Two types of recessions : Or why the welfare state is about to collapse

A brief overview of the Austrian Business Cycle Theory

It has been said by some financial commentators that the current economic downturn is wholly different than previous recessions, all the way back to the great depression. I would actually agree with them, because there is one fundamental difference between what has happened the last decades. For those of you not fluent in ABCT (Austrian Business Cycle Theory), the basic idea is that through artificially low interest rates, capital is misallocated into more long-term projects than people are actually interested in supporting with their savings. Money becomes artificially cheap, but since this bids up prices of goods and labour, a general miscalculation occurs. The recession enters once businesses and entrepreneurs realize that not enough real resources exist to complete their projects, and those who have overinvested too much goes bankrupt.

This is a rather simple explanation what happens if you change the price over time for money (interest rates). The economy looks like it has more real savings then it in fact does, and therefore it is necessary with a period where bad investments are liquidated, and capital and labour is re-allocated to the sectors that produce the things people are actually interested in. Once the production structure has re-aligned to better support peoples desire for consumption and investment, things go back to normal. This is what has occured during most small recessions since central banking started. Unfortunately, something quite different has happened this time. It may only be a difference in degree - both the "classical" business cycle and this second event can probably be said to have occured during all downturns, but there is still a monumental difference in scale.

Lending is done to enable the purchase by business of capital goods, which make them more effective and allow them to produce more goods and services at a lower price. Thus, their profit increases and it is out of this profit that the interest on the loan is paid. This is all good and well - it is how the economy has functioned and will always function, the problem arises when you start investing in non-productive assets. The two main non-productive assets that the world is currently riddled with is government loans and consumer loans. These loans are not made to increase future production, instead the opposite - they enable immediate consumption which reduces savings available for investment, and if pushed far enough they start devouring the existing capital structure. Here is a chart of different types of loans made in the US for a few decades :

Good loans, bad loans

Now, it would be wrong to consider this the whole picture - it does for instance not show the enormous amounts of securitization of different debt that has been done, rather it shows (if I understood the St. Louis Fed database correctly) loans that are directly on bank balance sheets. But notice what happens in the early 80's. There is a clear trend change, and more and more money is funneled into consumer and real-estate loans. These loans have as only collateral the future wages of the borrowers. Now, clearly, a certain amount of consumption loans is sustainable. But when you reach a certain point, the consumer loans themselves start crippling peoples ability to repay them. Future wages are wholly dependent on capital investment, and the more money funneled into consumer loans, the less money can be lent to business so they can make capital investments. And thus, we have now reached the point of no return. There is no way that consumer and residential loans can be payed back - much of them will be defaulted upon. If government and central banks kept their meddling fingers to themselves, this would mean a collapsing deflation of both debt and money supply. This is what started occuring in 2008, but was interrupted. Since then, the powers that be has done everything they can to prevent the unpreventable. The end result will be a default of the US government, as they have been trying to fill the hole left by consumers that cannot borrow anymore. The only thing that can, and MUST occur is that a significant part of the debt is defaulted upon, and simultaneously more and more savings are lent to business to use for investment.

This is only data for the US, but I can guarantee you that in most countries in the West it looks quite similar. I know it does in Sweden, where residential loans have more or less tripled in roughly ten years. Germany may be the sole exception, because they have had the most boring housing market in the world the last decade, and thus we can probably assume that funds have not been floating into residential loans to the same extent. To sum things up : If you invest mostly into productive assets, you can expect most of this money to be paid back, with interest. The interest rate will be decided by the availability of savings and the perceived risk of the investment. Since a functioning market consists of a vast number of participants, where the good investors are rewarded and the bad investors punished, we are guaranteed to have a development that drives money into the best investments available. When you start investing mostly in unproductive assets (consumer and government loans, for instance), you are guaranteed that an increasing amount of these debts will NOT be paid back, since increasing volumes of consumption and consumer debt leads to stagnant, or falling real wages.

The great charade

So, what has really happened here? First, there has been an enormous mispricing of assets and the risk associated with them. Consumer loans should have been made far more expensive, since they carry much greater risk. This would have worked to limit the amount of such loans. Second, the amount of consumer loans have expanded to their natural limit, namely where there is no further capacity of debt-servicing. This means that a huge swath of the economy is producing the wrong things - namely things that borrowing consumers can no longer afford. This production has to be re-aligned to produce whatever the holders of these loans want to spend their money on. Again - this should naturally lead to a deflationary collapse like in the 30's, which would have pushed even more borrowers into default. This is the natural way of a credit-expansion system of removing the rot, by collapsing both debt and money supply. But a deflationary collapse has many benefits as well. It lowers consumer prices, rewarding prudent savers. It lowers prices of capital goods even more, which means a shift of the means of production from the less talented and less responsible to the more talented and more responsible. This, by the way, hasn't happened either in the US, quite the opposite. The US financial sector is gobbling up more and more assets, leading the US economy further and further down the swamp.

