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Re: Fatal Flaw in Logic of the Crash Course?

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  • Sat, Feb 14, 2009 - 11:58pm

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    Re: Fatal Flaw in Logic of the Crash Course?

Antal E. Fekete has an interesting article about debt posted at Financial Sense.  The article is interesting and touches on this thread; some excepts:

Growth & Debt: is There a Trade-Off?

The Big Fix

The
Obama administration apparently believes in a trade-off between growth
and debt. It wants to stimulate fast growth and is willing to pay for
it in the form of unprecedented increases in government debt, because
it fully expects the growth to rake in tax revenues with which the debt
can be retired.

Perpetual debt

In
this article I shall argue that there is no trade-off between growth
and debt under the regime of the irredeemable dollar lacking, as it
does, an ultimate extinguisher of debt. Once new debt is piled on the
top of the old, total debt is increased that will never be reduced, and
will become perpetual debt. As protagonists of the stimulus
package well know, retirement of the debt of the federal government is
tantamount to deliberate deflation, that is, contraction in the money
supply, by reducing the pool of bonds available for monetization.

Liquidation value

Perpetual
debt is more than toxic. It behaves like nuclear fuel: once the
threshold is reached and exceeded, chain reaction sets in and the
monetary system explodes. To understand the dynamics, we need to refer
to the liquidation value of perpetual debt. This is a concept
that, for obvious reasons, is not recognized by mainstream economists.
If it were, they would be far more careful with their recommendation of
unlimited government spending as panacea for all economic ills.
Recognized or not, the liquidation value of debt acts as a trigger to a
cataclysmic destruction of the economy looming large on the horizon, of
which we have had a foretaste in the recent past. The tragedy is that
the Big Fix cowboys want to use the same remedy that has landed the
country in the present predicament in the first place. Home owners with
a mortgage, car owners with a loan, credit card holders, students,
state and municipal governments, and yes, the federal government, are
drowning in debt already.

Burden of debt

The liquidation value of debt is the amount that would liquidate it here and now. It obviously depends on the rate of interest. The liquidation value of total debt is inversely proportional to the prevailing rate of interest. In particular, halving the rate of interest by the central bank is equivalent to doubling the liquidation value of total debt.

I have been writing about this Iron Law of the Burden of the Debt
for many a year and have met with an almost total lack of
understanding, judging by the feedback from readers. The lack is due to
the reluctance of the mind to admit that cutting interest rates increases the burden of debt contracted in the past, because it contradicts one’s intuitive expectation that it should decrease the burden of debt to be contracted in the future. To
be sure, cutting interest rates does increase the burden of debt
contracted in the past because liquidation value is calculated by
capitalizing the stream of future interest payments. Since at the lower
rate the present value of that stream is smaller, a shortfall is
created that has to be amortized upon liquidation.

Perpetual debentures

In order to understand the Iron Law let us consider the market value of perpetual debentures
(or perpetuals for short; consols in British parlance). They are
marketable securities that never mature: they convert a lump sum into a
stream of annual payments in perpetuity. For example, a $1000, 4%
perpetual pays $40 per annum to its holder, who can sell it in the
secondary market at any time. The catch is that he may recover only
part of his original investment if the interest rate has fallen in the
meantime.

Present value

In calculating the present value B of a perpetual with face value A, paying interest at a percent per annum, we have to discount the annual interest payments at the prevailing rate of interest b. Since the annual interest payment is Aa, the discounted value of the nth interest payment is Aarn, where r = 1 – b is the discount factor. We have 0 < r < 1, hence rn approaches zero as n gets arbitrarily large. The discounted value of the string of interest payments is:

We conclude that Aa = Bb.
For example, the 4% perpetual with face value $1000, yielding $40 per
annum, can be traded in the secondary market for $1000 as long as the
market rate of interest b is 4%. However, if it is halved to
2%, the same perpetual can be sold for $2000, because at the lower rate
it would take two debentures to generate the same income stream.

According to this pleasantly simple formula Aa = Bb, if the rate of interest b is halved to ½b,
then the liquidation value of the perpetual is doubled. In case of a
serial halving of the rate of interest from 4 to 2, from 2 to 1, from 1
to ½, from ½ to ¼ percent, etc., the liquidation value will be
multiplied 2-fold, 4-fold, 8-fold, 16-fold, 32-fold, etc.

