In the meantime, the debasement of paper money continues

“When they stop buying bonds, the game is over.”

by DETLEV SCHLICHTER

I took the title for this blog from an interview that James Turk of the GoldMoney Foundation conducted with Eric Sprott, a Canadian fund manager. You can see it here. (I also recommend you have a look at this interview with Doug Casey.) I think the quote is a succinct summation of the role that the bond market, and in particular the market for government bonds, now plays in this crisis.

As you know, I would not touch bonds with a barge pole, especially government bonds. After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.

What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece. Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets. As I explainedhere, market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. What the system cannot cope with is higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defence asset.

Amazingly, Treasuries did almost as well (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefitted from the disaster in other euro bond markets, and they pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). I believe this is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going one way: up.

Progress is not irreversible

China’s Forgotten Industrial Revolution

by Stephen Davies 

We live in a world that has been shaped by a process that began some 250 years ago in northwestern Europe. We often call it the Industrial Revolution because one of its most dramatic features was the appearance of industrial manufacture with the rise of the factory system. However, this was only one element and not the most significant. Moreover, concentrating on industrialization suggests that the change is now complete. The process continues.

It has several important aspects, which are mutually reinforcing. The most obvious is continuous intensive economic growth. Intensive growth is marked by constant innovation and increased efficiency: doing new things and doing more with less. Extensive growth, the historical norm, means more of the same and doing more with more, that is, with no increase in efficiency or productivity. Another important part of the process is continuous technological innovation and improvement. This both reflects and encourages a growth of theoretical knowledge. (See Joel Mokyr’s The Gifts of Athena: Historical Origins of the Knowledge Economy.) Yet another part is the development of increasingly complex economic institutions and instruments.

All historians recognize the existence and importance of this phenomenon. However, they disagree about many other related matters. In particular there is no real agreement about how this process started and why it happened in Europe rather than some other part of the world. Why not in the Islamic world or in India? Above all, why not in China? The last question is the truly difficult one. As Kenneth Pomeranz points out in The Great Divergence: China, Europe and the Making of the Modern World Economy, economically China was on an equal footing with Europe until the mid-eighteenth century or later. In fact, for the greater part of human history China was by far the most innovative and technologically advanced of the great civilizations. The list of important inventions first made in China is almost endless. So why did the revolutionary process not start there?

Actually, it did start in China before it did in Europe. As Eric Jones has pointed out in Growth Recurring: Economic Change in World History, China had an “industrial revolution” comparable to that of eighteenth-century Europe—some 800 to 900 years ago. It happened under perhaps the most maligned yet fascinating of China’s imperial dynasties, the Song.

The Song reunited China following the division and chaos of the Five Dynasties (907–960). The dynasty was founded by two remarkable brothers, Song Taizu (960–976) and Song Taizong (976–997). They introduced a number of important changes in the economic policy and organization of the Empire. One was a measure that gave peasant farmers true property rights in their land, above all the right to sell it. The result was the emergence of a market in land, which led to the consolidation of smaller farms and the appearance of commercial agriculture. Even more important was their fiscal policy. Traditionally the Chinese state had depended on taxes levied on the peasantry, most often paid in kind. Song Taizu laid down the principle, “Agrarian taxes must not be increased.” Consequently, the Song came to depend increasingly on taxes on trade and so systematically encouraged it.

This had dramatic results. China rapidly became a highly monetized economy. In 750 only 4 percent of all taxes was paid in money, but by 1065, 50 percent was paid that way. In 1024, in the reign of Song Renzong, the widespread use of paper money began. Initially, paper notes had a strict three-year limit and were convertible into cash or specified quantities of commodities. With time, checks, promissory notes, and bills of exchange were all used. By the end of the dynasty, the amount of paper money in circulation was equivalent to 70 million strings of cash, or 70 billion copper coins.

Dramatic Economic Growth

Agriculture, trades, and manufacture all grew dramatically. It is clear, particularly from the agricultural evidence, that this was intensive, not extensive, in nature. Thus while the population doubled between 960 and 1020, the output of rice more than doubled. In 1078, China produced 125,000 tons of cast iron, more than the rest of the planet put together. This would not be surpassed until the 1790s, in Britain. A whole range of technological breakthroughs and improvements were made. These included movable type printing (1000), the blast furnace (1050), mechanical water clocks (1090), paddlewheel ships (1130), the magnetic compass (1150), water-powered textile machinery (1200), and most dramatically, huge oceangoing junks with watertight bulkheads, a carrying capacity of 200 to 600 tons, and a crew of about 1,000 (1200).

