If you’ve ever wondered how we’ve come to see America’s economic, social and moral decline, Angelo Codevilla’s insightful essay, published in the American Spectator a few days ago, illustrates how the pieces fit together. It’s rather lengthy, but well worth the time to read!

A brief summary is below… do make sure to read the full article: America’s Ruling Class – And the Perils of Revolution.

In the past the upper crust was diverse, drawing its wealth and status from various sources (industrialists, financiers, landowners, oilmen, etc).

“Few had much contact with government, and “bureaucrat” was a dirty word for all. So was “social engineering.” Nor had the schools and universities that formed yesterday’s upper crust imposed a single orthodoxy about the origins of man, about American history, and about how America should be governed. All that has changed.

Today’s ruling class, from Boston to San Diego, was formed by an educational system that exposed them to the same ideas and gave them remarkably uniform guidance, as well as tastes and habits. These amount to a social canon of judgments about good and evil, complete with secular sacred history, sins (against minorities and the environment), and saints. Using the right words and avoiding the wrong ones when referring to such matters – speaking the “in” language – serves as a badge of identity.”

No matter what their profession or income, today’s ruling elite (progressive Democrats and Republicans alike) climbed up via government channels and public money. As the author explains, professional position, money or academic achievement do not secure a membership in the ruling class – what is essential is an absolute commitment to the progressive doctrines and willingness to fit in.

The ruling class believes in its own intellectual and moral superiority and considers the rest of Americans “retrograde, racist, and dysfunctional unless properly constrained”.  As the more enlightened human beings, the elite see it as their task to improve the lesser mortals, which is where social engineering comes in.

Mr. Codevilla traces the beginnings of the progressive era to Woodrow Wilson, “the first American statesman to argue that the Founders had done badly by depriving the U.S. government of the power to reshape American society.” The progressives, while looking down on the American people, were sympathetic to Soviet Russia as well as, in many cases, to Fascist Italy and Nazi Germany.

And the elite have demonstrated contempt for ordinary Americans ever since (see Obama’s remark of ‘clinging to God and guns’ as typical of their inferiority), and have ruled based on the presumption that they, the enlightened ones, know best what the people need.

“Americans think it justice to spend the money they earn to satisfy their private desires even though the ruling class knows that justice lies in improving the community and the planet.”

And so the political elite, via taxation and intrusive regulations, strive to ‘improve’ the American people, and redirect them to tasks more worthy than those they choose for themselves.

Naturally their solution to all matters is a larger and more powerful government, allowing them to reward political support with jobs, contracts, handouts. Hence we see the continuous drive to redistribution, regulation of every aspect of life and business, opaque laws that benefit some and ruin others (in accordance to their political support), patent disregard for the Constitution, and discretionary powers of officeholders.  The ruling class has become the arbiter or wealth and poverty.

“But it surely increases the number of people dependent on the ruling class, and teaches Americans that satisfying that class is a surer way of making a living than producing goods and services that people want to buy.”

Not content with control over people’s economic lives, the elite use further lessons out of the Marxist handbook: indoctrination in schools and colleges, attack on religion and values, destruction of traditional family and marriage. All to fulfill their god-like mandate to ‘improve’ those who are beneath them.

“The ruling class is keener to reform the American people’s family and spiritual lives than their economic and civic ones. In no other areas is the ruling class’s self-definition so definite, its contempt for opposition so patent, its Kulturkampf so open. It believes that the Christian family (and the Orthodox Jewish one too) is rooted in and perpetuates the ignorance commonly called religion, divisive social prejudices, and repressive gender roles, that it is the greatest barrier to human progress because it looks to its very particular interest – often defined as mere coherence against outsiders who most often know better. Thus the family prevents its members from playing their proper roles in social reform. Worst of all, it reproduces itself.”

The war waged against marriage by the government, academia and media has produced the desired results: decline of the traditional family (and its replacement with the state), new ‘progressive’ family models, single motherhood – creating millions of faithful liberal voters largely dependent on government services.

Schools, aside from weapons of social engineering, serve as indoctrination institutes set to undermine the authority of parents and instill children with progressive ideals and statist worldview. (See also link at the bottom of this post.)

“Consensus among the right people is the only standard of truth. Facts and logic matter only insofar as proper authority acknowledges them.”

The ruling class’s main characteristic is its dislike for (the rest of) America, its condescending, patronizing attitude and dismissal of the American people’s moral, spiritual and intellectual values.

“Seldom does a Democratic official or member of the ruling class speak on public affairs without reiterating the litany of his class’s claim to authority, contrasting it with opponents who are either uninformed, stupid, racist, shills for business, violent, fundamentalist, or all of the above.”

Mr. Codevilla then goes on to describe what he, for the lack of a better word, calls the country class. They come from all walks of life, but are united in their core values and their desire to rule themselves rather than be ruled by others.

“The ruling class wears on its sleeve the view that the rest of Americans are racist, greedy, and above all stupid. The country class is ever more convinced that our rulers are corrupt, malevolent, and inept. The rulers want the ruled to shut up and obey. The ruled want self-governance.”

The clash, Mr. Codevilla recognizes, is certain to come. But what might be the outcome of this new revolution? See the full text of this must-read essay here.

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And speaking of education being misused for social engineering purposes, here are the details of a shocking recent study.

Links to interesting articles I have read over the past few days that you might also enjoy…

Fiscal Crises and Imperial Collapse (Niall Ferguson) – video presentation

Barney Frank Proven to Be a Liar and a Fraud!

Using Behavioral Finance to Better Understand the Psychology of Investors

Scientists Create Artificial Life: World First as Craig Venter Makes Designer Microbe from Scratch!

Fantastic Presentation on Human Cognitive Biases

Federal Debt As A Percent Of GDP – By President

Beware the Muni-Bond Bubble

The US Government Is About To Get Hit With ‘The Perfect Storm’ Of Debt

The Road to Serfdom (F. Hayek) – free download & a must read!

I think most Americans would agree taxes are heading higher. Yet, curiously, most may not care. (A Gallup survey shows 45% of Americans are happy with their tax rates and 3% believe them to be too low.) In fact, I suspect a significant portion of the population may welcome the tax increases with hardly concealed joy.

How is that possible, you ask?

The explanation is as simple as it is disturbing. For nearly half of US households taxes are simply somebody else’s problem. Approximately 47% pay no federal income taxes at all! (Data from Tax Policy Center for 2009.)

That’s right: nearly half of Americans qualified for enough credits and deductions to fully eliminate their tax liability, or had too low incomes to start with. (According to Deloitte, credits for low- and middle-income families have risen so much that a family with two children making $50,000 a year will owe no federal income tax.)

Half the country is happy with tax policies… well, they should be if they pay no taxes in the first place! These are the people who, more often than not, support higher marginal tax rates, for that simply means someone else will have to pay for their ever growing entitlements.

It is a sign of our hypocritical era that the cry of making taxes more ‘fair’ – meaning of course robbing higher earners blind so that lower earners need to pay nothing – has now been almost universally accepted.

But how on earth can one talk of fairness?

Consider this: the top 1% of Americans pay 40% of federal income taxes, the top 5% pay over 60%… while the bottom 50% pay less than 3%! (Data from the Congressional Budget Office, latest available tax burden release, 2006.)

Half the population is getting something for nothing, and they call this fairness?

As is always the case with expanding welfare states, generous entitlements are paid for by everyone except the actual beneficiaries.

There is nothing fair about redistributing incomes, much less on such a massive scale. There is no fairness in the government penalizing someone for working harder than others. (Not to mention it is unsustainable over a longer term – you will run out of wealthy people to tax.)

Now can you see the fundamental problem here? 40% of American households paid 86% of total federal tax liabilities. However, when it comes to deciding how the government should spend that money, they are outnumbered by the 60% who paid just 14% of taxes.

Is it any wonder that government spending is out of control and the US is coming close to fully adopting European-style socialism? The majority of voters decide on how to use other people’s money – why would they want any spending cuts?

The Congressional Budget Office data also shows that higher earners are paying a larger share of total federal taxes than ever before (as far back as tax burden data goes, to 1979).  

According to the IRS, in 1987 the top 5% of earners paid 43.26% of all federal income taxes; today, that group pays more than 60% of the tax burden – despite bringing in just 37% of the income. By contrast, the share of taxes paid by the bottom 50% of taxpayers – who bring home 12% of the income – has gradually fallen to less than 3%.

Higher earners have, over time, been forced to fund an increasing share of the federal government and fast growing entitlement programs. Meanwhile, according to the Tax Foundation, 60% of Americans consume more in government services than they pay in taxes, and the benefits extended to this group have been steadily increasing.