Serial halving of the rate of interest

In this new interpretation of our formula Aa = Bb, A is the total debt contracted at an average rate of interest a, b is the current market rate, and B is the liquidation value of total debt. We see that B is inversely proportional with b.
In particular, every time the rate of interest is halved, the
liquidation value of the total debt is doubled. If the interest rate is
halved serially by the Fed (which has happened in the past, and may
happen again, as interest rates can be halved any number of times
without hitting zero or going negative) then, for example, upon a ten-fold serial halving, the liquidation value of the total debt is increased more than a thousand-fold (210
= 1024). This means that trillion is promoted to quadrillion,
quadrillion is promoted to quintillion, and so on, in direct
consequence of the serial 10-fold halving.

Those
who argue that these frightening numbers are merely ‘notional’ and, as
such, they have no relevance to the real economy, do not know what they
are talking about. The size of the derivatives market is fast
approaching the quadrillion dollar mark (if it hasn’t already surpassed
it by the time this article is published). It has been talked down by
mainstream economists and the financial media saying that “there is
nothing to worry about, it is notional value anyhow”. Yet that notional
value was able to break the back of the mighty American banking system
(along with that of the British). This is so because the total notional
value of derivatives represents the liquidation value of insured bonded
debt.

We can expect much greater
increases in the debt of the federal government, in the trillions of
dollars, but the really frightening numbers are not so much the actual
increases in the outstanding debt but, rather, the increases in the
liquidation value of the total debt caused by the serial halving that
the monetization of the increased federal debt will necessitate.

Capacity to expand Treasury debt

Peter
Orszag, the new budget director in the Obama administration has
declared, as quoted by Leonhardt, that “one of the blessings of the
current environment is that we have a significant capacity to expand
and sell Treasury debt. If we didn’t have that, if the financial
markets didn’t have confidence that we would repay that debt, we would
be in even more dire straights than we are.”

The
budget director is dreaming. The financial markets don’t have a shred
of confidence that the U.S. government will ever repay its debt,
certainly not in dollars of the same purchasing power. The Treasury
paper is not being purchased by investors; it is bought by bond
speculators pursuing risk-free profits. The Big Fix cowboys create
unlimited demand for the bonds by holding out the carrot of risk free
profits. Speculators plan to dump the paper in the lap of the Fed at
the first given opportunity. They know full well that the Fed has to
monetize the Treasury debt to provide the wherewithal to pay for the
bailouts and stimulus packages. Without the promise of serial cuts in interest rates the U.S. Treasury paper is unsaleable.

The Obama White House has been hijacked

The
outlook is very bleak. The Obama White House has been hijacked by a
reactionary clique of Keynesians and Friedmanites before the new
president even had a chance to take stock. They are doctrinaires who
would never admit that they have made a fatal mistake when they
promised permanent prosperity, a world free of bank runs, panics,
domino-style bankruptcies, mass unemployment and depressions, provided
that they were allowed to quarantine gold and manage synthetic credit
as they see fit.

Latter-day Moloch

The result of the
bailouts and stimulus packages will be a vast expansion of government
debt, and a serial halving of the rate of interest to accommodate it,
followed by the escalation of the liquidation value of total debt to
the quadrillion and quintillion dollar range and beyond. Deflation will
sweep through the land making prices and wages fall. The depression
will surpass in severity any previously experienced. Industrial capital
will continue to be destroyed along with finance capital. Pension funds
will go up in smoke, unemployment will grow.

When the liquidation value of government debt reaches a
certain height where Federal Reserve notes in existence will no longer
be sufficient to supply the bond market with gambling chips the Fed
will, Zimbabwe-style, start adding serials of zeros to the face value
of its notes. You don’t have to be a rocket scientist to be able to
calculate the purchasing power of Federal Reserve notes denominated in
the millions. You just make a field-trip to Harare.

There
is no trade-off between growth and debt. Under the regime of
irredeemable currency, debt is no longer a servant. It is a Moloch,
devouring its children.