The period also saw rapid urbanization, most notably in cities such as Kaifeng, Liaoyang, and Hangzhou. One aspect of this was the deregulation of markets as part of the policy of encouraging commerce. Previously markets had only been allowed in specified places under tight control. Under the Song, towns and cities had street markets, shops on the major streets and thoroughfares, and specialized shopping areas with products from all over the empire and beyond. Two other aspects of Song policy were related to this phenomenon. One was the encouragement of import and export trade. In 964 total revenues from exports amounted to 500,000 strings of cash; by 1189 they came to 65 million strings. The other aspect was free movement throughout the empire, encouraged by another Chinese invention, the motel.

By the 1260s China had reached a level of technological sophistication and economic development that Europe would not achieve until the late eighteenth or early nineteenth century. All the above-mentioned features of the process that produced modernity can be found in Song China, which was clearly being transformed in the way that our world has been and continues to be. However, it did not continue. Instead Chinese society stabilized. It remained superior or equal to European society until about 1800, but the dynamic process stalled. That it did not continue is truly a tragedy. If it had we would be living in a “Chinese” world rather than a “Western” one. We would also be much richer and more knowledgeable.

Why did it not continue? As Jones says, this is the big and important question for economic historians. As ever, there are many answers. This is, however, not just of interest to historians, for the answers may have a considerable import for ourselves and our own position.

Leap in void

The Euro: The Folly of Political Currency

By Robert P. Murphy

The financial markets continue to surge and collapse based on the latest news from Europe. As of this writing, the big events are Slovakia’s unwillingness to contribute to a bailout fund and the failure of Dexia, a French-Belgian bank with assets of almost $700 billion. As the sovereign debt crisis has intensified in the last few months, it is becoming a real possibility that the euro itself will soon collapse.

Even if it managed to squeak through and survive—aided by massive taxpayer infusions along the way—the euro’s vulnerability underscores the folly of a political currency. More so than any other currency in history, the euro has been a creation of technocrats working for modern nation-states. That the euro may well be on its deathbed hardly a decade after its birth demonstrates the futility of central planning. A durable monetary system, free from recurring crises, can only emerge spontaneously from voluntary exchanges in the marketplace.

The European Union and euro were officially created by the Maastricht Treaty in 1993. In addition to the political and cultural objectives, the EU and the single currency, which went into circulation in 2002, were significant steps in the effort to turn Europe into a unified economic zone patterned after the United States.

Before the introduction of the euro, a large business based in France that, say, had a factory paying workers in Italy and which bought machine parts from Germany would be vulnerable to shifts in the exchange rate between the franc, lira, and mark. But with a single currency the firm could focus on its customers and product lines, rather than worrying about the foreign-exchange market. This stability across the continent would (supposedly) give European businesses the same advantages that U.S.-based firms enjoy, since Americans in all 50 states use the dollar.

Because a currency’s ability to facilitate transactions only increases as more people use it, at first we might expect that the nations adopting the euro would want as many of their neighbors as possible to join. Yet in reality there were formal rules (called the Maastricht criteria, also the “convergence criteria”) that new applicants needed to satisfy before adopting the euro. The rules set standards for countries’ inflation rates, budget deficits, government debt, exchange rates, and long-term interest rates.

At first glance it seems odd that the developers of a new currency would want to restrict its usage. To repeat, the whole point of a currency union is to reduce transaction costs among the individuals using it. Thus it would seem that these benefits would only increase as the group grew.

Yet there are other factors at work, which the designers of the euro understood (if only imperfectly). In particular the euro is a fiat currency, meaning that the printing press could be used to achieve political ends. This explains why governments already using the euro are reluctant to admit relatively spendthrift governments into their club: There is a danger that the more profligate members will hijack monetary policy directly, or that they will require a monetary bailout (as we are seeing in practice).

Benefits of a Commodity Standard

Notice that these potential problems would be nonexistent under a fully backed commodity standard. For example, suppose that the creators of the euro, rather than reading the work of mainstream monetary theorists such as Robert Mundell, instead had studied the proposals of Ludwig von Mises in The Theory of Money and Credit. In this alternate universe the authorities in Brussels would stand prepared to issue new paper euros to any individual or institution (including governments and central banks) that handed them a fixed weight of gold.

