AI's Bubble. Ready to burst yet?

While politicians here in NZ bicker about who should get credit for an Amazon data centre that either is (or isn't) opening, over in the States they're already wondering whether these data centres are part of an AI bubble that's starting to show clear signs of being about to burst. 

"Even Open AI boss Sam Altman is now talking about an AI bubble," notes Ted Gioia. "Of course, he knows better than anyone because he is seeing it up close—the disappointing release of ChatGPT-5 played a key role in setting off the current turmoil."

Consider this: 

AI buildout is contributing more to measured US economic growth than all of consumer spending.

I want you look long and hard at this chart, and consider the implications.

Another sign? Mark Zuckerberg just paid US$14 billion for a stake in Scale AI, the data-labelling startup that's never made a dollar.

Meanwhile in the real world, McDonald’s CFO told Bloomberg that the company is struggling because many customers are now too poor to afford breakfast. And this isn’t some isolated anecdote—it’s a data-driven report from the biggest restaurant chain in the world. ...

There’s a mismatch here between two visions of the emerging economy. So which one is real? Are we entering an AI-driven boom time like an out-of-control Monopoly game? Or will [Americans] be too broke to eat breakfast?

Several signs, maybe, that both are happening —many signs of businesses struggling, closing, unemployment and debt rising, customers at any price simply disappearing. And meanwhile, 

• half the gains in the stock market are due to betting on the shares of five companies, who are betting everything on their spending up AI data centres
• consumers however are spending so little that this "investment" spending on AI by just four CEOs (two of whose money is made mostly by selling ads) totals more in the last 6 months than all the spending by all those consumers
• the energy grid simply can't support this growth in AI data centres, and there’s no indication that consumers are willing to pay for the enormous infrastructure. 

That last is the biggest sign right there. 

Fewer than 1% of ChatGPT users are paid business accounts. That total is no larger than the number of paid Substack subscribers (but what a difference in company valuation!).

In fact, most of ChatGPT’s traffic disappears when students go on summer vacation.

That tells you how wide the chasm is between reality and the crazy claims of AI fanboys—but many of them (I bet) are also reluctant to pay for AI. ... The tech simply doesn’t live up to the hype. The more people deal with it, the less they like it. That’s why AI companies must give it away (or bundle it into an already successful product) in order to gain any reasonable usage.

So everywhere I go online, companies are touting free AI. That’s funny. It doesn’t fit the narrative of a transformative technology.

But even four billionaires can’t change reality," warns Gioia. 

Yes, they are spending like drunken sailors, but that just makes the bubble bigger. It can’t stop it from bursting. The crazy level of investment only makes the eventual fallout all the worse.

How much longer can it last? Maybe a few weeks or a few months or a few quarters. Billionaires often throw good money after bad. But the whole economy is fragile—or beyond fragile—right now. And that’s the bigger reality.

By any reasonable measure, the current trend is unsustainable. And there’s one thing I know about unsustainable trends—there’s a day of reckoning, and it’s not a happy one for the people who caused it. But, even sadder, they take down a lot of others with them when the bubble bursts.

Read the whole thing here. (NB: He's opened up the article from behind the paywall.)

PS: How is this AI capital malinvestment even possible? Because of absurdly low interest rates set by the state's economic planners at the US Federal Reserve — rates that are so "economically absurd" they are only made possible "because the monetary fraudsters on the Fed's Open Market Committee (FOMC) had their big fat thumbs on the scales in the bond pits."

And we do mean fraud: The Fed’s balance sheet rose by $1.2 trillion or 17% during the 12-month period ending on July 7, 2021, and at a time, as we will amplify below, when the Fed’s balance sheet should have actually grown by essentially zero.

That is to say, the FOMC was buying government debt and GSE paper hand-over-fist with fiat credits snatched from thin digital air, thereby starkly falsifying yields and prices in the bond pits. There is not a chance in the hot place that tax-paying, real money savers left to their own devices would accept such niggardly real yields.

David Stockman explains the Fed's fraud.

Ludwig Von Mises explains the inevitable results of malinvestment — "meaning bad investment in
lines of production that would not otherwise take place."

 

This guest post by Soham Patil is for everyone who still thinks that falling prices are a bad thing, and that rising prices are, somehow, good...

CNN Is Wrong. "Deflation" Is a Good Thing.

by Soham Patil

A recent video by CNN states that lower prices are bad for the economy, and that consumers must get used to the newer, higher prices. The video goes so far as to say, “We’re never going to pay 2019 prices again.” The video claims that deflation is responsible for a long list of problems including layoffs, high unemployment, and falling incomes. Americans should simply get used to paying more and more each year, they say, and be happy about it. Except, so-called "deflation" -- falling prices, caused by rising productivity rather than by monetary collapse — is actually good for consumers despite the contentions of inflation-supporting economists.

The conclusion that inflation is a good thing is reached by the mishandling of economic terms. While Austrian economics accepts that "inflation" when used accurately is the expansion of the money supply, mainstream economics contends that inflation is simply an increase in the general price level in an economy however it is caused. This skewed definition allows one to erroneously conclude that inflation causes prosperity by raising profits and incomes through higher consumer prices. The problem with this is that “price inflation” (rising prices) is also often caused by real inflation: i..e, the increase of the money supply. An increase in the money supply comes from the creation of additional units of money. The wealth of savers is diluted by the expansion of the money supply, which leads to the hardships many Americans face.

Further, while the video contends that the pandemic may have caused rising prices, it cannot explain the continual growth of prices even after the effects of the pandemic have subsided. The pandemic is not responsible for the continual trend of increasing prices; the growth of the money supply is.

Figure 1: The M2 in the United States, 1959–2024

Source: FRED. Data from the Board of Governors of the Federal Reserve System.

While the money supply of US dollars has increased steadily over the past few decades, a significant jump can be seen after 2019 when the Federal Reserve’s expansionary monetary policies caused a great rise in the money supply. This growth, uncompensated by additional production due to the pandemic, caused the price inflation that many now blame solely on the pandemic. The truth is that if the pandemic were the cause of prices rising a significant amount, the absence of the pandemic should account for a proportionally drastic deflationary period afterward. This never occurred, and thus the money supply paints a more honest picture of inflation than any index of a collection of prices ever could.

Rising prices are obviously troublesome for both consumers and producers (everyone faces rising costs). By contrast, deflation (falling prices) is often a good thing. "Deflation" in simple terms simply means that the same unit of money is worth more today than it was yesterday. Consumers thus can buy more today than they could yesterday. Instead of actively being impoverished during conditions of rising prices, during times of gently falling prices consumers would instead be made richer. There are two contrasting ways that we might see falling prices: when productivity increases faster than the money supply (a very good thing), or when the money supply collapses after a failed inflationary boom (almost always a bad thing). Unfortunately, both good and bad are tarred with the same semantic brush.

