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Buying dimes with dollars is bad business, government-funded or not.

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May 30, 2010 – Comments (3)

It is no secret that I agree with Eric Sprott quite a lot. I have written several posts that feature Sprott's viewpoints

- SqueezePlay: Sit-Down with Eric Sprott - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=396617
- Eric Sprott Interview on CNBC - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=377859
- Eric Sprott Interview on King World News - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=360939
- Is Sprott in the Market Trying to Buy 10 Tonnes of Gold? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=348703
- Five Questions About Gold The IMF Refuses To Answer - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=384031
- IMF Is Now Rejecting Prospective Buyers For Its Gold Stash - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=360779

In this interview, Sprott

My friend amassafortune pointed me to a new article by Eric Sprott and David Franklin that I again totally agree with. He lays out the ineffectiveness of the government stimulus, how small the return on investment is for all the new debt created. This is a topic that I have been harping on for months now. See   Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428 and  More on Debt Saturation Equals Diminishing Growth, Employment, and Capacity Utilization… - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=394221 .

There are two effects happening, both of which are bad. The government is not allocating the public's resources (the "stimulus" which is bought by debt which the public has to pay taxes on either through direct taxation or indirect taxation = currency debasement / devaluation) effectively. Notice I say the public's resources. The government has no resources of its own. This malinvestment at the macro level not only does not create the desired effect, but creates very little "good" effect at all. The government, in short, is a lousy investor because it has very little accountability. On top of that there is negative economonic impact because all this newly created debt has to have interest payed on it. When there is less economic output per each new unit of debt than it requires in servicing costs, then we reach debt saturation. All new debt has a declining marginal productivity. See the links above to show this very real phenomenon in action.

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Eric Sprott: A Busted Formula
by Eric Sprott and David Franklin
Submitted by Tyler Durden on 05/28/2010 15:43 -0500

http://www.zerohedge.com/article/eric-sprott-busted-formula

[excerpt]

There’s nothing wrong with throwing a little money at a problem to make it go away. There’s equally nothing wrong with throwing a little borrowed money at a problem to make it disappear, as long as you have the means to pay that borrowed money back.

But what happens if you throw a lot of borrowed money at a problem, and the problem doesn’t go away? If you’ve ever experienced a situation like that you can probably understand how Europe feels right now. It just unleashed a magnificent $1 trillion euro bailout and the market responded with a selloff by the end of the week! So what happened? That money was supposed to make the problem go away, after all. And it was a lot of money. Why did the market respond to it with such disdain?

We believe the market’s reaction is confirming what we have long suspected: that these bailouts provide next to no long-term value. They don’t produce real jobs. They don’t improve productivity. They just prolong the precarious leverage game played by the financial sector, and do so at tremendous cost to taxpayers. "Bailout and Stimulate" has been the rallying call for governments and central banks since the beginning of this financial crisis – and it has certainly had its impact over the last two years, but not the type of impact we need to propel real, sustainable growth. There are three recent, glaring examples of this busted "Bailout and Stimulate" formula in action:

Exhibit A: The United States

From the outset of this financial crisis, the US Government and Federal Reserve have spent prolific amounts of money to save its banks and stimulate its economy. According to Neil Barofsky, special investigator general for the Troubled Asset Relief Program, the United States has now spent approximately $3 trillion on various programs to stem the financial crisis.1 This figure is expected to be updated again in July.

This $3 trillion expenditure includes stimulus programs like ‘cash for clunkers’, the extension of unemployment benefits, infrastructure spending, the "Making Home Affordable" program, as well as the activities of the Federal Reserve. To measure what the fiscal stimulus has actually accomplished we looked to the US Federal budget outlays/receipts to gauge the impact of the stimulus on GDP.
Table A presents current dollar GDP increases year-over-year alongside current dollar budget deficits. Comparing the two in current dollars provides a sense of the hard dollar impact that stimulus spending has had on the economy. As the chart illustrates, the net impact of the stimulus contributions and promises made since 2008 have resulted in a combined budget deficit of close to $2.5 trillion dollars and an incremental net increase in GDP of $200 billion. A $200 billion return for a $2.5 trillion increase in debt represents a terrible return on investment. It implies that the net impact of the stimulus on GDP since 2008 has been a mere 9 cents for every deficit dollar spent. Buying dimes with dollars is bad business, government-funded or not.


READ THE REST OF THE ARTICLE

3 Comments – Post Your Own

#1) On May 30, 2010 at 9:29 PM, tomlongrpv (77.90) wrote:

An interesting critique but (as is often the case with these critiques) devoid of any constructive alternative.  What should we do?  Not bail out the banks?  That was tried during the Great Depression and resulted in 28 states not even having one bank.  How well would we all do in an economy without banks?

Its also intriguing to hear people refer to the stimulus money as "our tax money" or "borrowed."  Much of it is neither of those things.  No taxes have been raised to fund the stimulus.  Much of the money was simply created by the Federal Reserve.  In normal times this could cause disastrous inflation--and it still may if we don't gradually ease the money supply down as the economy recovers (as I think the Federal Reserve plans to do). 