Not cute as Che, but still ...

Castro regime is murdering Cuban political prisoner Ivonne Malleza

The Castro regime's slow murder of Cuban political prisoner Ivonne Malleza continues.

The blog La revolucion de los gladiolos reported Wednesday that after more than a week on hunger strike, Malleza is in "grave danger." She was recently transferred to the maximum security Manto Negro prison, where she was being held in an isolation punishment cell. (There was one report that Malleza was being forced to remain in the nude.)

The blog reported that Malleza is suffering heavy bleeding caused by uterine fibroids. She has requested medical attention -- a plea that has fallen on the deaf and/or indifferent ears of her jailers.

Malleza also has gone two days without drinking water because the only available water is warm and in a dirty container. Her supporters worry that if she doesn't drink water soon and receives needed medical care, she is at risk of organ failure and eventually, death.

Malleza, her husband Ignacio Martinez and another activist, Isabel Alvarez, have been in jail since Nov. 30, when they were arrested after they went to a Havana park and unfurled a banner carrying anti-Castro slogans.

For more about Malleza, read this.

And to sign a petition demanding the release of Malleza, Martinez and Alvarez, sign this petition.

Lost in translation

What Greece Can Learn From South America

Greek demonstrators protest in Athens on Nov. 8. Similar economic crises in Argentina and Uruguay a decade ago may be instructive for Greece today.

by JUAN FORERO

As Greece struggles with a financial crisis, there have been violent protests, creditors demanding their money, people losing their jobs and officials hunkering down.

A decade ago, that was the scene in South America when Argentina and Uruguay defaulted. The two handled the economic calamity in very different ways. Economists say their approaches — and what's happened in each country since — are instructive for European leaders as they try lifting Greece from its turmoil.

In 2001, Argentine police battled with rioters in Buenos Aires, and there was a run on bank deposits. The country couldn't pay its bills.

So President Adolfo Rodriguez Saa, who served just one week, announced before Congress that Argentina would default.

And then, in patriotic fervor, everyone shouted, "Argentina, Argentina!" It was the biggest default in history — $100 billion. Economists say the chaotic response from Argentine leaders was a recipe for disaster.

They failed to heed years of warnings. And then the government froze bank accounts and defaulted without negotiating with creditors.

Poverty rose to nearly 50 percent, and millions were instantly unemployed. Argentina also became a pariah for investors.

"In crises like this, there's a tendency to think that another loan will tide you over to the next year or the next two years, when things are better and you'll have access to the markets again," says John Taylor, who was an undersecretary at the U.S. Treasury Department back then and dealt with the Argentine fallout.

"But so often, and it certainly is the case in Greece, they had to have a write-down and more loans were not going to be the answer," says Taylor, who now teaches economics at Stanford.

By a write-down, Taylor says he means a default. But he says he has in mind an orderly and negotiated default, involving international creditors.

That was the case in the country of 3.5 million people across the River Plate from Argentina — Uruguay.

Uruguay's Pragmatic Approach

Like Argentina, Uruguay had a run on banks in 2002 and couldn't pay its bills.

But Uruguay's response was all calm pragmatism, according to Argentine economist Orlando Ferreres. Ferreres recently met with 70 European businessmen who came to Buenos Aires to learn about the Argentine and Uruguayan defaults.

The Uruguay solution was telling creditors we can't pay it all, Ferreres says, but we can pay you 80 percent by extending payments. Nearly all of Uruguay's creditors accepted. Uruguay also negotiated a $1.5 billion bridge loan from the U.S. Treasury Department and made cuts to pensions and salaries.

Carlos Steneri, an economist who oversaw Uruguay's debt management at the time, says moving fast was key.

"Time in these type of situations is crucial, and I believe the insolvency of the Greece case today is in part a consequence of the delay of taking actions," Steneri says.

What happened since can also serve as a lesson for Greece.

Both Argentina and Uruguay have seen their economies expand dramatically, thanks to booming Asian demand for agricultural products that took off soon after their defaults.

That growth generated adoration from Argentine supporters of President Cristina Fernandez de Kirchner, fueling her re-election in October.