The reason many economists are quick to champion inflationary booms as somehow creating prosperity is because central banks have previously used expansionary monetary policies to temporarily boost the economy by increasing aggregate demand. Several of these policies, often specifically lowering interest rates, cause a boom-bust cycle. When the money supply is expanded and cheap credit is abundant, firms are able to take on ambitious projects that they may not have been able to previously. Malinvestment results from the unsustainable credit expansion created by extremely low interest rates. There is greater demand for the factors of production, and an increase is seen in conventional metrics of economic growth such as gross domestic product.

During the process of malinvestment, an increase in employment occurs due to the firms having access to cheap and easy credit, allowing for greater business spending. However, when firms lose access to cheap and easy credit due to the central banks having to prioritise cutting inflation, jobs are lost. These job losses are not the fault of the deflation but rather of the malinvestment during the false economic booms. Without malinvestment and inflation, resources would have been invested in more-profitable endeavours, making better use of these resources.

Artificially cheap credit causes a misallocation of resources by skewing price information. Eventually, a bust must follow the boom. In this period, deflation often occurs due to market actors coming to more-realistic valuations of the factors of production. After these realistic valuations come about, consumers are able to pay less for their goods and services . . . at least until the central bank causes the next boom-bust cycle.

In conclusion, it would be wrong to pinpoint deflation as a potential issue for the economy. To do so would be to conflate the cause and effect of how money supply affects an economy. Contrary to CNN’s video, the Federal Reserve throughout its history has not helped the cause of consumers, evidenced by the exponential growth of prices since its foundation.

* * * * 

Soham Patil is a high school senior at Symbiosis International School. He is passionate about Austrian Economics and Philosophy.

 

His post first appeared at the Mises Wire.

What's ESG? What's ZIRP? -- and why should you care?

ZIRP (zero-interest rate policies) characterises the cheap credit that has flooded out of central banks in the last decade or more. 

ESG (environmental, social, and governance) is the dripping wet "stakeholder" theory that demands that so-called "ethical investors" should direct companies to undertake more politically-correct projects. It is the stakeholder theory route to collectivism.

Fortunately, as Peter Earle explains in this guest post, shareholders and consumers are starting to flex their muscles, and the credit contraction is making a lot of what was formerly cheap very expensive.

ESG as an Artifact of ZIRP

Guest post by Peter C. Earle

Founding myths tend to be mired in obscurity, and like many other investment trends, the roots of environmental, social, and governance (ESG) philosophies are unclear.

The founding of the World Economic Forum is one origin. Stakeholder theory is another of ESG’s clear antecedents, especially as formalised in R. Edward Freeman’s 1984 book Strategic Management: A Stakeholder Approach. The 2004 World Bank report “Who Cares Wins: Connecting Financial Markets to a Changing World” is another contender, providing as it did guidelines for firms to integrate ESG practices into their daily operations. And the publication of the reporting framework United Nations Principles for Responsible Investing in April 2006 (the most recent version of which can be found here) was another.

Its origins however are less important than the destruction it has caused.

Wherever it began, ESG clearly hit its stride within the last five to ten years. Those were heady times for bankers and financiers, first characterised by zero interest rate policies (ZIRP) and then, during the pandemic, by massively expansionary monetary and fiscal programs. Yet in the last two years or so, the prevailing economic circumstances have changed considerably. Inflation at four-decade highs is battering firms by raising the cost of doing business. It is also negatively impacting corporate revenues, as consumers retrench by cutting back on expenditures.

Nowhere are these effects more evident than in shareholder land, where the fourth-quarter 2022 S&P 500 earnings season is just about over. “Earnings quality” is an evaluation of the soundness of current corporate earnings and, consequently, how well they are likely to predict future earnings. For the past year, and certainly for the last quarter, the quality of earnings has been abysmal. One particular element – “accruals,” or cashless earnings – are their highest reported level ever, according to UBS. In that same report, we find the somewhat shocking revelation that nearly one in three Russell 3000 index constituents is unprofitable.

For those and other reasons, a theme in many of the fourth-quarter corporate earnings reports has been cost-cutting: Disney, Newscorp, eBay, Boeing, Alphabet, Dell, General Motors, and a handful of investment banks are all eliminating jobs and slashing unnecessary expenses. And although firms regularly write off the value of certain assets and goodwill, that process accelerates during recessions. 

Firms are additionally contending with the highest interest rates they’ve faced since 2007, and in some cases back to 2001. A substantial amount of corporate debt assumed at lower interest rates is now more costly to service, as a generation of managers grapple with a world of interest rates (and its effects) that they've never seen before.

Dividend payments for example, typically considered sacrosanct during all but the most severe financial straits, are being targeted for savings. February 24th in Fortune:

Intel, the world’s largest maker of computer processors, this week slashed its dividend payment to the lowest level in 16 years in an effort to preserve cash and help turn around its business. Hanesbrands Inc., a century-old apparel maker, earlier this month eliminated the quarterly dividend it started paying nearly a decade ago. VF Corp., which owns Vans, The North Face, and other brands, also cut its dividend in recent weeks as it works to reduce its debt burden … Retailers in particular face declining profits, as persistent inflation also erodes consumers’ willingness to spend. So far this year, as many as 17 companies in the Dow Jones US Total Stock Index cut their dividends, according to data compiled by Bloomberg.

All of this suggests two things.

First, if large firms are doing everything they can to reduce unnecessary overhead, then feel-good initiatives and other corporate baubles are likely to face the chopping block – even if quietly. ESG observance is one of those very costly trinkets, bringing as it does compliance costs, legal costs, measurement costs, and opportunity costs. The reporting requirements alone associated with upholding ESG standards are high, and rising. In 2022, two studies attempted to estimate those costs:

Corporate Issuers are currently spending an average of more than $675,000 per year on climate-related disclosures, and institutional investors are spending nearly $1.4 million on average to collect, analyze and report climate data, according to a new survey released by the SustainAbility Institute by ERM … The survey gathered data from 39 corporate issuers from across multiple U.S. sectors, with a market cap range of under $1 billion to over $200 billion, and 35 institutional investors representing a total of $7.2 trillion of AUM … The SEC has released its own estimates for complying with its proposed rules, predicting first year costs at $640,000, and annual ongoing costs for issuers at $530,000. The study explored the specific elements covered by the SEC requirements, and found that issuers on average spend $533,000 on these, in line with the SEC estimates. Elements not included in the SEC requirements included costs related to proxy responses to climate-related shareholder proposals, and costs for activities including developing and reporting on low-carbon transition plans, and for stakeholder engagement and government relations.

Difficulty measuring costs means difficulty budgeting for them. Another recent report commented:

Although it is inherently difficult to assess the costs [of ESG], it is fair to anticipate significant costs for ambitious ESG goals. In an article in The Economist, a specific cost estimate was made in relation to offset a company’s entire carbon footprint. This was estimated to cost about 0.4 percent of annual revenues. This could already be a huge component for many companies, but it is only one aspect of merely one ESG factor.

