Have Your Cake & Eat It, Too

Governments must borrow on a Herculean scale. But from whom?

WHEN RONALD REAGAN moved into the White House in January 1981, total US debt equaled 168% of GDP, notes Bill Bonner of The Daily Reckoning.

The next 27 years took the total to 370%; it was heralded as a triumph of the Anglo-Saxon free enterprise system, but it left people with an additional $27 trillion of debt.

And now, the economic system that created so many heavy balls and such long chains is in the recovery room – looked after by quacks and prayed for by most of the world.

You can explain the model in a few simple sentences:

1. Encourage people to spend;
2. When they run out of money, encourage them to borrow;
3. When they tire of borrowing and spending, lend them more at lower rates.

As a way for people to build wealth, this economic model of the Bubble Period was as ineffective as a bad banker. It was a 'have your cake and eat it too' school of financial success with an obvious flaw. People noticed it when the correction began. They went to their cupboards and found there was nothing there.

Homeowners – who had borrowed heavily against their houses – found their equity had disappeared. Capitalists found they had no capital. Workers lost their work.

And this year, governments' tax receipts are collapsing too. In the United States, they're down 14% in the first half of this fiscal year. Expenses, on the other hand, are exploding. This leads to a question: governments must borrow on a Herculean scale – but from whom? The United States is expected to float a record $2 trillion in I.O.Us. for 2009, totaling about 15% of GDP. If the downturn persists, as it has in Japan, we could see the US national debt rise to Japanese levels, close to 200% of GDP.

Here in London, the numbers are smaller, but the math is similar. The government has projected $175 billion deficits over the next two years. But this might be just the beginning. If deficits continue at this rate, Britain too could find itself back in the 1950s – after two world wars – with public debt at two times GDP.

What justifies such sacrifices? In time of war, citizens collect scrap iron...sell their jewelry...and buy bonds – anything to help pay for bullets and keep the Huns east of the Rhine. But what now? People clamp even bigger balls and longer chains on themselves...and for what? Taking flowers to the recovery room, they look in on the bubble model as though on a weary friend.

"He supported us all," says an anxious relative. "We must do all we can to save him."

But "Pull the plug," is our advice. Of course, when he was in his prime the bubble was fun – laughing, singing, spending...a grasshopper on stilts! And there were all those friendly ants in Asia ready to lend him money. At the peak, the USA had net borrowing of some $2 billion per day.

That's the annual trade deficit divided by 365. But now take America's anticipated budget deficit and divide it by 365. You get a figure of nearly $6 billion per day! So even at his peak, the old bug didn't bring in that kind of money. And now, the foreigners are in recession too. They've got their own aches and pains to cure. How will the United States finance the biggest deficit of all time? How has Japan done it?

Japan's economy has been locked up for 19 long years. It financed its confinement itself – drawing on the savings of a remarkably long-suffering population. Stimulus packages came and went. On average, they cost about 3% of GDP per year. The biggest came in 1998, with a price of 6% of GDP. Financing this house arrest was easy – Japan began the period with a savings rate of 14% of GDP. America, on the other hand, began with a savings rate of zero. More recently, the savings rate has been reported as high as 5% as middle-aged squirrels desperately hide a few nuts for a long winter retirement. But the gods can add it up. Even if every dollar of US savings is tossed down the public hole, it will still be two thirds empty.

Anticipating the problem, the Fed has already leapt into the hole itself. It offers to buy the government's bonds itself. Of course, the Fed has no real money. It must 'create' money to make the purchase. It's the latest miracle treatment, say the quacks in charge. If the Fed creates enough new money, it will offset the losses caused by the downturn. Then, happy days will be here again. The whole world seems to believe it. Stocks are rising. Ben Bernanke, this week, said the US economy would recover before Christmas. The convalescence may be long, he continued, with his vision apparently restored; but it will be steady.

How the gods must howl! "In the Bubble Epoque people tried to get something for nothing...Imagine, they thought they could get rich by borrowing money and spending it. Have you ever heard of something so ridiculous? Ha ha! Now, they think they can get rich by spending money that doesn't even exist."

"But that's not the half of it," one of them is sure to notice. "They're digging themselves deeper into debt – trying to revive the very oaf who pushed them down in the hole in the first place.

"Ha ha! Ha ha..."