And yet the likes of Mr. Obama continue to tell us the wealthy aren’t paying their ‘fair share’!

Hence the $650 billion or so in tax hikes and new taxes that will be imposed on higher earners over the next decade will hardly be of concern to the vast majority of Americans. This is a short-sighted view, but then most people aren’t programmed to think of long term consequences. Given the immediate benefits for oneself, who will spare any thought on the negative impact on the economy and future job creation?

Which of course explains the shift toward statism and socialism at a certain stage of mass democracy. (Not for nothing did John Adams, the 2nd President of the USA, say that “there never was a democracy yet that did not commit suicide”, and did James Madison and other Founding Fathers believe that individual rights must be protected from the “tyranny of the majority”. They understood that without checks and balances the propertyless majority would tyrannically tax away the property of the minority.)

The state has clearly become far too big and in the process has made the majority of the electorate dependent on hand-outs, with the result that voting for the necessary medicine will now be virtually impossible.

The massive deficits, unprecedented debts and out of control entitlement programs (as well as demographic trends) leave few options – drastic spending cuts or significant tax hikes (or a combination of the two).

According to a recent Goldman Sachs study (based on budgetary data for 24 OECD economies covering 35 years from 1975), there is only one effective way to reduce debt and sustain future economic growth: imposing budget expenditure cuts across the board. On the other hand, increasing taxes to compensate for a higher budget has proved very damaging to future growth.

While cutting spending would be of most benefit to the country’s prosperity and future, it simply won’t happen on any meaningful scale. When the majority of the electorate has no interest in giving up their entitlements, political leaders will always take the path of least resistance and penalize those voters who, being a minority, don’t present a sufficient threat to their political careers.

And so, on top of all the existing, technically bankrupt federal programs, the Obama administration created a new health care entitlement, to be paid for, as usual, by everyone except those who will benefit. (Detailed overview of associated taxes further below.)

The problem is the US – along with much of Europe – is on a wholly unsustainable budget path, with unprecedented public spending (largely paid for by borrowing and money printing). In the absence of Americans rejecting the expanding welfare and entitlement state, taxes will have to rise much beyond the scheduled increases. Unless, that is, the administration finds some other – miraculous – way to reduce the enormous amounts of debt it continues to pile up.

A recent study by the nonpartisan Tax Policy Center calculated that to reduce the federal budget deficit to a sustainable 3% of GDP, the government would have to find some $500 billion each year – in new revenue (or spending cuts). To get that amount via tax increases on the top two brackets (families with over $209,000 in taxable income) the rates would have to go from the current 33% and 35% to 72.4% and 76.8%.

You didn’t think socialism comes cheaply, did you?

The truth is, no matter how much marginal income tax rates will rise, they cannot realistically be taken high enough to fill the fiscal hole. A broader based tax or a consumption tax is therefore likely to be on the horizon in the coming years.

Speculation about a value-added-tax (VAT) is already ripe. Former Fed Chairman Paul Volcker, among others, has called for VAT to be considered in light of the massive deficits. VAT is a national sales tax applied at each stage of production and collected by businesses (meaning additional bookkeeping and costs). It’s difficult for anyone to escape the tax since it’s included in the price of products and services you buy. (In Europe VAT rates range from 15-22%.)

VAT, apart from being a convenient way to pay for ObamaCare, has other advantages as well. It would allow (via increasing rates) for funding of a continued expansion of government, and as such would undoubtedly permanently open up the floodgates of public spending.

But while VAT is (for now) just a speculation, the tax increases starting next year are very real. Below you’ll find an overview of tax hikes and new taxes to be imposed on (better-off) Americans in 2011-2018.

2011 – tax hikes (tax cuts expiry) on higher income and capital income

First there is the expiry of the Bush tax cuts at the beginning of next year. The highest tax bracket will move from 35% to 39.6% and the 33% bracket will rise to 36%. The estate tax will also revert to 55%, with an exemption of $1 million (unless Congress reinstates the 2009 rules of 45% federal rate and $3.5 million exemption).

Importantly for investors, the capital gains rate is set to rise to 20%, up from 15% now. Dividends, currently taxed at 15%, will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% (unless Congress enacts a proposal for a top dividend tax rate of 20%).

While most of these increases appear to only target wealthier Americans, they are also damaging to small businesses. (According to IRS data, some 26 million small business employers file under the individual income tax code and so will be subjected to much higher taxation.) This, along with the onerous new health care burdens, will certainly not help small businesses hire more people.

On top of the tax cuts reversal, Obama’s health care ‘reform’ brings a number of new taxes and tax increases (2011-18) aimed at financing part of the new spending. For obvious reasons most of the tax hikes will start in 2013, after the election year. (Some ObamaCare related taxes go into effect in 2011, however, these will affect drug makers and importers.)

2013 – increase in payroll tax + new tax on investment income

From the beginning of 2013 higher-income taxpayers will be hit with a tax increase on wages as well as an entirely new levy on investments.

Medicare payroll tax will rise by 0.9% from 1.45% to 2.35% – a gigantic 62% increase – on wages above $200,000 for individuals and $250,000 for married couples filing jointly.

In addition to that, and for the first time ever, Medicare taxes will be extended to investment income. A brand new 3.8% tax will be imposed on the falsely called ‘unearned’ income – dividends, capital gains, interest, rents and other investment income – for individuals making more than $200,000 a year and couples making more than $250,000.

(A 2.3% excise tax on sale of medical devices also goes into effect in 2013.)

2014 – penalties for lack of insurance

2014 is when the health coverage goes into effect, and the requirement begins for everyone to have health insurance. (The government will provide subsidies for lower and middle income groups.) If you don’t want health insurance, tough; you’ll pay penalties – $695/p.a., further rising in 2016.

Medicaid (the federal-state program for the poor) will expand to all Americans with incomes of up to 133% of federal poverty level; since this could bankrupt the states they might start electing out of Medicaid. (More than a dozen states have already filed lawsuits over the constitutionality of the burden imposed by Obama’s bill.)

Subsidies (tax credits of up to 50% of employer’s contribution) for small businesses (up to 10 employees) will provide for coverage increase. Penalties will be imposed on employers with over 50 employees who don’t provide ‘affordable’ coverage (note – affordable as deemed by government bureaucrats); they will be fined $2,000 a year per employee, excluding the first 30.

(The health insurance industry will also start paying annual fees; $8 billion in 2014, rising in subsequent years.)

2016 – steep rise in penalties for uninsured

Penalties for those who don’t carry coverage will rise to 2.5% of their taxable income or $695/p.a. – whichever is higher.

Not to mention, a mammoth bureaucracy will be created thanks to ObamaCare (see here the astonishing list of all the new boards, commissions and agencies the bill gave birth to). The government will also hire an estimated 16,000 IRS agents to harass and audit individuals and individual businesses to check for compliance. (I suppose Mr. Obama would expect us to applaud this convenient new job creation scheme?!)

2018 – tax on high value plans

An excise tax of 40% will be imposed on health care plans with premiums exceeding $10,200 (individual coverage) and $27,500 (family coverage).

Investors hardest hit

Apart from higher-income taxpayers being disproportionately targeted as a revenue source, policy is now clearly taking the path of increased taxation of passive income. In fact investors and higher earners will bear all the burden of ObamaCare (without getting any of the benefits).

Let’s look again at the massive new taxes Obama assaulted investors with, as well as the likely impact.

Those with income from stocks, real estate or other investments are expected to contribute a giant share of the costs of health care expansion. (I suppose we’re seeing a theme here… from the continuing witch-hunt on the financial sector to the increasingly investor-hostile environment.)

Aside of the income tax and payroll tax hikes detailed above, there are three specific developments penalizing investors: increase in capital gains tax from 15% to 20% (2011), increase in dividend tax (to either 20% or as high as 39.6% – see further below; 2011), and the new additional 3.8% tax on all ‘unearned’ income (2013).

What exactly will be subject to the 3.8% tax? Dividends, interest, annuities, royalties, rents, as well as capital gains (minus deductions properly allocatable to such income). Basically, all income and gains derived from a ‘passive activity’ count as investment income. (Note that income and gains from an investment fund, even if the fund is classified as a ‘trader’ for tax purposes, will be subject to the tax.) Tax-exempt interest income and distributions from tax-qualified retirement plans, including IRAs and Roth IRAs, are not to be included in investment income.

Capital gains, currently taxed at 15%, will therefore be subject to a 23.8% tax (20% after expiry of the Bush tax cuts + 3.8% in new tax).