Yet that comment concludes with the kind of assurance that flows effortlessly from consultants well-positioned to, frankly, make a lot of money off of ESG compliance: “However, there is no real choice. The climate certainly cannot wait.” Given the recent backlash against ESG, whether driven by ideology or accounting, it’s clear that there is a real choice, and that choice is being invoked with increasing frequency throughout the commercial world.

Second, the recent explosion of ESG adoption may have been in the spirit, if not embodying a strictly theoretical manifestation, of malinvestment as predicted by Austrian Business Cycle Theory (ABCT). 

Without engaging in a lengthy discussion of ABCT, artificially-low interest rates (interest rates set by policymakers instead of markets) undercut the natural rate of interest, misleading entrepreneurs and business managers. Many years of negligible interest rates, indeed negative real rates, have given rise to bubble-like firms, projects, and I would argue, by extension, business concepts. The latter, which include but are not limited to ESG, seem feasible and arguably essential when the money spigots are open. When interest rates normalise and sobriety re-obtains, cost structures reassert themselves. It’s back to the business of business. 

Interest rates are now beginning to normalise. And, perhaps, business practices with them.

Gone are the salad days of easy money, and with it the schmaltzy wishlists of niceties which a decade of monetary expansion permitted activists to blithely force upon corporate executives. In the face of rising interest rates, an uncertain path for inflation, budget-constrained consumers, and rapidly deteriorating corporate earnings, shareholders are likely to take a closer look at how and where their money is being spent than they have in some time. 

Although it is unlikely to disappear completely, the ESG fad is probably past the crest of its popularity. It’s time again for firms to focus, singularly and completely, on the inestimable task of making money.

* * * * 

Peter C. Earle is an economist who joined the American Institute for Economic Research (AIER) in 2018. Prior to that he spent over 20 years as a trader and analyst at a number of securities firms and hedge funds in the New York metropolitan area. His research focuses on financial markets, monetary policy, and problems in economic measurement. He has been quoted by the Wall Street Journal, Bloomberg, Reuters, CNBC, Grant’s Interest Rate Observer, NPR, and in numerous other media outlets and publications. Pete holds an MA in Applied Economics from American University, an MBA (Finance), and a BS in Engineering from the United States Military Academy at West Point.

His post first appeared at the AIER blog.

How the Central Bank's Easy Money Killed Silicon Valley Bank [updated]

 

The second-largest collapse of a bank in recent history would not have existed if not for ultra-loose monetary policy, as Daniel Lacalle explains in this Guest Post. SVB made one big mistake: follow exactly the incentives created by the central bank's loose monetary policy and banking regulations: its lending and asset base read like the clearest example of the old mantra “Don’t fight the Fed.”
[Since this piece was written, of course, we've had the disgraceful announcement by the dumbarse in the White House and from the former Fed chair who helped blow up the tech bubble, of what is effectively a bailout-to-infinity for depositors. UPDATE: David Stockman, Reagan's former Budget Director, calls it A Bailout Most Crooked. "They have done it again [he comments], and in a way that makes a flaming mockery of both honest market economics and the so-called rule of law. In effect, the triumvirate of fools at the Fed, Treasury and FDIC have essentially guaranteed $9 trillion of uninsured bank deposits with no legislative mandate and no capital."]

How the Central Bank's Easy Money Killed Silicon Valley Bank

by Daniel Lacalle

THE SECOND-LARGEST COLLAPSE of a bank in recent history (after Lehman Brothers in 2008)  could have been prevented. Now the impact is too large, and the contagion risk is difficult to measure.

The demise of the Silicon Valley Bank (SVB) is a classic bank run driven by a liquidity event, but the important lesson for everyone is that the enormity of the unrealised losses and the financial hole in the bank’s accounts would not have existed if not for ultra-loose monetary policy. Let me explain why.

According to their public accounts, as of December 31, 2022, Silicon Valley Bank had approximately $209.0 billion in total assets and about $175.4 billion in total deposits. Their top shareholders are Vanguard Group (11.3 percent), BlackRock (8.1 percent), StateStreet (5.2 percent) and the Swedish pension fund Alecta (4.5 percent).

The incredible growth and success of SVB could not have happened without negative rates, ultra-loose monetary policy, and the tech bubble that burst in 2022. Furthermore, the bank’s liquidity event could not have happened without the regulatory and monetary policy incentives to accumulate sovereign debt and mortgage-backed securities (MBS).

Silicon Valley Bank’s asset base read like the clearest example of the old mantra “Don’t fight the Fed.” Silicon Valley Bank made one big mistake: follow exactly the incentives created by loose monetary policy and regulation.

WHAT HAPPENED IN 2021? Massive success that, unfortunately, was also the first step to demise. The bank’s deposits nearly doubled with the tech boom. Everyone wanted a piece of the unstoppable new tech paradigm. Silicon Valley Bank’s assets also rose and almost doubled.

The bank’s assets rose in value. More than 40 percent were long-dated Treasuries and Mortage-Backed Securities. The rest were seemingly world-conquering new tech and venture capital investments.

Most of those “low risk” bonds and securities were held to maturity. Silicon Valley Bank was following the mainstream rulebook: low-risk assets to balance the risk in venture capital investments. When the Federal Reserve raised interest rates, Silicon Valley Bank must have been shocked.

Its entire asset base was a single bet: low rates and quantitative easing for longer. Tech valuations soared in the period of loose monetary policy, and the best way to “hedge” that risk was with Treasuries and Mortage-Backed Securities. Why bet on anything else? This is what the Fed was buying in billions every month. These were the lowest-risk assets according to all regulations, and, according to the Fed and all mainstream economists, inflation was purely “transitory,” a base-effect anecdote. What could go wrong?

Inflation was not transitory, and easy money was not endless.

Rate hikes happened. And they caught the bank suffering massive losses everywhere. Goodbye, bonds' and Mortage-Backed Securities' prices. Goodbye, “new paradigm” tech valuations. And hello, panic. A good old bank run, despite the strong recovery of Silicon Valley Bank shares in January. Mark-to-market unrealised losses of $15 billion were almost 100 percent of the bank’s market capitalisation. Wipeout.

As the bank manager said in the famous South Park episode: “Aaaaand it’s gone.” Silicon Valley Bank showed how quickly the capital of a bank can dissolve in front of our eyes.

The Federal Deposit Insurance Corporation (FDIC) will step in [and has - Ed.], but that is not enough because only 3 percent of Silicon Valley Bank deposits were under $250,000. ['So what,' said Janet Yellen, the former Fed Chair ho helped blow up this bubble- Ed.]  According to Time magazine, more than 85 percent of Silicon Valley Bank’s deposits were not insured. [But this has not bothered Yellen, who has now ignored her rules, rewarded this failure, and further ignited the financial industry's glaring moral hazard - Ed.]

It gets worse. One-third of US deposits are in small banks, and around half are uninsured, according to Bloomberg. Depositors at Silicon Valley Bank will likely lose most of their money [or should have - Ed.], and this will also create significant uncertainty in other entities [or should have - Ed.].