Much of the stimulus money lent to banks has already been paid back and much of it with interest.  I haven't seen the latest analysis of what the losses are but if GM and the insurance company formerly known as AIG both pay back in full (and there is some chance of that) the losses will not be that significant as a percentage of GNP.  And while the bailout may not seem to have stimulated much growth it may be all that stood between us and a real 1930s style depression. 

One thing we might do that would do more to close the deficit than most other things would be to stop intervening in other nations' civil wars.  Or at least to bail out once we have determined that those nations in fact don't have weapons os mass destruction.  The costs of our undeclared wars has been a big portion of the $2.5 trillion that this critique complains of.

 

 

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#2) On May 31, 2010 at 12:00 AM, topsecret09 (44.12) wrote:

   U. S banks still have 75 Billion dollars of "toxic assets" on their books. They still have to figure out a way to either take huge charge offs,or sell those derivitives at pennies on the dollar. Why do you think Citigroup Is still 4 bucks ?  The banks are not as healthy as most people think.....   TS

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#3) On May 31, 2010 at 12:28 PM, binve (< 20) wrote:

tomlongrpv ,

>>An interesting critique but (as is often the case with these critiques) devoid of any constructive alternative.

I will address this one in a moment

>>What should we do?  Not bail out the banks? 

I think that would have been a step in the right direction

>>That was tried during the Great Depression and resulted in 28 states not even having one bank.  How well would we all do in an economy without banks?

Since you felt free to criticize my post (which is fine by me), I will feel free to criticize this comment (which I hope if fine by you).

This is a fairly riduculous statement. With the plethora a types of banks out there now, credit unions and such, much of them which have nothing to do with the housing boom or having exposure to real estate, or overleveraged positions like the shadow banking system, much of the US's smaller and regional banks would be just fine. The ones that would die are the ones that present systemic risk.

But instead of killing that vampire while it was still possible, the US economy in now more inextricably linked.

I have written many times that financials are the cancer of the economy.

Financials are not, at their core, bad businesses (at least financials of 30-40 years ago). They do perform a very vital role of facilitating the dispersion of resources. It it not productive, so there is a loss of efficiency, but there is an overall economic good that comes out of it.

But today, financials (investement / shadow banks in particular) comprise a disproportionate size of the economy to the amount of economic usefulness they perform. This non-productive garbage has to be cleaned out, just like cancer. This is precisely why I call financials the cancer of the economy. They are a huge drain that transfers the economy's money (the wealth of the productive part of society), largely between each other, collecting fees for their "work".

On top of that, throw in the corruption and blatant fraud that is associated with most of these debt instruments, they should be illegal, and really are when you consider the spirit of the law. The letter of the law, of course, gets bent all the time to suit.

These two posts (one by Denninger and one my Mole) sum up my outrage and disgust perfectly: Choices - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=339577 and Financial Carcinoma -- Denninger: Did You Need a PhD For That? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=322718.

But lets get back to your first criticism. The one that my post was devoid of any constructive alternative.

The horse has left the barn. With regard to the bailout, it is done. So my point in criticising the bailout is not to revist the past per se, it is to show how utterly ineffective it has been when you consider the low return on investement and the effects of increasing debt saturation.

I write these posts to illustate the fallacy in the tradtional Keynesian econmic arguments and to dispel the myth of a "magic recovery". I write macroecomic posts like Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=369098 to show the real reason for the stock market bounce, not some recovery that was purchased by debt that failed to fix any of the underlying problems.

>>Its also intriguing to hear people refer to the stimulus money as "our tax money" or "borrowed."  Much of it is neither of those things.  No taxes have been raised to fund the stimulus.  Much of the money was simply created by the Federal Reserve.

I already addressed this above: There are two effects happening, both of which are bad. The government is not allocating the public's resources (the "stimulus" which is bought by debt which the public has to pay taxes on either through direct taxation or indirect taxation = currency debasement / devaluation) effectively. Notice I say the public's resources.

The fact that monetary inflation has not become price inflation yet is not unexpected. But all of this montery inflation will beget price inflation eventually. I have been hammering on the topic because it is the critical issue to understand how all of the advanced economies government's action will not only fail to produce the desired effects, but will more importantly make matters worse. The main issue is  Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. It is critical to understand that an increasing debt load has decreasing marginal utility and there comes a point due to servicing requirements that all new debt has a negative economic impact. This is why we were NEVER going to be able to borrow and spend our way out of a crisis that was caused by too much debt to begin with.

This sets up an extreme deflationary environment (this debt load is unsustainable) within which the Federal Resevere will monetized uprecendented amounts of debt at uncprecedented rates. Which will result in a simultaneous deflationary and inflationary outcome: stagflation. There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes.

I do think that most inflationists discount the amount of debt that is collapsing (even though most deflationists use measures like M2 and M3, which have a lot of non-monetary components to prove their point) while at the same time most deflationists discount the amount of monetary inflation the Fed can generate (they argue that the Fed creating base money is like pushing on a string because the banks don't have to lend, even though I am many others have pointed out that the Fed has gone around the banking system and has started monetizing private sector debt directly, which is a trend that is likely to increase not decrease). Most people on either side of the debate is not considering strong evidence that both forces are significant.

topsecret09 ,

I totally agree. Thanks for the comment!..

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