world's gold, and the only reserve currency.

The logical implication of Krugman's arguments remains that working in productive employment is not at all necessary. If this is true, why not have people just save gas and stay home? The government could simply borrow and/or print money and send it to foreign countries that are dumb enough to produce goods and services for US consumption. Christina Romer, former Chair to Obama's Council of Economic Advisors, also sided with Krugman in a commentary posted in Sunday's New York Times finance section. In it, she pontificated on the lessons to be learned from the Great Depression, saying: "It would be a mistake to respond by reducing the deficit more sharply in the near-term. That would almost surely condemn us to a repeat of the 1937 downturn." This misdirection demonstrates her lack of understanding of what causes economic depressions in the first place.

The cause of the Great Depression in the 1930s and the Great Recession beginning in December 2007 were one and the same - an over-leveraged economy. Easy money provided by the banking system eventually brings debt in the economy to an unsustainable level. At that point, the only real and viable solution is for the public and private sectors to undergo a protracted period of deleveraging. The ensuing depression is, in actuality, the healing process at work, and is marked by the selling of assets and the paying down of debt. Unfortunately, our politicians today are focused on fighting the natural healing process of deleveraging by promoting the accumulation of even more debt.

During this latest economic contraction, the Federal Reserve has taken interest rates to near 0% for the past 2 ¾ years, and it has just promised to keep them there for an additional 2 years! Meanwhile, the Obama administration is leveraging up the public sector to record levels in an effort to re-leverage the private sector. The government's philosophy is tantamount to sticking a frostbitten man in the freezer so he won't have to suffer the pain associated with the thawing of his extremities.

During the Great Depression, real GDP plummeted 32%. The Great Recession, through which we are still struggling, began in December 2007, according to the National Bureau of Economic Research. But, in contrast to the 1930s, GDP during this recession shrank only 3.6% from the fourth quarter of 2007 through its low point in the second quarter of 2009.

The contraction in GDP during the Great Depression was the direct result of consumers paying down debt and selling off assets. Household debt as a percentage of GDP reached nearly 100% in 1929. To put that number in perspective, household debt did not go back above 50% of GDP until 1985. And it was not until the first quarter of 2009 that household debt once again approached the 1929 level.

Between the start of the Great Depression and the end of World War II, household debt fell from 100% to just above 20% of GDP. Getting there was a painful process, but such de-leveraging was the only real cure for an economy swimming in debt. Thanks to government efforts to carry on our debt-fueled consumption binge, during today's Great Recession, household debt has barely contracted at all - it has only been reduced to 90% of GDP as of Q1 '11.

To make matters even worse, during this current crisis our government's response has been to dramatically increase its own borrowing. At the start of the Great Depression, gross national debt was 16% of GDP. It peaked just below 44% when the Depression ended. While the national debt did increase significantly during that period, it was still relatively benign compared to other Western governments. The US entered this current Great Recession with gross national debt equal to 65% of GDP. It has since exploded to 98% of GDP!

US federal debt did rise dramatically during World War II, topping out at 120% of GDP in 1946. But consumer debt plunged concurrently. So, while Washington was adding debt to fight and win a global war, households were taking the necessary steps to ensure their balance sheets were well prepared for the aftermath of the battle.

Today, for the first time in our history, gross national debt and household debt are both at least 90% of GDP.

Mr. Krugman and his allies believe that we can grow our way out of this recession like we have in the past few. Unfortunately, we're dealing with a completely different animal. In every past recession, the government, under the guidance of Keynesians, decided to put off deleveraging in return for artificial growth. Well, that tab has come due.

Since these economists keep trying to spend like it's World War III, we are moving inexorably closer to causing Great Depression II. If policymakers and mainstream economists fail to understand that the progenitor of a depression is debt, they will also be unable to provide a genuine solution. Instead, by pushing public debt past the point of our creditors' willingness to lend, they may ensure that this next Great Depression will be accompanied by runaway inflation. If history is any guide, this is a truly lethal combination.

 


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Author: Michael Pento

Michael Pento, Senior Economist
Euro Pacific Capital, Inc.

Michael Pento

Michael Pento is Senior Economist and Vice President of Managed Products for Euro Pacific Capital. He is a well-established specialist in the Austrian School of economic theory and a regular guest on CNBC and other national media outlets.

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