SILICON VALLEY BANK WAS the poster boy of banking management by the book. They followed a conservative policy of acquiring the safest assets—long-dated Treasury bills—as deposits soared.

Silicon Valley Bank did exactly what those that blamed the 2008 crisis on “deregulation” recommended. Silicon Valley Bank was a boring, conservative bank that invested its rising deposits in sovereign bonds and mortgage-backed securities, believing that inflation was transitory, as everyone except us, the crazy minority, repeated.

Silicon Valley Bank did nothing but follow regulation, monetary policy incentives, and Keynesian economists’ recommendations point by point. It was the epitome of mainstream economic thinking. And mainstream killed the tech star.

Many will now blame greed, capitalism, and lack of regulation, but guess what? More regulation would have done nothing because regulation and policy incentivise buying these “low risk” assets. Furthermore, regulation and monetary policy are directly responsible for the tech bubble. The increasingly elevated valuations of unprofitable tech and the allegedly unstoppable flow of capital to fund innovation and green investments would never have happened without negative real rates and massive liquidity injections. In the case of Silicon Valley Bank, its phenomenal growth in 2021 was a direct consequence of the insane monetary policy implemented in 2020, when the major central banks increased their balance sheet to $20 trillion as if nothing would happen.

Silicon Valley Bank is a casualty of the narrative that money printing does not cause inflation and can continue forever. They embraced it wholeheartedly, and now they are gone. [Or should be.]

Silicon Valley Bank invested in the entire bubble of everything: Sovereign bonds, Mortage-Backed Securities, and tech. Did they do it because they were stupid or reckless? No. They did it because they perceived that there was very little to no risk in those assets. No bank accumulates risk in an asset it believes is high risk. The only way in which banks accumulate risk is if they perceive that there is none. Why do they perceive no risk? Because the government, regulators, central banks, and the experts tell them there is none. Who will be next?

Many will blame everything except the perverse incentives and bubbles created by monetary policy and regulation, and they will demand rate cuts and quantitative easing to solve the problem. It will only worsen. You do not solve the consequences of a bubble with more bubbles.

The demise of Silicon Valley Bank highlights the enormity of the problem of risk accumulation by political design. Silicon Valley Bank did not collapse due to reckless management, but because they did exactly what Keynesians and monetary interventionists wanted them to do. Congratulations.

Author:
Daniel Lacalle, PhD, economist and fund manager, is the author of the bestselling books Freedom or Equality (2020), Escape from the Central Bank Trap (2017), The Energy World Is Flat (2015), and Life in the Financial Markets (2014).
He is a professor of global economy at IE Business School in Madrid.

His post first appeared at the Mises Economics Blog.

"Fix housing regulation and you go along way toward fixing malinvestment."

"Most people don’t understand this process. When they see it play out, they misdiagnose what is actually going on. I see article after article claiming that [central banks like] the US Federal Reserve 'artificially' lowered interest rates, and that this created “malinvestment” into unproductive projects. They claim the problem can be fixed by raising interest rates to a level that imposes discipline on investors, a rate that doesn’t allow for low quality investments to be profitable. That’s wrong.
    "[New Zealand] does have a malinvestment problem, but it’s not at all what many pundits assume. The cause of the malinvestment is zoning and other regulations that make it difficult to build housing. And housing is not just another sector; it’s a key part of investment. These bad regulations push saving into areas that are less productive than housing construction, including marginally productive government and corporate investment.
    "The problem of malinvestment cannot be fixed [just] by having the [Reserve Bank] tweak interest rates; it requires much more fundamental solution. The only way to fix malinvestment is to remove regulations that prevent developers from building what people really want, which is high-quality housing. [Cities like Auckland were transformed in the 1920s when a ring of affordable yet attractive California bungalows were built by profit-seeking speculators at the end of new tram lines. But New Zealand has lost the ambition for such things, and settled instead for three-storey stagnation.]
    "If you ask most people what stands in the way of them having the sort of lifestyle they wish to have, not many will mention a lack of food or clothing. Most have adequate cars and TV sets. Most have a school to send their kid to and some form of health care. Instead, housing is the one area where lots of people are dissatisfied, where dramatic improvements in living standards are still possible. But that requires building new housing in locations close to good jobs. Bandaids such as rent control do not result in a single extra person having housing, and indeed reduce the housing stock in the long run. More housing is the low hanging fruit to raising living standards. Fix housing regulation and you go along way toward fixing malinvestment."

~ Scott Sumner, from his post 'Zoning and 'malinvestment'' [US references have been localised]

 

Central banks' unprecedented monetary expansion over recent years has created damage they cannot simply undo by switching directions now - as Frank Shostak explains in this guest post, their tight interest stance now will struggle to undo the damage caused by their previously ultra-profligate position.

Central Banks Cannot Undo the Damage They Have Already Caused

by Frank Shostak

On March 16 this year, the US central bank (aka the Federal Reserve) raised the target for their federal funds rate by 0.25 percent, to 0.50 percent. According to officials of "The Fed," their increase was in response to the strong increases in the yearly growth rate of the Consumer Price Index (CPI), which in February stood at 7.9 percent (risen from 7.5 percent in January, and from 1.7 percent in February of the year before).

Most commentators believe that by raising the interest rate target, the central bank can slow the increase of prices of goods and services. Supporters of this strategy often refer to May 1981, when then Fed chairman Paul Volcker raised the Fed's funds-rate target from 11.25 percent to 19 percent. The change was dramatic. By December 1986, the yearly growth rate in the CPI, which in April 1980 had stood at 14.8 percent, had fallen to 1.1 percent (see Fig. 1 below).

Fig. 1: CPI vs Federal Funds Rate, 1980 to 1986

Note that commentators commonly identify the growth rate measured by the CPI, i.e. rising prices, as "inflation." We hold, however, that what inflation is all about is increases in money supply. 

As such, we do not say that inflation is caused by increases in money supply, as some commentators are suggesting. Instead, we hold that increases in money supply are what inflation is all about. 

The price of a good is the amount of money paid for it, but whenever there is an increase in the money injected into a particular goods market, this means that the price of the goods in money terms will tend to rise. All things being equal, however, this increase in money in one market will be offset by a decrease elsewhere. It is only an increase in the money supply itself that allows all prices to raise across all markets. This general increase in prices is itself not inflation, however, but rather the manifestation of inflation as a result of the increase in money supply, all other things being equal.

Bad as this is, what is even more important than the increases it causes in the prices of retail goods is the damage that monetary inflation inflicts to the process of wealth generation. This is because increases in money supply set in motion an exchange of nothing for something, which generates a similar outcome to what counterfeit money does. This counterfeit capital progressively weakens wealth generators, thereby weakening their ability to generate wealth. This, in turn, undermines living standards even as real capital is consumed.

Also, note that when this new money is injected, it initially enters a particular goods market. Once the price of those goods rises to a level at which they are perceived as fully valued, the money begins spilling over into other markets that are now considered under-valued. This gradual shift from one market to other markets gives rise to a time lag between these increases in new money, and their effect on the wealth generation process.