Lets talk about the welfare state. The late 70's and early 80's was not a good time for the welfare state. In Sweden, we had a huge property bubble that burst in the early 90's, and the welfare state ended up on the brink of collapse. But for most countries, something shifted after the troublesome 70's. What had been a highly inflationary environment turned into a period of lower inflation and lower interest rates. Part of this can probably be contributed to the IT revolution, which has enabled massive effectivisation across all sectors of the economy. But unfortunately, that isn't nearly enough to explain what shifted. What really occured was that economies that were suffering from high taxation and high inflation started instead borrowing from the future. By a self-perpetuating scheme of loans for consumption, the economy started looking better, and asset prices went up, which meant people found themselves more wealthy, which enabled further loans, and slowly the entire economic culture shifted from one of savings and frugality to one of borrowing and spending.

This charade has been relying on one thing, and one thing only - that no one ever tries to cash in their "wealth" as represented by their paper assets, and that there is always an increasing number of people willing to indebt themselves further so that more financial assets can be created from these loans. Unfortunately, the entire western world has hit the brick wall. There are no more people that can borrow more money, and simultaneously more and more people are growing older and want to cash out their retirement money. This has started leading, and will increasingly lead to a situation where asset prices continue to fall due to more sellers than buyers, and a massive, neverending (almost) wave of defaults. The response so far has been to print money to replace the non-performing assets. Yet even if we somehow magically managed to replace all bad debts without hyperinflating currencies - this wouldn't help! Due to demographic trends and the fact that we are no longer starting with a high savings rate and frugal behaviour, it is IMPOSSIBLE to repeat what has happened the last 30 years.

No one gets to retire

What has basically happened is the largest fraud in the history of mankind. I keep coming back to this, and here is the UNDENIABLE truth : There is no retirement money, because the real wealth has already been spent and consumed! It has been invested in bonds that are increasingly worthless because the money cannot be paid back, and vastly overpriced stocks that will perform horribly until there is enough savings to produce more stuff cheaper, so people can again afford them. The western economy has gone from productive engine to ponzi scheme, and there is no way out. Real wages will fall for a very long period, real wealth levels will continue to sink, and none of this stops until there is a change in behaviour across the spectrum, and savings rates go back to what they need to be to maintain a high-level production structure. Sadly, this is likely to be stopped by the machinations of government and central banks.

By now you should be seeing quite clearly what will happen to government tax revenue. Simultaneously, entitlements and future obligations continue to grow at an exponential rate. We can see what happens when these two collide in the US right now - government spending is 140% of revenue and rising. What happens thereafter can be best seen by looking at Greece - trying to shrink the welfare state leads to a permanent state of recession, because it takes time for new private sector jobs to appear, and for production to change from things that the government used to buy, to things that the private economy wants. This must go on until the welfare state has been made small enough to be supported by an economy that has been crippled by underinvestment and overconsumption.

We all know this is not going to happen. Taxes will be increased once the ability to borrow disappears. This will further cripple the economy, leading to the need for even further cutbacks. The spiral continues until we either get a complete collapse of most of the economy, or until the State finally retreats because the public demands it. The latter hasn't happened ever. And this time, it must. Because the last 30 years looked like they proved that the welfare state "worked" as long as you had some semblance of control over government spending. The fact is, that we borrowed roughly a generation of future wealth to sustain the welfare state, and now we must both accept that what we have been promised will never be delivered, AND we must pay back that which was borrowed the last 30 years.

Game over

Will there be revolt? Yes. Will there be one or more gigantic depression-style collapses of Western economies? Yes. Will there be increasing number of poor people? Yes. Will there be raving mad inflation and possibly hyperinflation as central banks try to save a collapsing debt system? Yes. What will remain? That depends on when this all stops. Clearly, there is no way for the democratic system to solve this through regular means. The path we are on leads to Soviet, the stone-age, or Argentina. Only if people revolt against the system can things be turned around, and even then it will take a long time to re-establish sound institutions of banking, while simultaneously people who are much poorer will need to learn to save money instead of consuming. If none of this sounds like it has a snowballs chance in hell of happening, then you know where I'm coming from. To quote our minister of finance, from the worst moments of early 2009.

"It's going to be a long, dark, cold winter."

He might not understand it right now, but in time he will learn how right he was, and what it was he caught a glimpse of during the frightful winter of 08-09. It's coming, and you cannot prevent it. You can only prepare. Doug Casey (whom have written many insightful things) recently published a set of scenarios for the US economy. The sum of it all was to buckle up, because it is going to be a very challenging 20 years ahead of us.

It is Game Over for the welfare state, even if nearly no one has understood it yet.