Dividend income (currently taxed at 15%) will be particularly hard hit. In 2011 dividends will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% from 35%. With the additional 3.8% Medicare tax dividend tax will go as high as 43.4% in 2013. Obama has proposed a top dividend tax rate of 20%; if Congress enacts the proposal, the top tax rate for dividends would rise to ‘only’ 23.8% at the beginning of 2013.

Impact on investment and investors’ behavior

Overall, some $409 billion in additional taxes will be snatched from investors in order to pay for big government socialism. What will be the likely impact on investment?

Essentially, investment income (capital gains, dividends) will be worth less to investors once the tax hikes/new taxes go into force than it is today. It is feasible that it could revalue the entire stock market lower.

Credit Suisse in a recent (April 2010) report estimates that a 10% rise in dividend and capital gains tax in the US would take about 7% off the fair value of the equity markets (assuming that 30% of the market is owned by tax-exempt funds and foreigners and the higher tax rates will apply for 15 years).

The 2011 capital gains tax increase could also prompt investors to liquidate holdings this year, ahead of the increase.

In addition, we may see shifts in investors’ behavior, in particular if dividend tax goes up by nearly 200%. Investors will certainly take that into consideration when making decisions; as a result they could shy away from dividend stocks and focus on those they perceive as having greater potential to appreciate.

More generally, the new taxes will discourage investment, making it more difficult for companies to bounce back after the recession. On top of that, as noted earlier, most small businesses pay the individual income tax, and the rate hike will have a negative impact on expansion and hiring. (Mr. Obama of course sees small business owners not as job and wealth creators but as rich exploiters who must pay yet more onerous taxes so that those who don’t pay any can enjoy still further entitlements.)

Add higher income taxes for the most productive Americans and higher payroll taxes, and it becomes clear that the Obama administration is penalizing those who have worked hard, saved, and invested, while rewarding and indulging the less able, unproductive and lazy. Classic Marxist class warfare… blaming the productive and enterprising for all of society’s ills, which can naturally only be ‘fixed’ by redistribution of unprecedented scale.

We will not need to wait too long to see the outcome. Significant tax increases can only reduce economic growth, for they take away people’s incentives to work, save, and invest. (They also encourage tax avoidance, thereby defeating the purpose of the tax increases.) Capital will be allocated to where it can avoid (some of) the taxes instead of where it would be most productive for the economy.

“When people who earn more than the average have their ‘surplus’ or the greater part of it seized from them in taxes, and when people who earn less than the average have the deficiency, or the greater part of it, turned over to them in hand-outs and doles, the production of all must sharply decline, for the energetic and able lose their incentive to produce more than the average and the slothful and unskilled lose their incentive to improve their condition.”

(Henry Hazlitt)

I will not even take into consideration increases in other taxes at federal, state and city levels, including corporate tax hike proposals, a likely consumption tax on energy (as part of climate change legislation) and possibly a value added tax.

And in the unlikely case you still believe Mr. Obama’s socialist propaganda on how the ‘rich’ aren’t paying their ‘fair share’, please review the statistical data at the beginning of this article. Not only do higher-earners pay a fair share, they are being robbed blind. (Brief recap – the top 5% earn 37% of income yet pay nearly 61% of all federal income taxes, while the lower 50% earn 12% of income and pay less than 3% of taxes. And that is before any of the coming tax hikes on the better-off!)

How did we get to this sorry state?

Consider that in 1913 the top rate of income tax was just 7%! Not only have taxes gotten more progressive and excessive, there has also been a staggering increase in related bureaucracy. The number of pages in the tax code has increased by 16,775% in the past century.

Taxes are, however, only a side issue. What should really concern us is how, within a relatively short period of time, the US went from a limited government, free enterprise, individual liberty valuing regime (of the Founders) to big government statism and finally the progressive socialism of today. The people, once freedom loving and self-reliant, have carelessly traded their liberties and responsibilities for entitlements and handouts.

Government programs and welfare only make people less reliant on themselves and more dependent on the state, which in turn prompts an ever increasing size of government, until one inevitably ends up with socialism.

The dependency mindset is now almost as prevalent among Americans as has long been the case in much of Europe. The productive sector that adds value to society is sucked dry by the parasitic state bureaucracy, the able and hard working are penalized for their success; as a result the whole society ends up much poorer. (Not to mention the terrifying and impoverishing public debt burden left to the next generations.)

Of course all this happens in the name of ‘fairness’ and ‘equality’.

Yet redistribution has nothing to do with fairness and everything to do with envy and theft. Such action gains, thanks to majority rule, a seal of legitimacy, but it really is no better than common robbery.

The fact is today the vast majority of people feel entitled to the property of others. They demand that it be taken away from them through taxation, so that (some of) it can be given to those they deem to be ‘in need’ – i.e. those who have less but of course feel entitled to have more.

Forcibly taking other people’s money would in other circumstances be considered criminal, yet this mass criminality is rationalized on the grounds of democracy, will of the people, political mandates, etc. Progressive taxation appeals to the masses who, more often than not, have a desire to pull down the minority of the most productive, talented, enterprising (and as a result more successful). Progressive policies in general are just a mean to an end; the end being an envy-based redistribution.

Unfortunately once a certain stage of statism or progressive socialism is reached it is nearly impossible to reverse. Once a voting majority pays no income tax and benefits from entitlements, the productive and enterprising minority is doomed. The majority will continue to vote away the rights of others, and call it the will of the people.

This is the tyranny of democracy the Founding Fathers had warned against. They did not intend for the state to guarantee everyone’s well-being and provide support against every possible obstacle. They would be horrified at the idea of divesting some people of their properties for the advancement of others in society. And yet today that is exactly what much of the population expects – to be taken care of by the government, be given something for nothing – all at the expense of those who stand on their own two feet and attain things by hard work.

One can work and produce goods or services that others want to pay for, or one can steal (or give the government a mandate to loot on their behalf). It is human nature to take the path of least resistance, which explains why most believe it is perfectly acceptable to plunder others rather than obtain what they desire by their own efforts and sweat. Naturally they will always find a justification for such action; hence it is deemed a matter of fairness for a minority to subsidize the majority who are perceived as disadvantaged in one way or the other (never less apt, less willing or simply lazy).

This socialist disease has now infected much of the fabric of the society. And it’s not just the liberals who prefer the state to make life-governing decisions for them. According to information from the 2008 American National Election Study about spending priorities, the majority of self-identified conservatives isn’t really in favor of cutting spending on most government programs either.

Of course anyone who disagrees with this entitlement mentality is labeled uncaring, uncharitable, lacking social conscience, or worse. The notion that unless we let the state do everything for us we are ‘bad’ persons is now so prevalent that few dare to mention the choices that must be made. How many in public office take up the cause for limited government and hence severe cuts to welfare and the public sector (including eliminating millions of counterproductive public jobs, bureaucracies, regulations, entitlement programs, etc)?

And yet far from unfair or uncaring, that is the only viable path to safeguarding America’s economic future.

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Here we are again, back to the disturbing – but entirely unsurprising – war on the ‘free market’ (or whatever is left of it after decades of government interventionism).

The pattern of governments creating a mess and promptly laying the blame at the feet of the private sector is not at all new, so EU’s and Washington’s attacks on the markets and George Papandreou’s continuing threats against ‘evil speculators’ should not have caught anyone by surprise. In much the same manner, the coming (politically motivated) clampdowns and regulations of various market activities are being designed with the sole purpose of shifting blame – for excessive borrowing, overspending, harmful interventions and defective regulation – away from the policy makers.

Of course diversion of blame and responsibility is not a behavior exclusive to governments. It has come to characterize much of today’s society, and is largely responsible for the economic, social and moral decline we’re at present witnessing all around us. (More on that in an upcoming post.)

Let’s start with Greece. Prime Minister Papandreou has stepped up his rhetoric about his country being victimized and having problems servicing its debt, not as a result of irresponsible and fraudulent behavior over many years, but because of speculators’ bets to bring it down.

“Despite the deep reforms we are making, traders and speculators have forced interest rates on Greek bonds to record highs. Many believe there have been malicious rumors, endlessly repeated and tactically amplified, that have been used to manipulate normal market terms for our bonds.” He went on to say that as a result Greece was forced to borrow at rates almost twice as high as Germany, and that such ‘prohibitive’ interest rates would swallow all gains from the planned austerity measures.

Manipulate ‘normal’ market terms? ‘Prohibitive’ rates? Someone please show Mr. Papandreou the spread between Greek and German bonds pre-Maastricht Treaty – at multiples of what it is today! See for yourself in this astonishing chart: Club Med spreads (1992-2010).