Central Banks do not set interest rates. Individuals do.

Note that contrary to popular thinking, interest rates are determined not by central bank monetary policy. Instead, they are driven by the time preferences of individuals. According to the founder of the Austrian school of economics, Carl Menger, the phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services now than they do to identical goods and services in the future. I is this that we call "time preference."

For example, most people will generally prefer being given $100 now rather than, say, $103 a year from now. It is this evaluation by multiple individuals that is the driving force of interest rates across all markets.

Observe that the higher valuation of present goods is not the result of capricious behaviour, but rather the identification that life in the future is impossible without sustaining it in the present. According to Menger:

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economising men generally endeavour to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1

Hence, various goods and services required to sustain one’s life at present must therefore be of a greater importance to that individual than the same goods and services in the future. The individual is likely to assign higher value to the same good in the present versus the same good in the future.

Naturally, each individual's time preference is different. Those with paltry means often have shorter time horizons -- they can contemplate only short-term goals, such as making a basic tool. As his means increase, however, he can consider undertaking the making of better tools. With the expansion in the pool of means, individuals are able to allocate more means towards the accomplishment of ever-more remote goals in order to improve their quality of life over time.

Again, while prior to the expansion of means, the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more resources now this has become possible.

Not that few, if any, individuals will embark on a business venture promises a zero rate-of-return. The maintenance of the process of life, over and above hand-to-mouth existence, requires an expansion in wealth. Wealth expansion implies positive returns.

Is the lowering of rates the key cause behind the increase in capital-goods investment?

Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in capital-goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but rather the increase in the pool of savings.

This "pool of savings" comprises of finished consumer goods -- finished consumer goods produced, but not yet consumed. It is this pool of savings that sustains people employed in the enhancement and the expansion of capital goods such as tools and machinery. With these increased and enhanced capital goods, it is then possible to increase the production of future consumer goods.

Note that in an unhampered market it is not the interest rate per se that drives this pool of savings towards more (or less) future-directed production -- it is the sum of individuals' time preferences toward more (or less) future focus that compel producers to make this choice.

Individuals' decisions to allocate a greater amount of means towards the production of capital goods is signalled by the lowering of individuals' time preferences, i.e., assigning a relatively greater importance to the future goods versus the present goods. 

Hence, the interest rate is just an indicator as it were, which reflects individuals’ decisions regarding their present consumption versus future consumption. (Again, the decline of the interest rate is not the cause of the increase in capital investment. The decline simply mirrors the decision to invest a greater portion of savings towards capital-goods investment).

In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their ventures must abide by consumers’ instructions, and organise a suitable infrastructure to accommodate this signalled demand for more consumer goods in the future (rather than now). 

Note that through the lowering of time preferences, individuals have signalled that they have increased savings which will support the expansion of the production structure to become more future-directed. In the unhampered market, the decline in interest rate is therefore both a signal for more future-directed production, and a reward for undertaking it.

Observe that in an unhampered market, fluctuations in interest rates will tend to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate, they respond to it by increasing their investment in capital goods to accommodate the likely increase in demand for future consumer goods. (Note again that in a free-market economy, a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods versus present consumer goods).

What I have described here however is what happens in a free unhampered market -- in particular, one unencumbered by a government central bank. A major reason for the discrepancy between the so-called 'market interest rate' and the interest rate described here (i.e., the interest rate that fully reflects individuals' time preferences) is caused by the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate regardless of individuals' expressed time preference. Businesses respond to this lowering by increasing the production of capital goods, i.e., tools and machinery, in order to be able to accommodate the demand for consumer goods in the future. Note, however, that consumers have not actually indicated a change in their preferences toward present consumer goods. The time-preference interest rate did not go down. And so a gap emerges between the time-preference rate and the market rate.

It is this gap that causes the dislocations between consumption and consumption that presage economic corrections in future, and encourage over-consumption of capital now.

Because of this breach between the time-preference interest rate and the market interest rate, businesses responding to the declining market interest rate have essentially malinvested in capital goods relative to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that pass decisions with regard to the capital-goods expansion were in error.

Why tightening now cannot undo the negatives of a previous loose stance

According to Ludwig von Mises, a tight monetary stance cannot undo the negatives of the previous loose stance. (In other words, the central bank cannot generate a “soft landing” for the economy.) The misallocation of resources due to a loose monetary policy has already happened, and cannot simply be reversed by a tighter stance. (Mises likens the attempted correction to attempting to cure a road-accident victim by reversing over him.) According to Percy L. Greaves Jr. in the introduction to Mises's The Causes of the Economic Crisis, and Other Essays before and after the Great Depression:

Mises also refers to the fact that deflation can never repair the damage of a prior inflation.... Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

A tighter interest-rate stance, while likely to undermine current bubble activities, is also however still likely to generate various distortions, thereby inflicting damage to wealth generators. Note that a tighter stance is still intervention by the central bank, and in this sense it still falsifies the interest-rate signal set by consumers. A tighter interest-rate stance still doesn't result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter interest rate stance can reverse the damage caused by inflationary policy. 

Now, if we were to accept that inflation is about increases in money supply, then all that is required to erase inflation is to seal off the loopholes for the generation of money out of “thin air” by the central bank. A careful scrutiny of this is going to reveal that the culprit behind the increases in money supply is the monetary policies of the central bank. 

Policies aimed at stabilising price increases are in fact producing economic upheavals. Observe that by February 2021, the yearly growth rate of our monetary measure for the USA jumped to almost 80 percent! This is truly astonishing. Against the background of this massive increase, one should not be at all surprised that the yearly growth-rate of the CPI has accelerated. And against the background of this article, one might begin to understand why policies that aim only at slowing the growth rate of the CPI rather than arresting the growth rate of money supply are likely to undermine economic conditions rather than improve them.

Conclusion

As long as sustaining our lives remains individuals' ultimate goal of individuals (that is, as long as our species continues to breathe), they will go on assigning a higher valuation to present goods than they will to future goods -- to $100 now rather than to $103 a year from now -- and no amount of central-bank interest-rate manipulation is going to change this reality. 

But this will not stop them trying. Any attempt by central bank policy makers to overrule this fact however will undermine the process of wealth formation, and will lower individual living standards.

On the one hand, if individuals have not allocated adequate savings to support the expansion of capital goods investments, then it  is not going to help economic growth if the central bank artificially lowers interest rates. It is not going to help, because it it not possible to replace real savings with more money and an artificial lowering of the interest rate. It is not possible, because it it not possible to generate something from nothing. 

Likewise, by raising interest rates the central bank cannot undo the damage from its previously easy interest-rate stance. A tighter stance will likely generate various other distortions. Hence, what is required is that policy makers should leave the economy alone -- and let the market be completely free from central-bank tampering.

* * * * 

Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen.

Versions of this post previously appeared at the Mises Wire and Cobden Centre.