But the effects of how the two countries responded to the crisis are still readily apparent — in their access to capital markets.

Only five months after defaulting, Uruguay was once again able to borrow internationally. Argentina, on the other hand, is effectively barred from borrowing on the open market.

Ten years later, it uses central bank reserves and the nationalized pension system to fund a big-spending government.

Times are about to get ugly

Ain't no Chairs

By Bob Moriarty
I came across an interesting quote recently in The Gartman Letter. Dennis Gartman quotes Charles Biderman of TrimTabs fame.

"European leaders are searching for a relatively quick and easy way out of the government debt bubble that has been building for decades and just started to burst a few years ago. Unfortunately, there is no quick or easy way out.

"Debt has to be reckoned with one way or another. It either has to be repaid, or someone has to bear the losses on what cannot be repaid, either through default or inflation and currency debasement. If it were otherwise, everyone could be rich.

"The bailouts proposed for the Eurozone do not solve the underlying solvency problem. Instead, they are little more than shell games to shift losses on bad debt from bondholders to taxpayers."

That of course is a variation of my very important concept that all debt gets paid, either by the borrower or by the lender.

Greece is a serial deadbeat and has not even the slightest intention of paying their bills. The EU can play games until the cows come home but the Greek debt is not going to get paid. Greece defaulted many months ago and the governments of the EU and the financial media keep pretending there is a solution. There is none.

Here are the facts. There is $195 trillion dollars of debt in the world but only $150 trillion in assets. That assumes there isn't trillions more of debt hidden in the $600 trillion in derivatives. I suspect the debt may be far higher than anyone anticipates today.

The debt cannot be paid, even if the entire load is dumped like bales of hay onto the backs of the taxpaying camels. The debt must be written off and governments, like corporations and families, must learn to live within their budgets. We cannot float in a sea of debt attached to an anchor of unpaid obligations.

No one in the United States has done the math on the obligations the Federal Reserve dumped on the backs of Americans since 2008 else they would be carrying pitchforks and hot tubs of tar to the local OWS rally. If you assume 330 million Americans and $16 trillion in loans from the Fed, that is $48,000 and change per every American. Will that ever be paid back? No.

I made the comment years ago that the $600 trillion in derivatives is like a game of musical chairs in a giant casino with people playing with Monopoly money. Well, the music stopped in September of 2008 and there ain't no chairs.

The world economy is in a minefield where each day another unforeseen mine explodes. The Dexia Bank, Belgium's largest, which passed the fake stress tests with the highest ratings, crashed a few weeks ago. I cannot help but be reminded of the failure of the Credit-Anstalt Bank of Austria that crashed in May of 1931 and led to a series of cascading bank failures and eventually to a total shutdown of all US banks in March of 1933.

I'm going to crawl out on a limb and suggest that 2012 is going to go down in history as the year of the bank failures. Every bank in the United States has been underwater since 2008 and the only reason the doors remain open is a mob psychosis insisting the King is indeed clothed. Well, he ain't and the banks will collapse.

We had a perfect example of surprise explosions proving market forces are far more significant than government manipulation with the sudden collapse of MF Global on October 31st. This is the biggest bankruptcy since the fall of Lehman Brothers in 2008 but was a total shock to the market.

November 1, 2011 brought yet another mine explosion with the release of news from Greece where Prime Minister George Papandreou announced that he would call for a referendum by Greek voters as to implementation of new austerity measures. Given that 80% of voters indicate they are against the measures and 70% are in favor of staying in the Euro (And why not? It's a Goodo Dealo.) Greece just blew the French/German bailout plan sky-high. The Greeks literally are caught between a rock and a hard place.

I want to make it abundantly clear that there are no good solutions in Europe, the Euro is doomed. Indeed there are no good solutions on our side of the water, our financial system is toast.

The AWA protests in the United States (Americans with an Attitude) have escalated to a new degree with the shooting in the head at point blank range of a Former Marine protester by a San Francisco policeman working in Oakland on October 25. It's interesting and noteworthy that a Federal Judge ruled that the demonstrators were there perfectly legally. Clearly Scott Olsen was peaceful in his actions and presented no threat to anyone.

Videos show a SFPD officer firing a tear gas grenade at Olsen at a range of about 10 feet. When Olsen collapsed and fell to the ground, other demonstrators tried to come to his aid. The same policemen pulled out a flashbang grenade and tossed it into the middle of the group.