Let’s not forget that the Greeks (and other fiscally shaky Southern European states) have only enjoyed – undeservedly – low rates thanks to the EMU. And, had Greece not lied about its finances, it would never have been admitted into the monetary union in the first place (it has never complied with the required fiscal discipline, preferring to falsify data). The current rates on Greek borrowing are more than appropriate (in fact, quite benevolent) for a country that carelessly jeopardized its own future by decades-long irresponsibility.

For a decade the markets have ignored the vast differences in fiscal policies between eurozone members; risk premiums on sovereign bonds were barely discernible. After the financial crisis investors started awakening to sovereign risk and spreads became far more aligned with reality. The bond markets are once again reflecting fiscal policies, as they should. Far from ‘market manipulation’, it’s simply a return of country risk.

Indeed the financial markets are now doing the job that politicians have failed at so miserably – forcing the countries to take measures that will lead to a return to fiscal sanity (or else face the consequences). It should also be obvious that any country’s funding costs will now increasingly reflect its own fundamentals, rather than those of say Germany, as investors are unlikely to be blinded by any implicit EMU guarantees again, at least for the foreseeable future.

The Greeks, who have over decades borrowed and squandered too much money, won’t admit that their 12.7% budget deficit (that being the official figure; the true deficit is estimated at 16%), 120% debt/GDP (135% estimate for 2011), out of control government spending (at over 50% of GDP), rampant tax evasion, among other problems, are the root-cause of their troubles and consequent risk pricing by the markets. (For an analysis of the Greek situation and possible solutions see recent article here.)

Given that Greece has defaulted on its debt 108 times in the last 200 years, showing no sign that it has learned fiscal responsibility, it is rather astonishing that the Greeks should be surprised at rising interest costs. Would any responsible lender extend credit to an over-leveraged borrower on the verge of bankruptcy, at extremely low rates?

Yet the Greeks appear to believe that threats and regulation will force the capital markets to supply them with unreasonably cheap credit. During a recent Washington visit to win President Obama’s support for the war against evil speculators, Mr. Papandreou said: “Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system not to mention the human consequences of lost jobs, foreclosed homes and decimated pensions.”

Therefore, investors should lend to Greece at ultra low rates, ignoring any default risk, in order to allow the Greek government and population to carry on with a spending binge, delaying the day of reckoning indefinitely. (Much like banks had been coerced by the US government into lending to unworthy borrowers with no deposits and insufficient income; and we know how that ended. But more on that later.)

The Greeks’ sense of entitlement to other people’s wealth, their perceived ‘right’ to borrow at low rates, is indeed quite disturbing. Though rather than being solely a Greek issue it appears to be a sign of our times.

But why the widespread hatred of market participants, be it speculators, traders or investors?

After all, it wasn’t speculators who had run up massive debts and a 13% deficit, but the Greek politicians (and population). Investors and traders have merely exposed the truth the Greeks, as well as EU authorities, would have preferred to keep hidden. It should be obvious that Greece only has itself to blame for not being able to borrow at the same rates as fiscally prudent Germany.

The much vilified short sellers, as well as CDS (credit default swap) buyers, perform a vital function by pointing to problems and deficiencies (whether in companies, industries or countries) and backing their opinion with their money. When they believe an entity may go bust, shouldn’t they be allowed to protect themselves and/or profit accordingly? When it comes to sovereign debt, if it wasn’t for the markets, politicians would never take the necessary action to put their house in order.

Papandreou’s argument that “unprincipled speculators are making billions every day by betting on a Greek default” misses the point entirely. If Greece’s fundamentals were less disastrous, anyone betting on a default would be losing billions. No speculators can bring down a healthy company, currency or country. In any case, there are always two sides to each trade. For everyone shorting Greek debt there is also someone on the long side.

As for the fallacy of speculators destabilizing the Greek bond market via CDS use: Germany’s financial regulator (BaFin) has found no evidence that CDS were used for large scale speculation against Greek government bonds, reporting (earlier this month) that the net volume of outstanding CDS contracts has barely changed since the beginning of the year. Some of the most active CDS traders are German and French banks, who happen to hold significant amount of Greek debt. If there were no CDS (essentially, insurance against default), who would take on the risk of financing Greek debt?

Ironically, it has just been uncovered that the biggest CDS speculator, holding 15% ($1.2 billion) of the total $8 billion of Greek CDS, has been the Greek state-owned Hellenic Post Bank! (Article here.)

And yet, despite his obvious delusion, Mr. Papandreou has been finding an attentive audience in other European leaders as well as President Obama. After all, Greece’s is not the only government that views the markets as a welcome scapegoat for their own mismanagement and incompetency.

Given bureaucrats’ readiness never to waste an opportunity to further restrict economic freedom, it isn’t particularly surprising that the European Commission is discussing regulation of the sovereign CDS market, and the US Justice Department has reportedly been looking into hedge funds’ short positions against the euro, to determine whether they colluded to drive down the value of the single currency.

European politicians, who have a long tradition of anti free market beliefs, have blamed speculators for the recent decline of the euro in the wake of the Greek crisis. They, much like the Greeks, feel entitled to low borrowing costs for EMU members and a stable euro, irrespective of the fiscal and economic mess of the EU.

Germany’s finance minister, Wolfgang Schaeuble, went as far as suggesting the use of anti-terrorism methods against financial speculators in order to protect the euro. He said the government might “set up surveillance of who is getting together with whom for which kinds of speculative processes, and where.”

What’s next? Will they start arresting traders for threatening ‘economic stability’ if they happen to dislike the fundamentals of a certain country or currency and vote against it with their money?

It would seem there is no better sign that an entity is in severe trouble than authorities starting to crack down on short bets against it. The truth is, if the euro was fundamentally sound, it would not have been ‘attacked’. (Not to mention that those who believe speculators have caused the euro to drop to unfairly low levels can always back their opinion by taking action in the forex market.)

What Greece and other nations need to learn is that one cannot go on indefinitely increasing government spending and borrowing without consequences. There comes a point when markets lose confidence in the country’s ability to pay and refuse to lend the money (at acceptable rates). That moment appears to be fast approaching for a number of countries.     

Of course when it comes to short term political gain, shifting the blame onto the private sector is an entirely valid strategy. We have seen its success in the aftermath of the 2008 crisis; the people have, without much questioning, accepted the official line: the crisis was caused by insufficient state intervention and regulation of the ‘free market’. Therefore, we have been told, a massive increase in government bureaucracy and regulation was necessary.

The threats against speculators in (Greek) sovereign debt are reminiscent of the attacks on banks, hedge funds and financial markets in general, over the last two years. Of course there was much that went wrong in the financial sector, but the blame game has been indicative of the failure of governments to admit their own mistakes.

Notice that any economic boom is always a result of ‘wise government policies’. When the inevitable collapse comes, a culprit must be found, fast, before anyone starts looking at possible policy makers’ faults. And so all crises are quickly declared to be a problem of the ‘free market’.

Such denunciations look particularly misplaced given the disastrous track record of public management, including the crucial role of the Fed and US policy makers in creating the recent crisis. It was the Fed’s loose monetary policy that had encouraged speculation and inflated a massive housing bubble, aided by vote grabbing policy makers’ interventions in the housing market (incl. coercing financial institutions into lending to unqualified, low income borrowers under such monstrosities as the Community Reinvestment Act).

And of course the government sponsored Fannie Mae and Freddie Mac were by far the worst offenders, likely to end up costing the US taxpayer some $400 billion. (They remain an ‘off-balance sheet’ – or so the politically convenient fiction goes – dumping ground for the debris of the housing crisis.) But don’t hold your breath waiting for Obama et al. to acknowledge any of this; they’re too busy pounding on the banks.

Bizarrely, our political elites appear to fully ignore the fact that highly expansionary monetary policies – and resulting unprecedented indebtedness – have been largely responsible for the current mess. It’s nothing new; interventions into (what was once) the free market have always brought unintended negative consequences. And yet the link between low interest rates, excessive credit growth and asset bubbles appears to evade policy makers’ understanding.

The slashing of interest rates in 2001, and keeping them at record low levels for several years, has led to the credit and housing bubble. Spiraling debt contributed, in a large part, to the apparent prosperity of the last 15-20 years (much as it had in the 1920s, ending, equally disastrously, in the Great Depression). Greenspan and Bernanke acted as cheerleaders of debt, while policy makers were busy identifying new targets for lending, in the name of democratization of access to credit.