"Stimulus" from the Santa Claus state will fail us as badly as their phony boom

The world was already awash in debt, borrowed into thin air by the banking system. The cracks had already begin to open up. In setting interest rates to such historically-low levels the financial engineers had already red-lined everything, grievously discouraging savings, grossly inflating every single asset price beyond anything approaching reason, and grotesquely distorting a structure of production already bruised from the disaster of 2008 from which it had never been allowed to repair itself.

But now these bastards have an alibi for the collapse they'd set in motion. This phoney-baloney bubble was already bursting, spectacularly, just as this pandemic hit the globe. It's killing people. But it's rescued the creators of financial apocalypse because everyone's to focused on coronavirus to see their fingerprints for what they are. And everyone can continue to ignore the reality that should be staring them in the face: that we have been consuming the seed corn for decades, and we are just beginning to face the consequences; that for decades now we have over-invested in speculative bubbles, under-invested in productivity-increasing assets, and squandered borrowed money on consumption; that rather than boost productivity, we have lowered productivity via mal-investment, propped up unproductive sectors with immense sums of borrowed money, and finessed the figures to make things look like we were moving forwards.

'Cos the harsh reality is that we weren't moving forwards at all. And it wasn't the pandemic that exposed the lie. It's this pandemic that's allowing the liars to escape responsibility for the destruction that their policies of lose lending and fiscal stimulus unleashed.

And now -- as we're all locked up under home arrest, with nobody allowed to go out and make stuff -- with governments worldwide sending people cheques to keep buying the dwindling amount of stuff that is being made -- mainstream economists everywhere are still scratching their chins on new "fixes," as if "stimulus" from the Santa Claus state will save us instead of sink us all.

For years they've ignored the coming consequences of their economic programme -- which is based on nothing more than promoting the bizarre idea that economic prosperity means living on debt forever. They watched, these central bank planners and mainstream economic engineers, as interest rates had to go ever lower to get the tiniest amount of effect, and as the marginal productivity of every dollar of new debt sunk ever lower. They talked smack about "rock-star economies" and "tech-led booms" while refusing to see the reality in front of them, or to ask themselves the slightest question about their methods.

And now that the consequences are upon us all, they're arguing about a "v-shaped recovery" or a "u-shaped recovery" as if that isn't just fantasy land. And instead of being exposed as the charlatans that they are, instead they're hiding behind the "exogenous shock" of the pandemic as if their gross irresponsibility wasn't responsible for leaving us so unable to cope.

And on panels and advisory committees everywhere, the very people who are responsible for the global economic meltdown their own advice set in motion are now being called on to deliver advice on what to do next.

It's like asking an arsonist how to rebuild after the fire he himself set.

It's grotesque.

LISTEN: And how little intelligent commentary is there at the moment analysing the twin problems of the bursting bubble coupled with the pandemic -- and the irresponsible government and central bank responses. Here's one of the few that I've found: Professors Joseph Salerno and Peter Klein join Tom Woods "to discuss the economics of the extraordinary episode we are currently living through, as well as the likely consequences of how the U.S. federal government and the Federal Reserve Bank are responding."

Sorry Mr Keynes, credit creation does not create credible growth

 

Keynesians and all those modern mainstream economists who still follow his meretricious macroeconomic meanderings maintain that what drives economic growth is not savings but credit growth – and the more credit growth you have, even if it’s credit created not out of real savings but totally out of thin air, the more of that freshly-minted paper you have then the more economic growth you will have.

QED. Or as the Latin scholars say, Quod Erat Demonstrandum.

And yet is never has been demonstrandum.

This is perhaps the single most important thing to understand about economics in the age of paper money: their faith-based conviction that credit growth in and of itself drives economic growth. It is held by modern macro types almost as a religious fixation, immune to criticism ever since postulated by the Master.

It’s what’s behind all the efforts ever since this Great Recession began to “kickstart” economies by lowering, lowering, ever-lowering interest rates --- lower them enough, credit growth will take off, and economic growth will be sure to follow. That’s what wil happen, they assure us.

But it hasn’t. In fact, it never has happened liked that.

In 1971, in the US, the ratio of total credit to GDP was 150%. Now it is 354%. In other words, credit has been growing much more rapidly than the economy for the past four decades.

You think, maybe, these boys may have ever read about something called diminishing returns? Because even with a measure of growth that juices up spending, which is all that GDP really measures, they still can’t get their gimmick to really achieve take-off. Not in the US. Not in China. Not in Japan. Not in Europe. Not in New Zealand (where credit is growing at a rate of between 6-10% per year, and growth by their measure by something around a quarter of that).  And the more they try to juice things up, the more fragile they make the system – and the more that rapidly growing debt bubbles up in all the places that it shouldn’t.

Like our over-heated housing market.

Here’s what a busted theory looks like:

If their creation of counterfeit capital causes anything, then it’s not growth but booms and bubbles and all their inevitable busts (with the credit-to-GDP gap rising significantly before every bust):

Do you think these boys ever read anything about malinvestment?

Frankly, friends, when real sustainable growth really does happen, it happens despite these morons, not because of them.

But as the theory is seen to be holding less and less water, instead of questioning their incantation – more counterfeit credit, more economic growth -- the modern macro types in positions of central-banking power instead have just kept right on lowering interest rates until things pop. Lower, and lower, and lower, impervious to all the damage they’ve been doing, right on down until interest rates in some parts of the world are now negative. Below zero. Past the quantum limit. Out there past the speed of light. Boldly going where not even another central banker had historically gone before.

This really is uncharted economic territory, and we’re out there without even a hard-money lifeboat to save us. Negative interest rates mean that you now pay banks to hold your paper money. Savers now pay them interest to look after it.

But as more and more central bankers take the plunge into negative interest rates, they’re discovering that it’s still not working [listen to AUDIO] and with no other tinking from their tatty textbooks to try, they’re just going to keep doubling, down, down, and ever further down.

What do you think that will do to the rate of saving – out of which comes genuine credit creation?

What do you surmise that will do to savers themselves? and to pension funds dead-set reliant on passive income?

What do you think that will do in the long run, or even the medium run when we’re all still far from dead, to the economic expansion these modern macro morons say their creation of phoney credit is trying to encourage?

Real credit creation comes not from thin air but from the pool of real saving – the saving that Grandmaster Keynes said wasn’t necessary. The saving that sets aside real resources for productive future use, instead of being consumed now.

But that’s the very saving the phony credit-creation discourages – and is ever-more discouraging as interest rates sink ever lower into negative territory.

When do you think these morons will begin questioning their faith? Because you can’t create savings or growth just by printing more money.

.

Dairy, oil, iron, rubber, steel, malinvestment

 

Oil prices are historically low, and oil producers are struggling to cope.

Dairy prices are historically low, and dairy farmers are struggling to cope.

These two stories are both in the news this morning.

These two stories are not unrelated.

The price of all commodities are at historical lows, not just these, and the reason for all is the same: the creation in the last seven years of counterfeit capital at record rates. This is what “stimulus season” finally wrought: an avalanche of malinvestment creating a mountain of over-supply.