If the United States were a nation of laws, that officer would be in jail on charges of attempted murder. But when the biggest criminals in the country are working on Wall Street and the Justice Department thinks that arming Mexican drug gangs is a great idea, we are long past the point where those in power obey laws. It's interesting that the Oakland PD says that it will take months to investigate the case. Yea, right.

I wasn't shocked over the protests in New York and spreading protests all over the United States. Frankly I've wondered since 2008 just how long it would take Americans to wake up and recognize the shafting they were getting from the government. Frankly I was shocked over the protests spreading to Canada.

Face it, the only thing Canadian have felt like rioting over in the last 350 year was ice hockey. For Canadians to recognize that maybe Big Government wasn't their best friend is a sea change in attitude. We are in the early days of a Global Revolution. It's going to be ugly, it's going to be bloody and no one today can even guess how bad things will get. The AWA demonstrators are demanding changes government will not make until the entire false edifice has burned down.

For months I have been suggesting that cash was the best investment you could hold and a better time for investment would come at the end of October. It was a good call in that cash was the best investment since May but I don't see a safe environment for investment now. It's time to stay in cash and head for the bunker. Times are about to get ugly.

Spontaneous Order vs Urban Planning

Urban-Development Legends

Grand theories do little to revive cities.

By Mario Polese

Cities that have used incentives to lure heavy
 industry have created little long-term growth

For decades, city fathers and academics have studied economic development, searching diligently for ways to make urban economies prosper. Surely this quest is understandable—as understandable as the search for success that so many people undertake in the personal-finance section of the local bookstore. But just as personal finance has yet to unlock the secret of how to get rich, no surefire government-led strategy exists that can turn around a troubled economy like Buffalo’s or Gary’s. Cities, like people, are too diverse to allow anything but fairly commonsense prescriptions. A lot of grand theories have been advanced—targeted tax incentives! bike paths!—but they have proven of little practical use.

The history of local economic development is a story of academic fads. The 1960s, when I was a student at the University of Pennsylvania, were the heyday of growth poles and multipliers, of econometrics and mathematical modeling made possible by powerful mainframe computers. For a city, the key to generating jobs and income was to lure strategic industries by offering them tax breaks, loans at favorable rates, promises of infrastructure development that would benefit them, and so on. This approach would propel the entire local economy forward, the theory held, so long as the city picked the right industries. On a corridor wall in Penn’s Wharton School building was plastered a huge input-output table of the Philadelphia economy, which would help planners make the right choices. The direct and indirect employment effects of any investment could be precisely predicted. It was all very scientific.

The unfortunate results of that optimistic epoch were large industrial complexes, often in petrochemicals or steel, which created jobs but little subsequent growth. It turned out that input-output models were essentially static, limited to one-shot income and employment effects. Over the long term, in fact, investing in supposedly strategic industries frequently had a negative effect on growth; for example, those large plants tended to be unionized, which pushed up local labor costs and drove employers away. Take the Canadian province I hail from, Quebec, which in the 1960s proudly inaugurated a large steel complex in the city of Sorel, near Montreal. The story of Sorel since then has not been a happy one; employment there has long been stuck below the province’s average rate.

The next fad was high-tech industrial parks. Every city wanted its research park, equipped with all the latest frills and a billboard declaring it the high-tech capital of the region, the nation, the world. Accompanying the parks were goodies that cities offered firms to induce them to come. Some parks, such as North Carolina’s Research Triangle, were highly successful, but just as many weren’t. Many other conditions had to be in place for the approach to work, such as competitive costs, a propitious location, and the presence of major research universities.

In the 1980s, “clusters” came along, thanks in no small part to the marketing skills of Harvard Business School professor Michael Porter. Porter noted that related industries tended to bunch together. The key to success, then, was identifying a cluster—say, health or fashion or aerospace—in which a city purportedly held a competitive advantage and then building on it with targeted public investments. Though cluster-based strategies remain popular among economic-development strategists, they contain an inherent flaw: today’s winning clusters may be tomorrow’s losing clusters. Building an entire development strategy on one cluster is as risky as assembling an investment portfolio concentrated in one or two stocks. And history shows clearly that politicians are even worse at picking winners than investment bankers are, which these days is saying a lot.