And let’s not forget the essential role of greedy housing market participants, millions of whom have knowingly taken on mortgages and loans they couldn’t afford to pay back, in order to satisfy their irresponsible craving for a lifestyle beyond their means. (In the past 25 years the amount owed by US families has risen more than sevenfold, from less than $2 trillion in 1984 to nearly $14 trillion, according to the Fed.) Inevitably, cheap credit has also created huge imbalances and fueled speculation in the financial sector.

And yet, shockingly, no lessons seem to have been learned. Central banks and governments – in particular in the US and UK, considering a painful period of readjustment (perhaps a short depression) to be politically unacceptable, have embarked on massive quantitative easing (in other words money printing) and huge stimuli to restore economic growth. In the process they have loaded their countries with an unprecedented mountain of debt.

Indeed, blind to the fact that easy credit and excessive debt created the crisis in the first place, the Fed and the Obama administration are happily running up higher and higher debts. In an unprecedented printing press exercise the Fed has purchased over $1.2 trillion of toxic agency (Fannie, Freddie, Ginnie Mae) mortgage backed securities (MBS), creating a floor for housing prices and so delaying necessary corrections. Hence the massive burden of toxic assets now weighs down not only the private financial markets but also the Fed itself.

Numerous other government support measures have been masking the fundamental sickness of the housing market, including tax breaks for home buyers and government-mandated loan modifications (the majority of which end up in default again within six months). The Federal Housing Administration (FHA), with its aim to make homes more affordable, has underwritten hundreds of billions of dollars of mortgages in the last two years alone. Its support for the housing market is expected to double again – growing to $1.5 trillion – over the next five years. FHA foolishly continues to require down payments as low as 3.5%, when it should be obvious that a 15-20% deposit would allow home owners to better withstand any future crisis. (Unsurprisingly, a record number of FHA-insured loans are delinquent.)

Speaking of loose monetary policy… rates have been fixed at near zero. The resulting boost to the price of securities held by banks, as well as what are, in effect, zero interest loans from depositors, have translated into strong revenues for the sector, allowing banks to ignore the bad loans still on their books. It is clear that the irrational monetary policy with artificially low interest rates, plus monetization of debt, will continue for quite some time. A certain recipe for the next bubble and crisis.

And of course the government has also embarked on an unprecedented fiscal stimulus, a consequence of which is a massive increase in public sector debt. (The US national debt now stands at over $12 trillion. But add the ‘off-balance sheet’ unfunded liabilities and the total public debt comes to an estimated $60 trillion – an amount that can clearly never be paid off. We’ve discussed the impact of extreme debt levels in a recent post here.)

Despite the shocking debt and deficit we’re unlikely to see any serious attempt at spending cuts any time soon; quite the opposite, there seems to be a new US spending bill proposed almost every week. Crucially, at a time when existing entitlement programs are bankrupt, the Obama administration saw it fit to create a monstrous new $2 trillion health care entitlement.

In spite of the alleged temporary nature of the public spending boom, the expansion of government will likely be permanent. The price to pay is obvious – high deficit, high taxes, slower economic growth and less wealth. Unless, that is, you agree with Mr. Obama and the ‘leading’ economists that government spending creates wealth.

The belief we can cure a debt crisis with even more debt would also be rather comical, if the situation, and consequences, weren’t so tragic.

So what then is the solution?

Instead of the government attempting to micromanage the financial markets (and any other private industries) via further interventions, regulation, punitive taxation, bans and growing bureaucracy, we should simply allow the free market to work. The finance industry as well as borrowers should be let to suffer the consequences of their actions (be it bad lending or irresponsible borrowing). They also need to be allowed to make commercial decisions without coercion or interference from policy makers. In the absence of government intervention – that only creates distortions and moral hazard – the markets would curb bad behavior via defaults and bankruptcies, resulting in suitable risk adjustment by other participants.

US home owners should also be liable for any outstanding mortgage balances (as is common in virtually every other country), instead of simply being allowed to walk away from underwater mortgages. Naturally such policies would mean fewer home buyers taking on mortgages they can’t afford to repay, and that goes against the government’s idea of home ownership being a near universal ‘right’ – a notion which, bizarrely, still appears to be alive and well in Washington. But until people return to a suitably affordable lifestyle (whether that be renting instead of home ownership, or a more modest home) we are only kicking the problems down the road for a little longer.

It is natural that in a crisis, recession or period of high unemployment people are angry; they need to externalize the enemy. The markets, speculators, or Wall Street are a highly convenient (and sometimes justified) target when it comes to diverting blame away from policy makers, central banks and general population. They also provide a welcome opportunity for governments to expand and to regulate more, tax more and interfere more in private sector activities.

However, if any lessons are to be learned at all, we must acknowledge that it was the culture of living on (cheap) credit and spending beyond our means – spurred by disastrous monetary policies and interventions - that led to record indebtedness, housing bubble and collapse, and resulting financial and economic hardship. Only then will we be able to recognize that the current policies are simply setting the stage for a much larger crisis a few years from now.

The Dubai and Greek crises have forced investors to pay attention to something long ignored – rising sovereign risk. According to this week’s reports, Dubai is trying to settle debts for 60 cents on the dollar. Meanwhile, there has been no real progress in the unfolding Greek debt crisis.

Given the scale of fiscal deterioration in much of the developed world, the trouble is unlikely to end with Greece. For now, however, this looks like a mainly EU-specific problem.

Germany is, for the moment, unwilling to talk about bailouts, and demands austerity measures from the Greek government. EU finance ministers stated Athens must comply with austerity demands within 30 days or risk losing control over its own tax and spend policies. But the truth is, the EU has no real enforcement mechanism, and Greece knows it.

The Greek government promised to reduce its fiscal deficit to 2.8% of GDP by 2012, and to under 9% by the end of this year. However, the EU authorities are fooling themselves into believing this to be possible – current Greek deficit is 12.7% (and that is only the official figure; Greece has forged data before). Due to both political and economic reasons chances of Greece meeting such targets are near zero. The Greek population is largely against austerity (and keen to express it via crippling strikes and riots), making it highly unlikely that the socialist Papandreou government will be able to enforce any meaningful measures.

Some 95% of Greek debt is held by a number of large European banks, so a Greek default would most likely spark a massive bank crisis in Europe. The contagion would inevitably spread to Portugal, Spain, Italy, Ireland and possibly other countries. But even if Greece is bailed out, it will unlikely meet the conditions that will come attached to a bailout, hence just kicking the problem down the road for another while.

And of course the problem is much larger than just Greece. Fundamentals are very poor across much of the eurozone, meaning that a number of countries could easily follow Greece down.

The root of the problem is the one-size-fits-all monetary policy of the euro. The monetary policy set for the centre (Germany, France) was always going to be inappropriate for the economies of the periphery. Instead of adopting stricter fiscal discipline (since monetary and exchange rate policy was no longer in their control), Greece, Spain, Portugal etc used the extremely low interest rates and high credit rating they gained access to thanks to the EMU to go on a long, wild spending spree. The cheap credit fueled housing bubbles as well as ever growing public sectors and generous welfare systems. It was inevitable that the day of reckoning would come.

Southern Europe’s competitiveness has also declined sharply as these countries joined the eurozone with an exchange rate that overvalued their currencies, raising the cost of labour.

The fiscally precarious states benefited from low rates because, in the eyes of investors, their bonds enjoyed an implicit guarantee of the stronger eurozone members. Once investors finally started paying attention to their fiscal situation, and to the risk of Greece being let to fail, the spreads between German Bunds and Greek bonds have widened considerably, increasing the country’s debt servicing costs.

In a staggering display of self-delusion the Greek prime minister said yesterday that Greece wants to be able to borrow on the same terms as other eurozone countries. I suppose we shouldn’t be surprised at such misguided sense of entitlement; entitlement, after all, is the theme of our times. Papandreou also stated “it is a fallacy to say the Greeks are reckless”. Yes, Greeks indeed are the model of prudence and their current fiscal mess and the fact they have been in default for 105 years out of the last 200 should just be ignored by the markets (or ‘socially useless’ speculators in modern day political speech).

Although distrusting Greece’s willingness and ability to reduce deficit, the markets, for the moment, continue to believe in an eventual bailout. Should it start looking like there will be no such thing after all, the spreads on Greek debt would dramatically expand and most likely push Greece into default.

Yet the fiscally responsible Germans have little appetite for bailing out Greece. A bailout, in their view, would destroy EU’s monetary (and any remaining fiscal) discipline and undermine the credibility of the euro. Not to mention that it would not solve the structural problems facing the eurozone. Since German taxpayers are hardly going to be willing to open their wallets to the profligate states every time there is a crisis, a bailout of Greece may only bring closer an eventual break-up of the EMU.