See, here’s the thing. While many were worrying when stimulunacy was all the rage that record low interest rates being lent out at record levels would simply result in hyper-inflation. (And, if you look at Auckland house prices, they’re partly right.)

But not all of that record lending went into buying holidays for cashed-up Auckland vendors. As much or as more of that record lending went into production—to production in a very bad context. That context being this: this seven-year period of Greater Recession began because the structure of prodution was out of whack. (That’s what generally causes a recession: the structure of production being out of whack often because of a period of profligate lending at low interest rates.)

So, much of that new lending going into production around the world simply helped prop up these existing bad positions. It kept the zombies going. But as much again went into genuinely new production: of impossibly productive shale oil fields; of newly-rich dairy farms; of iron ore and steel and rubber and on and on and on.

All that lending going into what Hayek explained as the “early stages” of production produced a short-term yet (this time) very flaccid boom. The bust is what happens when it is realised not all the world wants all that product, and at those prices as they are now few are in a position to stay afloat.

That was the Fourth Act of this depressing story played out on Morning Report today with fourth-generation Northland farmer Ben Smith one of those taking the fall. [Listen to his interview here.]

So too are rubber producers.

And iron-ore producers.

And oil producers.

And on, and on, and on.

It’s true that in the last two decades in which central banks have been organising debt into currency at record rates much economic progress has been made, and much real wealth has been produced. But in times like this it’s desperately hard to tell the malinvestment from the real thing.

Stated differently, the worldwide economic and industrial boom since the early 1990s was not indicative of sublime human progress or the break-out of a newly energetic market capitalism on a global basis. Instead, the approximate $50 trillion gain in the reported global GDP over the past two decades was an unhealthy and unsustainable economic deformation financed by a vast outpouring of fiat credit and false prices in the capital markets.
    For that reason, the radical swings in commodity prices during the last two decades mark not merely the unique local supply and demand factors which pertain to crude oil, copper, iron ore, or the rest, but the path of a central bank generated macro-economic bubble.

Folk like Ben Smith are now paying that price.

RELATED POSTS:

• “Dairy farm debt has reached $38 billion, and the Reserve Bank's financial stability report said the risk of non-performing loans had increased over the past two years. It listed a ‘severe’ future scenario as a milk price of $4. The "worst case scenario" would feature a slow recovery in payout and sharp decline in land values resulting in non-performing loans - in other words, defaults on payments - increasing to about 44 percent.”
  Dairy downturn expected to hit land values: 'They are going to see land values drop' – RADIO NZ
• “From the debt problems of an underwater government --now over $100 billion in debt and counting -- to the debt problems of underwater dairy farmers who, like dairy farmers around the globe, had credit extended to bring new dairy into production, only to find that debt-driven overproduction has lowered dairy prices below what many need even just to repay their debt.
  ”Can anyone yet spell malinvestment?”
  Dairy’s debt delusion – NOT PC, 2015
• “Are you surprised?  Mainstream economists might be, but this is precisely what Austrian economists expect to see as the “rapid growth” of a credit-created boom turns into debt-based bust.   You see, Austrian economists understand two relevant things here that mainstreamers don’t … “
  Dairy bubble starts to pop – and guess who’s holding the pin? – NOT PC, 2009
• “Investors’ desperate search for yield has all the Fed’s counterfeit capital been pumped into supplying more commodities, like oil, than the market actually demands? If so, does that make the recent savage surge in oil supply a classic Austrian mountain of malinvestment? And if so, then what happens next?”
  Q: So what happens when oil hits $45 a barrel? – NOT PC, 2015

The further failure of phony credit creation

The mainstream view on economic growth is that it is based on credit, great gobs of it, created out of thin air by trading banks on the back of very scanty reserves and lent out under the control and at the behest of the central bank. Created credit creates growth, they say.

The Austrian view is that economic progress is based on progress in creating and accumulating capital. That created credit is counterfeit capital. That growth created by counterfeit capital is illusory, is malinvestment. That it leads to bubbles (borrowing to buy inflating assets, assets inflating further, inducing more borrowing to buy more inflating assets … rinse and repeat), to over-supply, and to long-period projects begun but not able to be completed. That its phony boom leads inexorably to a real bust.

Every 6-12 years we seem to have to undergo the test between these views again. Guess which view is being exposed in recent headlines. First:

S&P downgrades NZ banks on Auckland bubble – MACROBUSINESS
Standard & Poor’s has cut its stand-alone credit profiles on New Zealand’s big four banks, and lowered its ratings on some other local financial institutions, due to concern over rising Auckland house prices.

NZ houses being purchased, of course, very largely by large amounts of created credit. Second:

Doomsday clock for global market crash strikes one minute to midnight as central banks lose control – TELEGRAPH
When the banking crisis crippled global markets seven years ago, central bankers stepped in as lenders of last resort. Profligate private-sector loans were moved on to the public-sector balance sheet and vast money-printing [i.e., of counterfeit capital creation] gave the global economy room to “heal.”
    Time is now rapidly running out. From China to Brazil, the central banks have lost control and at the same time the global economy is grinding to a halt. It is only a matter of time before stock markets collapse under the weight of their lofty expectations and record valuations.

The Telegraph lists several sinister signposts towards a bust:

1. China slowdown … recent Chinese economic activity having being boosted on the back of credit creation
2. Commodity price collapse … commodity production having been boosted on the back of credit creation
3. Resource sector credit crisis … producers borrowing on the back of credit creation losing money on prices created by oversupply boosted by credit creation
4. Emerging markets begin to fall … crippled by currency devaluation on the back of collapsing commodity prices
5. Credit markets roll over … as six years of reliance on central banks for funds has left the credit system unable to cope
6. Interest rate shock … as the last six years of low-interest fantasy turns into a higher-interest reality
7. Bull market third longest on record … on only two other occasions in history has the market risen for longer. One is in the lead-up to the Great Crash in 1929 and the other before the bursting of the dotcom bubble in the early 2000s …
8. Overvalued US market … Professor Robert Shiller’s cyclically adjusted price earnings ratio for the S&P 500 stands at 27.2, some 64pc above its historic average of 16.6. On only three occasions since 1882 has it been higher – in 1929, 2000 and 2007

Can you see a connection?

Phony credit was created in large gobs in the hope of “healing” the previous bust, which was created on the back of large gobs of phony credit creation in the hope of “healing” the previous bust, which was created on the back of large gobs of phony credit creation in the hope of “healing” the previous bust ... rinse, repeat … but repent?

Over to you mainstreamers.

[Hat tip Hugh Pavletich]

The Slow-Motion Financial Suicide of the Roman Empire

The Bailout State Is as Old as Rome

Guest post by Larry Reed

More than 2,000 years before America’s bailouts and entitlement programs, the ancient Romans experimented with similar schemes. The Roman government rescued failing institutions, cancelled personal debts, and spent huge sums on welfare programs. The result wasn’t pretty.