The story of Montreal’s Multimedia City, launched in the 1990s, is illustrative. Montreal and Quebec decided to jump-start a “high-tech multimedia cluster” in a dilapidated city neighborhood—and to stimulate the wider local economy—by building a new high-tech complex and promising generous tax write-offs to firms that would locate there. The firms came. But Montreal’s most dynamic software companies flourished in a different part of the city, a gentrifying area with a lively street life and a long tradition of small business. Multimedia City had no such natural advantages; all it had was the dubious distinction of having been publicly anointed. Firms and communities elsewhere then began to demand equal treatment, and Quebec eventually extended the program to them, simultaneously making it even more costly and defeating its original intent. Montreal was left with a shiny new building filled with subsidized firms, but few visible economic spin-offs. Quebec has since ended the program—no newcomers need apply—and one may well ask what will happen to the current beneficiaries when their subsidies expire.

Fiscal conservatism can be popular

Sweden Shows Europe How to Cut Debt

By The Bloomberg Editors

Sweden faces a difficult year, like every other European economy, but unlike the rest of the European Union, it’s equipped to cope. There are lessons here, especially for the EU’s other non-euro countries.

Scandinavia’s biggest economy will see growth slow to less than 1 percent in 2012, down from an impressive 4.5 percent in 2011, according to the National Institute of Economic Research. Sweden relies heavily on exports to the rest of Europe, and the EU’s protracted economic crisis will set it back.

Shortly before Christmas, the Riksbank cut its benchmark rate for the first time since 2009 to 1.75 percent. The NIER predicts further reductions this year in response to a weaker economy and slower inflation. This prospect underscores the seriousness of the situation -- and how valuable it is at such times to have an interest rate to change.

The value of monetary independence is the first and most important Swedish lesson. Sweden stayed out of the euro system when the currency was introduced in 1999, and in the past several years, the government has used this monetary flexibility to the full.

Firm Fiscal Hand

With most of the EU bound by the European Central Bank’s excessive monetary caution, the Riksbank cut interest rates more sharply than the ECB and (in real terms) the U.S. Federal Reserve from 2007 to 2009. Its inflation-adjusted interest rate fell from 2.25 percent to minus 1.5 percent. The central bank also devised new credit facilities and other unconventional measures to support the Swedish financial system.

Fiscal policy played a smaller role in steadying the economy. This, too, was a legacy of the 1990s, when budget deficits widened and a national consensus formed around the need to curbgovernment spending and stabilize the public finances. Sweden’s subsequent success in doing that is nothing less than remarkable.

Hence Sweden’s second lesson: Fiscal stimulus isn’t a necessary condition for economic recovery. Through the course of the recent recession, the government’s cyclically adjusted budget stayed in surplus. As a result, Swedish government debt stands at less than 40 percent of gross domestic product, among the lowest of any rich country.

Fiscal policy still helped to cushion the recession and support a recovery -- not with discretionary stimulus, but through so-called automatic stabilizers, which are relatively strong in Sweden. (Measures such as consumption taxes and generous unemployment benefits relax fiscal policy in recessions and tighten it in booms, even if policy stands pat.)

In Sweden’s case, a firm fiscal hand, far from stifling the recovery, probably helped it along. Keeping the budget under control buoyed consumer and investor confidence. Surging demand for Swedish debt drove bond prices higher last year; indeed, Sweden’s government pays less to borrow than Germany’s.

Should others follow its example? For one group, the answer is plainly yes. Members of the EU that have not yet adopted the euro are nonetheless committed in principle to doing so. (This includes Sweden; the U.K. and Denmark are two exceptions.) Sweden proves, if further proof were needed, that euro membership is a mistake.

Lacking a currency to devalue and interest rates to cut, members of the euro system would only worsen their recessions if they squeezed fiscal policy as tightly as Sweden did. Beyond the EU, though, Sweden does suggest that sufficiently powerful monetary easing can carry most, if not all, of the burden of economic stabilization.

New Swedish Model

Models have their limits. Every country has to cope with its own special circumstances. It helped Sweden that the most recent slump, unlike that of the 1990s, was export-led: Its exports are capital-intensive, so a drop in foreign demand raises unemployment by less than a decline in demand at home. It also helped that since coming to power in 2006, the country’s center-right coalition government has made private-sector job creation a priority.