Having said that, German banks have massive exposure to Spanish, Irish, Italian and, to a lesser extent, Greek and Portuguese debt – to the tune of some 523 billion euros. Germany will undoubtedly take that into consideration when deciding on bailing Greece out or letting it fail.

So what are the options for Greece? The traditional remedy would be currency devaluation, but eurozone members don’t have such luxury. Control over their monetary policy is in the hands of the European Central Bank (ECB).

The most prudent thing for Greece would be to undertake the severe budget cuts necessary to get its fiscal deficit down to 3% of GDP over the next few years. Such extraordinary fiscal tightening would result in a few years of declining GDP and high unemployment. There is not much indication that Greek voters are even remotely considering taking a few years of pain (austerity & recession) for a future gain.

Another option is default, which would reduce the debt burden but also result in a severe and long recession/depression. Government spending would be cut drastically and immediately since Greece wouldn’t be able to borrow for quite some time. Finally, Greece could also decide to leave the eurozone, go back to drachma and, in effect, devalue its debt. It would make the country more competitive. Of course their borrowing costs would also soar. However, this appears to be the least likely path for Greece to take.

Essentially, Greece and the Greek voters should be given two choices: take the pain and make the necessary cuts or leave the EU. This would leave the decision in the hands of the Greek people, avoiding further cries of them being stripped of their sovereignty, and it would ultimately be better for EU’s monetary and fiscal discipline than a bailout and the moral hazards that come with it.

After all, Greece is not eurozone’s only problem. Budget deficits have reached unprecedented proportions in many EU countries. Concerns about the weak fundamentals and the state of public finances in Portugal, Spain, Italy, Ireland, the UK are evident in the financial markets, with rising sovereign bond yields and sliding euro.

Portugal’s and Spain’s external debt position is worse than that of Greece; their household debt is also considerably higher. Spain, apart from a nearly 10% deficit, has unemployment close to 20% and a banking system weighted down by a massive amount of overvalued real estate. Oh, and the socialist Zapatero government is not any more likely to be able and willing to cut spending than the Greeks. Italy’s and Ireland’s external debt obligations as well as GDP and unemployment rates are also worse than those of Greece. So while the markets’ focus is primarily on Greece, contagion is a very real threat. And not even Germany has the finances to bail out the likes of Spain. Given its size, a full blown fiscal crisis (or default) in Spain would most likely be the death of the euro.

The eurozone governments have to borrow approx 2.2 trillion euros from the capital markets this year to finance their budget deficits (Greece needs some 60 billion just to make it through the year); it won’t be an easy task. A wider fiscal crisis in Europe appears increasingly likely.

Yet ballooning national debts, out of control deficits and rising sovereign risks are not just a European issue. Most advanced economies have huge fiscal problems. The IMF projects the G20 government debt/GDP ratio to reach 118% by 2014. This will severely constrain economic growth.

A recent study by Carmen Reinhart and Kenneth Rogoff (‘Growth in a Time of Debt’) found that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”

The following chart shows the public debt to GDP ratios across the world.

(And let’s not forget the true public debt/GDP levels are several times higher then the explicit figures that exclude massive unfunded liabilities for public pensions, healthcare, social security.)

Consider also the high government spending as a percentage of GDP in many advanced economies today, which causes a further drag on growth, and you get a future of slow economic growth and high unemployment. (In Greece, as well as the US, UK and other countries government spending now makes for approx 50% of GDP.)

The fiscal deterioration will become worse still due to the massive demographic challenges in the developed world. The IMF estimates that increased health spending and other costs related to aging population will drive debt to GDP levels of advanced economies up by a further 50% over the next 20 years.

We will therefore see a significantly higher economic growth in low debt, and most likely sluggish growth in high debt economies such as the UK, US, much of the eurozone and Japan. (A strong rise in government bond yields of much of the developed world is also inevitable.)

But it’s not just government debt. There’s too much debt everywhere, including in the private sector (although the private sector has started deleveraging, while the public sector increased leverage). Total debt is highest in Japan at 459% of GDP and the UK at 469% of GDP (or 380% if adjusted to reflect UK’s position as a financial hub). Spain follows in the third place at 342% (in Greece total private-public debt stands at around 225% of GDP).  

Over the next decade sovereign debt crises and defaults seem inevitable. Those countries that can resort to the printing presses will take the path of a massive monetization of debt, hence reducing their debts through severe inflation. That is the most likely outcome in the US and UK. (Clearly, paying our debts back in devalued currency is simply default by another name.)

Of course the most desirable way to address the budget problems would be by radical spending cuts. The scale of fiscal tightening necessary to return to healthier debt levels would cause a medium-term drag on growth. But not reducing debt will ultimately have much greater consequences.

However, chances we will witness drastic spending cuts in the UK, US and across the eurozone in the next few years are rather slim. The culture of entitlement has made it near impossible to talk about the hard facts. Our political elites will continue to ignore the fact that the bloated welfare states have become unsustainable and we can no longer afford them. The reason is simple – it’s not what the voters want to hear. Instead of acknowledging painful reality and the need to make sacrifices, we prefer to keep kicking the problems into the future. Until the inevitable day of reckoning comes.

Indeed the developments in the US and UK are not at all encouraging.

The Obama administration is determined not to waste a good crisis and continues to focus on a massive expansion of government. Instead of letting the free markets work and acknowledging that it’s the private sector that creates wealth and will be the engine of growth, the political leaders on both sides of the Atlantic show an enormous zeal to meddle in the free markets and reinvent and fix what wasn’t broken.

Redistribution of wealth via tax hikes (as well as introduction of entirely new taxes), a ruinous healthcare reform, expensive energy and climate change legislation, pro-union policies, excessive and ill thought-out regulation… Obama has shown a deep lack of understanding (and indeed contempt) of private business and a determination to socialize the US economy.

And while the productive part of the economy is being hammered, the public sector has been enjoying an unprecedented boom. In 1902 total US government spending was approx 7% of GDP. In 1928 it came to just over 10%; two thirds of that was state and local and just 3% was federal spending (about the same as 150 years earlier, excluding increases during war periods). Government spending has since exploded, making for more than 40% of GDP – two thirds of that being federal expenditure. Public spending increases in 2009 alone came to well over $1 trillion, a rise of more than 20% from 2008.

The UK has fared even worse, with government spending increasing from about 36% of GDP to almost 55%, putting increasing pressure on the dwindling productive segment of the economy.

The following chart from the Wall Street Journal shows the shocking and unsustainable spending explosion. US government spending has grown seven times as much in real terms as median household income over the last 40 years!

And, just as in the UK, employment and compensation in the public sector have continued to increase while the private sector has taken the pain. (Public workers not only enjoy far higher wages than their private sector counterparts but also benefit from extremely generous pensions. These largely unfunded public sector pension liabilities will naturally just serve as further drag on economic growth for many decades to come.)

As the following chart from the Business Insider shows, the US has gone from producing jobs in wealth creating private industries to jobs in the wealth destroying government sector. By the end of 2007 the total number of government jobs exceeded the total number of goods producing jobs.

Indeed, whether we look at the public sector gorging itself at the expense of the private sector, or the widespread culture of entitlement and welfare state (at the expense of the dwindling numbers of hard working taxpayers), this is what has come to characterize our time: enabling the unproductive and lazy to steal from the productive and enterprising. Otherwise called socialism.

So what is being done? Do we see any plans for serious fiscal tightening and debt reduction? Quite the opposite, our leaders seem to be enjoying a rather long vacation from reality.

Obama (and Gordon Brown) have apparently not been listening to Reinhart and Rogoff, or they wouldn’t be attempting to solve our problems by issuing yet more debt.

Perhaps we shouldn’t be too surprised that debt reduction doesn’t seem to be our policy makers’ priority. Indeed, one might think our extreme indebtedness is nothing more than a minor nuisance. Neither our political elites nor the central bankers and leading economists appear to grasp the obvious: that years of cheap, excessive credit and high debt were precisely what got us into trouble. And yet we’re still happily continuing on the same path.

In only three years the Obama administration will have increased the national debt by some $4.35 trillion. (And that excludes the huge deficits of off-budget programs like Medicare, Medicaid, social security.) The budget freeze proposed by the administration for 2011 is projected to save some $15 billion (or about 0.4% of the total budget, a drop in the ocean). Note that it’s merely a budget freeze, not a cut in nominal terms. Worse still, the the vast majority of federal programs (incl. Medicare, Medicaid, social security, military, homeland security etc) are to be exempt from the freeze.

It should be obvious that the US won’t get its debt under control unless it sharply reduces government spending, including on health and pensions that have simply become unaffordable. The US is not much behind Britain and the eurozone when it comes to the horrific shape of public finances. The only advantage, for now, is the dollar’s status as the world’s reserve currency (and of course the country’s control over its own monetary policy).