Roman politicians picked winners and losers, generally favouring the politically well connected — a practice that’s central to the welfare state of modern times, too. As numerous writers have noted, these expensive rob-Peter-to-pay-Paul efforts were major factors in bankrupting Roman society. They inevitably led to even more destructive interventions. Rome wasn’t built in a day, as the old saying goes — and it took a while to tear it down as well. Eventually, when the republic faded into an imperial autocracy, the emperors attempted to control the entire economy.

Debt forgiveness in ancient Rome was a contentious issue that was enacted multiple times. One of the earliest Roman populist reformers, the tribune Licinius Stolo, passed a bill that was essentially a moratorium on debt around 367 BC, a time of economic uncertainty. The legislation enabled debtors to subtract the interest paid from the principal owed if the remainder was paid off within a three-year window. By 352 BC, the financial situation in Rome was still bleak, and the state treasury paid many defaulted private debts owed to the unfortunate lenders. It was assumed that the debtors would eventually repay the state, but if you think they did, then you probably think Greece is a good credit risk today.

In 357 BC, the maximum permissible interest rate on loans was roughly 8 percent. Ten years later, this was considered insufficient, so Roman administrators lowered the cap to 4 percent. By 342, the successive reductions apparently failed to mollify the debtors or satisfactorily ease economic tensions, so interest on loans was abolished altogether. To no one’s surprise, creditors began to refuse to loan money. The law banning interest became completely ignored in time.

By 133 BC, the up-and-coming politician Tiberius Gracchus decided that Licinius’s measures were not enough. Tiberius passed a bill granting free tracts of state-owned farmland to the poor. Additionally, the government funded the erection of their new homes and the purchase of their faming tools. It’s been estimated that 75,000 families received free land because of this legislation. This was a government program that provided complimentary land, housing, and even a small business, all likely charged to the taxpayers or plundered from newly conquered nations. However, as soon as it was permissible, many settlers thanklessly sold their farms and returned to the city. Tiberius didn’t live to see these beneficiaries reject Roman generosity, because a group of senators murdered him in 133 BC, but his younger brother Gaius Gracchus took up his populist mantle and furthered his reforms.

Tiberius, incidentally, also passed Rome’s first subsidized food program, which provided discounted grain to many citizens. Initially, Romans dedicated to the ideal of self-reliance were shocked at the concept of mandated welfare, but before long, tens of thousands were receiving subsidized food, and not just the needy. Any Roman citizen who stood in the grain lines was entitled to assistance. One rich consul named Piso, who opposed the grain dole, was spotted waiting for the discounted food. He stated that if his wealth was going to be redistributed, then he intended on getting his share of grain.

By the third century AD, the food program had been amended multiple times. Discounted grain was replaced with entirely free grain, and at its peak, a third of Rome took advantage of the program. It became a hereditary privilege, passed down from parent to child. Other foodstuffs, including olive oil, pork, and salt, were regularly incorporated into the dole. The program ballooned until it was the second-largest expenditure in the imperial budget, behind the military.It failed to serve as a temporary safety net; like many government programs, it became perpetual assistance for a permanent constituency who felt entitled to its benefits.

In 88 BC, Rome was reeling from the Social War, a debilitating conflict with its former allies in the Italian peninsula. One victorious commander was a man named Sulla, who that year became consul (the top political position in the days of the republic) and later ruled as a dictator. To ease the economic catastrophe,Sulla cancelled portions of citizens’ private debt, perhaps up to 10 percent,leaving lenders in a difficult position. He also revived and enforced a maximum interest rate on loans, likely similar to the law of 357 BC. The crisis continually worsened, and to address the situation in 86 BC, a measure was passed that reduced private debts by another 75 percent under the consulships of Cinna and Marius.

Less than two decades after Sulla, Catiline, the infamous populist radical and foe of Cicero, campaigned for the consulship on a platform of total debt forgiveness. Somehow, he was defeated, likely with bankers and Romans who actually repaid their debts opposing his candidacy. His life ended shortly thereafter in a failed coup attempt.

In 60 BC, the rising patrician Julius Caesar was elected consul, and he continued the policies of many of his populist predecessors with a few innovations of his own. Once again, Rome was in the midst of a crisis. In this period, private contractors called tax farmers collected taxes owed to the state. These tax collectors would bid on tax-farming contracts and were permitted to keep any surplus over the contract price as payment. In 59 BC, the tax-farmer industry was on the brink of collapse. Caesar forgave as much as one-third of their debt to the state. The bailout of the tax-farming market must have greatly affected Roman budgets and perhaps even taxpayers, but the catalyst for the relief measure was that Caesar and his crony Crassus had heavily invested in the struggling sector.

In 33 AD, half a century after the collapse of the republic, Emperor Tiberius faced a panic in the banking industry. He responded by providing a massive bailout of interest-free loans to bankers in an attempt to stabilize the market. Over 80 years later, Emperor Hadrian unilaterally forgave 225 million denarii in back taxes for many Romans, fostering resentment among others who had painstakingly paid their tax burdens in full.

Emperor Trajan conquered Dacia (modern Romania) early in the second century AD, flooding state coffers with booty. With this treasure trove, he funded a social program, the alimenta, which competed with private banking institutions by providing low-interest loans to landowners while the interest benefited underprivileged children. Trajan’s successors continued this programme until the devaluation of the denarius, the Roman currency, rendered the alimenta defunct.

By 301 AD, while Emperor Diocletian was restructuring the government, the military, and the economy, he issued the famous Edict of Maximum Prices. Rome had become a totalitarian state that blamed many of its economic woes on supposed greedy profiteers. The edict defined the maximum prices and wages for goods and services. Failure to obey was punishable by death. Again, to no one’s surprise, many vendors refused to sell their goods at the set prices, and within a few years, Romans were ignoring the edict.

Enormous entitlement programs also became the norm in old Rome. At its height, the largest state expenditure was an army of 300,000–600,000 legionaries. The soldiers realized their role and necessity in Roman politics, and consequently their demands increased. They required exorbitant retirement packages in the form of free tracts of farmland or large bonuses of gold equal to more than a decade’s worth of their salary. They also expected enormous and periodic bonuses in order to prevent uprisings.

The Roman experience teaches important lessons. As the 20th-century economist Howard Kershner put it, “When a self-governing people confer upon their government the power to take from some and give to others, the process will not stop until the last bone of the last taxpayer is picked bare.” Putting one’s livelihood in the hands of vote-buying politicians compromises not just one’s personal independence, but the financial integrity of society as well. The welfare state, once begun, is difficult to reverse and never ends well.

Rome fell to invaders in 476 AD, but who the real barbarians were is an open question. The Roman people who supported the welfare state and the politicians who administered it so weakened society that the Western Roman Empire fell like a ripe plum that year. Maybe the real barbarians were those Romans who had effectively committed a slow-motion financial suicide.

---

Lawrence W. ("Larry") Reed became president of the Foundation for Economic Education (FEE) in 2008 after serving as chairman of its board of trustees in the 1990s and both writing and speaking for FEE since the late 1970s.
This post first appeared at FEE’s blog, Anything Peaceful.