Note, therefore, that this isn’t the old Swedish model. Taxes on labor have been cut and the country’s once-lavish welfare state is being squeezed.

What do Sweden’s voters, who once elected left-wing Social Democrats by default, make of that? Their economic concerns have increased lately, but few blame Prime Minister Fredrik Reinfeldt and his government, and the Social Democrats have failed to recover.

This suggests a third lesson, political rather than economic: Fiscal conservatism can be popular. Sweden is reluctant to put its hard-won fiscal strength at risk. Rightly so. Sweden is better placed than most to deal with the further economic setbacks the EU seems determined to dispense. More interest-rate cuts and a shift to budget stimulus, if needed, are options that few other rich economies have.

Echoes from another era

Lessons for Europe From America's First Great Depression

By Alasdair Roberts

The European Union is in trouble. Some governments are teetering on default, and even German creditworthiness is questioned. Interbank lending in the euro area is increasingly strained. The entire project of European economic integration, wrought through six decades of delicate negotiation, seems at risk of collapse.

In the U.S., meanwhile, European leaders are being criticized for failing to face up to their troubles. The New York Times condemns them for "gross mismanagement of the euro-zone debt crisis." "European elites," says the Boston Globe, "have for too long deceived themselves into believing they can have their cake and eat it too." Europe would be better off today, says the Washington Post's David Ignatius, if its leaders "had handled their problems as cleanly as the United States did three years ago."

But Americans with a sense of history should be wary of the temptation to lecture. One hundred and seventy years ago, the U.S. was a new and fragile federation, struggling with a similar crisis. And the performance of American politicians then was little better than that of their European counterparts today. European creditors bemoaned the country's unwillingness to face up to hard economic realities. Eventually it did -- but only after a decade of wrenching political struggle that offers lessons for Europe today.

In the 1830s, European investors poured vast amounts of money into the expansion of U.S. cotton plantations, frontier banks, canals and railroads. This fueled a speculative boom, which the U.S. government encouraged through reckless monetary and banking policies. Many state governments served as intermediaries for foreign lenders, borrowing in Europe and investing directly in banks and public works.

In 1837, a slowdown in the British economy, combined with an increase in U.S. cotton production, caused a steep decline in the price of cotton, and also in the price of land. The boom suddenly ended. Banks collapsed, government revenues evaporated and the states' grandiose improvement projects were instantly transformed into white elephants.

State governments began to default on their obligations to foreign lenders. The first were Michigan and Indiana, which defaulted in July 1841, followed by Maryland, Illinois, Pennsylvania and Louisiana. Three southern states -- Arkansas, Mississippi and Florida -- simply repudiated their debts.

Sovereign Debt and Dirty Shirts

Family Feud

By William H. Gross

• Investors should recognize that Euroland’s problems are global and secular in nature; it will be years before Euroland and developed nations in total can constructively escape from their straitjacket of debt.
• Global growth will likely remain stunted, interest rates artificially low and investors continually disenchanted with returns that fail to match expectations.
• Investors should consider risk assets in emerging economies, such as Brazil and Asia, and bonds in the strongest developed economies, where the steep yield curve may offer opportunities for capital gains and potentially higher total returns.

A 12-year-old coffee mug has a permanent place on the right corner of my office desk. Given to me by an Allianz executive to commemorate PIMCO’s marriage in 1999, it reads: “You can always tell a German but you can’t tell him much.”

It was hilarious then, but less so today given the events of the past several months, which have exposed a rather dysfunctional Euroland family. Still, my mug might now legitimately be joined by others that jointly bear the burden of dysfunctionality.

"Beware of Greeks bearing gifts” could be one; “Luck of the Irish” another; and how about a giant Italian five-letter “Scusi” to sum up the current predicament?

The fact is that Euroland’s fingers are pointing in all directions, each member believing they have done more than their fair share to resolve a crisis that appears intractable and never-ending. The world is telling them to come together; they’re telling each other the same; but as of now, it appears that you can’t tell any of them very much.

The investment message to be taken from this policy foodfight is that sovereign credit is a legitimate risk spread from now until the “twelfth of never.”

Standard & Poor’s shocked the world in August with its downgrade of the U.S. – one of the world’s cleanest dirty shirts – to double A plus. But what was once an emerging market phenomenon has long since infected developed economies as post-Lehman deleveraging and disappointing growth exposed balance sheet excesses of prior decades.