But that doesn’t change the basic fact – you cannot spend your way out of a fiscal crisis. The current path is unsustainable. The Obama prescription of more debt, more spending and more taxes is a triple ticket to ruin, plain and simple.

But, it would be unfair to focus solely on the US, for here in Britain we are in an even greater mess.

The UK has not only the world’s highest total debt/GDP (along with Japan) but also one of the worst budget deficits at 12.6% of GDP. (According to OECD, only Iceland and Greece have higher deficits, at 15.7% and 12.7%, respectively. The UK is expected to post a 12.8-13% deficit this year, overtaking Greece.)

The speed of the debt run-up has been nothing short of alarming. Unsurprisingly, Britain is already paying higher interest rates to borrow than Spain or Italy. While the yields on gilts have recently risen significantly, they are heading far higher – as soon as the markets start taking a look at other basket-case economies aside of Greece. The pound has fallen by some 25% vs the dollar, and has much further to go unless the markets start seeing some credible solutions from Britain.

Yet there is no political will to face the excessive debt, no meaningful plans for deficit reduction. Gordon Brown’s government has rejected any idea of implementing spending cuts in 2010/2011. And the opposition? David Cameron said spending cuts during the early part of a Conservative government wouldn’t be ‘particularly extensive’.

Government spending has exploded over the 13 years of Labour governments and is now completely out of control. But one would look in vain for austerity measures and severe fiscal tightening, not just from Labour, but also from the (so-called) Conservatives.

The micro-cuts that both the government and the Tories are proposing will not even make a dent in the monstrous amount of public spending. The pledges to ring-fence all main areas of spending, including the wasteful, bureaucratic and inefficient NHS, instantly expose any deficit reduction plans as lacking of credibility.

What remains are tax raises. As if Gordon Brown’s hike of higher earner income tax from 40% to 50% (or 62% once national insurance contributions are added on) wasn’t bad enough, further tax increases are likely on the way. All that (along with the insanity of the additional 50% bonus tax) will only achieve one thing – further damage to the dwindling private sector already suffocated by a gargantuan web of high taxes, red tape, hostile regulation and uncertain political environment.

From Labour’s point of view, there is no harm in further undermining the only economically productive part of the economy. Expansion of government and redistribution of wealth are the objectives. What Brown and Obama have in common is their disdain for and antagonism toward anyone earning (or striving to earn) a decent income, and the desire to redistribute from the hard working and productive to the idle and unproductive.

It matters little which party wins the upcoming general elections; all three of the country’s main political parties have fully embraced ‘progressive’ (read socialist) ideas. A Tory victory may be slightly less disastrous than another Labour term, but nothing that the party is offering will set Britain onto the right path.

And the people have only themselves to blame. Thanks to the vast expansion of government too many millions are now enjoying an idle life of welfare-dependency. Add the millions more in public sector jobs with their high wages and appallingly generous pensions, and it is little wonder that politicians are unwilling to do anything that would anger the majority of the voters.

We have become a society with an overwhelming sense of entitlement – at the expense of those who still believe in self-reliance and hard work, only to see their wealth stolen by the parasites. This unsustainable situation will inevitably blow up, and deservedly so. Only then will a new cycle be able to start. And perhaps, just perhaps, we will even witness a return to common sense one day – as in smaller government, less interference in the free markets and the productive sector, less dependency and more self-reliance.

But in the meantime, as public debt is becoming a crushing burden on most developed economies, the only thing that appears certain is a widespread sovereign debt crisis (and defaults) a few years from now.

The recovery we are embarked on has a schizophrenic quality about it; it is typical and it is anything but typical, the diseased roots have been cleaned out and the diseased roots remain very much in place, central bankers have matters in hand and central bankers are clueless, economics offers sufficient explanations and economics is in crisis.

We believe that the distinction between normal cyclic processes and deeper level long term processes will offer clarification. The hidden layers, one might say, are generally obscured from view behind (an often politically convenient) smokescreen of day to day and week to week noise processes which drive the media cartoons that pass for informed discussion.

To begin with, we must look at Total Public Debt, which unfolds in three acts. The first shows a rising debt through the eighties until the late nineties, until it began to slow and level off going into the 21st century. This was a period when the world was expecting a reduction in military expenditures and a globalized neoliberal trade arrangement.

When the attacks of 9/11 occurred, and the American project was suddenly recalibrated as the GWOT, the Global War On Terror, the public debt surged at about a fifty degree angle between 2001 and 2008. During this phase, the equity value of the defense sector increased fourfold, by 400%. There was a phenomenal boom in real estate. Credit became absurdly convenient and absurdly lax.

Oddly, very oddly, the entire credit for this seismic shift was given to innovations in the lending and loan securitization markets. No mention was made of the stimulative effects of ramping up a militarized economy which was, in effect, shifting future growth into present hot expenditure. We would argue that it was a combination of massive public borrowing during a low interest rate boom that produced the extreme overshoot in multiple asset classes in the late 2000s.

Then, with the collapse of the private sector in 2008 the Total Public Debt exploded by about 3 trillion dollars in one final vertical surge. With very little clear idea as to how this debt will be paid down, or even how the annual interest on this debt will be paid off.

Even at 3% per annum for the aggregate debt, we’ve got to come up with a 360,000,000,000, that’s three hundred sixty billion dollars per year in interest, for a very long time.  We’re basically sticking future American generations with a long term multiple hundred billion debt obligation to pay for the current generation’s missteps.

A phenomenal, unsustainable debt obligation that will hit us hardest precisely as the baby boom generation becomes most dependent on public solutions to long term health care problems. As it stands, the Congressional Budget Office has calculated that the United States will experience a significant output gap (enforcing deflationary pressures) between now and 2015. We believe that this problem has been greatly understated.

One critical factor not to be overlooked is the progression of the American demographic. In 1956 the future of the country was literally in its infancy, and following a long decline in the birth rate during the Great Depression and WWII, there was a massive population surge. This baby boom would define many of the dominant characteristics of both our economic operation and our cultural and political tastes throughout its life cycle.

As the Baby Boom outgrew its’ younger, more radical student phase in the Viet Nam era, with drugs, lifestyle experimentation and protest, and then embarked on adult concerns and a rightward drift in their political tastes, the financial culture of the United States also morphed from a Great Depression inspired risk averse way of thinking into the New Thing, which fetishised theories like the Efficient Market Hypothesis, Neo-Classical economics, Monte-Carlo simulations, Gaussian probability distributions, and the salutary effects of unrestricted capital flows.

The Baby Boom had grown into financial power and drifted away from its youthful political radicalism, slowly but surely into an airlessly dogmatic sense of the revealed truth, while retaining its elemental characteristics, what Freud referred to as Die Anlage, the “essential blueprint”, the idea that reality could be remade by the imposition of a theory. One could say that the fate of Cuba and the fate of a business school worldview had a common spiritual ancestor.

This generation would exchange radical theories of society for radical, very typically for that generation, academic ideas that were prized more for their elegance than their practical conformation with reality. This avaricious, indulged, entitled, theory and model loving generation would, combined with global changes in finance and technology, unleash the long wave that ran from 1982 until 2007.

The final denouement coincided with the beginning of the end of the Baby Boom driven cultural cycle and the  ascendancy of Generation X, the air pocket behind the Baby Boom, whose first major representative is Barack Obama. We feel that whatever his imperfections, far too much has been imputed to the person of President Obama, and far too little to the mass dynamics of one asymmetrical generation leaving the stage, with all of their self serving narcissism, with all of their sense of being owed, with their irresponsibility and shallow thinking, and being replaced by another generation whose worldview is based in a very different relationship to advantage and opportunity.

As of this writing, year 2010, the US population is yet again 10 years older, with the maximum age cohort from 45 years to 54, now in their positions of senior management and positions to direct policy. The absolutely essential point to grasp is that this generation will be in their last stages of public involvement within the coming decade and there will be a wholesale shift from the Baby Boom mode to the Generation X mode, of whom Barack Obama is but a stylistic harbinger.

There will be an accelerating shift toward health and medical expenditure, a much lowered interest in foreign involvements, and a phenomenal amount of debt outstanding.

We note with some alarm that the Dallas Fed’s in house measure of inflation and deflation pressures, the Trimmed Mean CPE inflation rate, which we take as a more reliable indicator as to what the Fed really thinks versus the popular CPI numbers that are sops thrown out to give talking heads something to mumble about, is diving quite nicely into deflationary territory.