Portugal, Ireland, Iceland and Greece hit the headlines first, but “new normal” growth that was structurally as opposed to cyclically dominated exposed gaping holes in previously sacrosanct sovereign credits. 

What has become obvious in the last few years is that debt-driven growth is a flawed business model when financial markets and society no longer have an appetite for it. In addition to initial conditions of debt to gross domestic product and related metrics, the ability of a sovereign to snatch more than its fair share of growth from an anorexic global economy has become the defining condition of creditworthiness – and very few nations are equal to the challenge.

It was in this “growth snatching” that the dysfunctional Euroland family was especially vulnerable. Work ethic and hourly working weeks aside, the Euroland clan has long been confined to the same monetary house. One rate, one policy fits all, whereas serial debt offenders such as the U.S., U.K. and numerous G-20 others have had the ability to print and “grow” their way out of it.

Beggar thy neighbor if necessary was the weapon of choice in the Depression, and it has conveniently kept highly indebted non-Euroland sovereigns with independent central banks afloat during the past few years as well. Depressed growth with more inflation, perhaps, but better than the alternative straitjacket in Euroland. As currently structured, Euroland’s worst offenders now find themselves at the feet of a Germanic European Central Bank that cannot be told to go all-in and to print as much and as quickly as America and its lookalikes. 

The End of Scarcity and other fairy tales

Keynes, the Future and Present Austerity

by Chidem Kurdas

In 1930, John Maynard Keynes dashed off an amazing prophecy. Extrapolating from the productivity gains of the past centuries, he came to the bold conclusion that the fundamental economic problem of scarcity would fade away in 100 years or so. Thanks to technological innovation and the accumulation of capital, the ancient condition of limited resources to satisfy competing wants would give way to a new age of plenty. Human beings would then face a very different quandary, namely what to do with themselves once they no longer have to work in order to survive.

Eighty-one years into the timeline Keynes suggested in his article, “Economic Possibilities for Our Grandchildren,” scarcity shows no sign of disappearing. Where did he go wrong?

He did hedge his bet by making it conditional on there being no important wars and no major increase in population. One reason we continue to experience a dearth of means to pursue the ends we desire is that wars absorb immense resources. Thus the $1 trillion spent on the Iraq war could have instead been used to satisfy myriad needs.

But aside from that, Keynes made a mistake in his reasoning. He argued that some high level of output be sufficient to meet needs because these will not grow as much as the ability to produce. He thought a point may soon be reached where what he called absolute needs – in contrast to relative needs or conspicuous consumption – will all be satisfied.

This notion of “absolute need” comes from a limited view of technological change as improving productivity while preferences for goods and services remain relatively stable. But in fact technology creates new products and tastes, working on the demand side as well as the supply side. It is not the case that there is a fixed basket of wants. We now want MRIs and smart phones; in the past there was no such need since we had no conception of these things.

That Keynes postulated less long-term growth in demand compared to supply fits in with his later theory that deficiency in aggregate demand causes recessions. Hence his argument that government spending can alleviate the down part of the business cycle by creating demand—the main rationale for large-scale stimulus programs, including the Obama administration’s questionable projects.

In a sense Keynesian policies reduce the possibility of the age of plenty that the man himself foresaw. Besides the question of the effectiveness of such programs – click for one of the posts on the subject by Mario Rizzo –  there is the matter of runaway government spending.  Keynes himself favored budget surpluses in good times to balance deficit spending in recessions.  Over the cycle surpluses would make up for deficits. But that is not the way it worked in reality.

A recent piece by Steven Horwitz in the Freeman reminds us of the seminal 1977 critique by James Buchanan and Richard Wagner, who pointed out that Keynes and the Keynesians removed institutional and moral impediments to deficit spending, thereby freeing politicians to spend without limit and rack up debt. No matter how huge the resources, the black hole of government spending can absorb it all.

Hence the current European debt crisis, brought on by various governments’ improvident spending.  Austerity is the word that dominates European policy discussions, the belt tightening necessary to counter past profligacy.  So Keynes provided governments with the excuse to run deficits with consequences that now threaten to create painful scarcity.

Almost certainly he would not have liked this unintended result. The end to the economic problem looks further off than ever.