Deflation implies staying put, real estate sells with less vigor when inflation isn’t there to justify price increases, the arguments for wage increases are less convincing, and yes, we’re stuck with an awful lot of debt to service. Inflation may ultimately reduce debt service real costs, but the path there as rates increase can get painfully expensive, painfully quickly.

The Fed, the Treasury, Congress and the President must feel as if they’re walking on a razor’s edge. Maintaining a slow, steady, low growth posture risks plunging into a deflation spiral and attempting to use inflation as a way of ultimately evaporating the debt risks a hyperinflation spiral. It will be exceedingly hard to find the Goldilocks wonderland that gave the late 1990’s their “end of history” quality. The 2010s are sure to be a “history is back, with a vengeance” epoch.

As we can see from the Rectified Unemployment chart (total unemployment minus five week and less), serious unemployment has just barely turned the corner, but we feel that this unprecedented destruction of work opportunity has been so cauterizing that it will leave scars on the public psyche long into the future.

The government’s plan to buy stolen data on Swiss bank accounts of alleged tax evaders generated a heated debate in Germany this week. A CD with some 1,500 names of German citizens with accounts at the bank (according to some reports HSBC’s private bank) was offered to the German authorities for the price of €2.5 million, by an alleged employee of the bank.

Germany’s main political parties have been divided on the question of legality and morality of the purchase. The opposition parties SPD (Social Democratic Party), Greens and the Left Party are in favour of the transaction; Angela Merkel’s Christian Democratic Union (CDU) and the business friendly Free Democratic Party (FDP) are split on the issue.

However, Chancellor Merkel has been very vocal on her intent to go ahead with the acquisition and Finance minister Wolfgang Schäuble (CDU) confirmed that the decision has, in principle, been made.

There is a precedent for such action – Bundesnachrichtendienst (Germany’s foreign intelligence service) paid €4.6 million to a thief two years ago, in exchange for confidential files on account holders at his former employer, LGT Group in Liechtenstein. That action netted the state approx €200 million in back taxes and penalties; then-CEO of Deutsche Post Klaus Zumwinkel was the most prominent German caught in the operation.

The majority of Germans approve the (possibly illegal) transaction – 57% want the government to pay for the stolen data, according to a poll by Stern.

The question is whether the state can and should buy stolen goods in order to catch potential tax evaders. To the government it appears to be a no-brainer. Not only will it play well with the populist sentiment of the moment, but the tax authorities may retrieve over €100 million in undeclared taxes.

Can a government break its own laws? According to prominent German legal experts – who have voiced concerns about the legality of the transaction – the government is running into a judicial minefield.

Purchase of stolen goods is a criminal offence in Germany and punishable with up to five years in prison. The question then is, must the state abide by its own laws, or is it exempt from such constraints, for some fictional ‘greater good’?

The notion that the authorities should be free to break the country’s laws ought to be inacceptable. Not only would it mean the state can commit a crime (or participate in one) with impunity, it would also encourage further data theft. It will not be long before another enterprising bank employee decides to quickly make a few millions by stealing confidential client information. The government’s action opens all doors to such criminal activity.

Germany is undoubtedly threading on dangerous terrain and the price to pay could be high. Put into question is the integrity of the German state and the rule of law.

Volker Kauder (Chairman of the CDU/CSU parliamentary group in the Bundestag) declared that the state should not collaborate with thieves. Constitutional law expert Prof. Dr. Helmut Siekmann said the possible multi-million euro revenue does not justify a purchase of illegally obtained data. In his view, the state, as the citizens, is obliged to abide by the laws. Data protection expert and Federal Commissioner for Data Protection and Freedom of Information Peter Schaar expressed great doubts about the legality of the transaction, considering it inacceptable.

Should any of the involved take the matter to court, the likelihood of the illegally obtained evidence being accepted as valid is low. The government will of course count on any tax offenders paying up quietly rather than taking on a lengthy legal battle against the state.

The question about the (im)morality of the proposed action seems easier still to answer. Then again, we should be under no illusion of our rulers being overly concerned with such matters.

When a government takes the liberty to ignore its own laws and willingly purchases stolen data in order to catch tax evaders and gain money for its coffers, what are the citizens supposed to think? If the authorities can break the law to satisfy their own pursuits, what example does it set for the people who until then had respect for law and order? Should the state not be bound by the laws of the land, even more so than its citizens?

Unsurprisingly, the relationship between Germany and Switzerland has suffered further damage. Swiss politicians of all parties have strongly condemned Germany’s intent to reward, rather than prosecute, the thief. The Conservatives compared Angela Merkel to a bank robber and the Swiss population seems to support that view.

“I consider it rather insidious that a state operating under the rule of law would make use of illegal data,” said Swiss President Doris Leuthard.

The Swiss see the German (and international) assault on their banking system and bank secrecy as a personal affront. Tax evasion, unlike tax fraud, is not considered a crime in Switzerland, and bank clients’ privacy is an utmost priority. The bank secrecy has started to crack recently, in particular thanks to US pressure on UBS and the bank’s resulting cooperation with US authorities. The country has a lot to lose; the financial sector is one of the most important for the Swiss economy.

But as shown above, there is far more at stake. No matter how keen the majority of the German population may be on prosecuting (supposedly rich) tax evaders, the ends must not justify the means. The government’s action should cause grave concern to everyone – not just those who dodge their taxes.

The rule of law requires that all individuals in a society are subject to the same laws, including – and especially – those who govern us. Our rulers cannot be exempt from it, regardless of any potential ‘good’ that might come from breaking the law. Indeed, what other protection from arbitrary government action and abuse do citizens have, if not the laws?

Clearly, IF we had the rule of law, a government wouldn’t be permitted to become accomplice in theft. But this episode is not the first indication that rule of law has died a quiet death some time ago. And I doubt it will be the last.

It’s not a specifically German issue either. Whether we look at the US, UK or any other of our cherished democracies, the state has increasingly been above the law, even though citizens may not yet have fully woken up to the fact. (As one recent example among many, consider the Chrysler bankruptcy and the mockery the Obama administration made of the bankruptcy laws and the rights of the secured creditors, in order to pay off a political debt to the unions.)

Be under no illusion, this is our new reality – and it’s here to stay – governments who don’t lose any time on legal niceties in a ruthless pursuit of their own goals.

The past week had the unmistakable feeling of an inflection point. Such moments of transition are the coming into awareness of potential realities and possible futures that had been slowly percolating in the collective unconscious. Per Clausewitz, “ it is always out of a mere inkling and foreboding of the truth that a man acts”… if anything, this has been a week of inklings and forebodings. There has been a general sense of expectations coming unglued, coupled with the anxiety that we’re not looking at a V shaped recovery, nor a U shaped recovery, but a long dreary slog through a slough of despond.

Not that we’re exactly shocked. The political class in the United States appears to have succumbed to the corrosive temptations of empires, rather like a primordial tarpit that slowly suffocates anything so unfortunate as to walk into said tarpit.

We also believe that Obama made a cardinal miscalculation by attempting to shift the agenda to health care reform dreadfully prematurely, long before the endemic problems in the financial and manufacturing sectors (and the attendant severe issues of unemployment) were adequately repaired. To have thrown the weight of his political capital into the infinite labyrinth of the health care industry so soon after the market collapse was pure folly.

This brief analysis based on the Fed’s data gives us a rather amazing insight into how extensive, consistent, and programmatic the collapse of the industrial sector in the United States has truly been. More incredible is that this chart showing the true nature of the decline, and the length of the decline, hasn’t made it into the financial media as far as we know. Quelle Surprise.

The first chart is the raw number, dating from 1939, when the average house cost $3,800, the last man was guillotined in France, Hitler invaded Poland, and Tina Turner was born, of people employed in the manufacture of durable goods.

This next chart shows the percentage of the entire US workforce employed in durable goods manufacture. As late as 1969 it consisted of 15% of the workforce, by 1990 it was 10% of the workforce, by December 2009 it was about 5% of the workforce. If it continues in this pattern, by 2030 it will cease to exist altogether.

We predict this has put many Americans in such an economically untenable position that we will see the inevitable return to protectionism, nativism, and paranoia that is part and parcel of American history when fear and loathing of displacement enters the national discussion. These phases are rarely a pretty sight.

State budgets are in absolutely horrible shape. Unlike their federal counterpart, states can’t print money and they are required to run balanced budgets, which has become a technical and practical impossibility. When Montana and North Dakota are the fiscally healthiest states in the nation, you really have to wonder.

The difficulties are hardly limited to the United States. We’ve been wondering mightily about the real significance of the price of gold. Our attention has been drawn to the idea that China is a major purchaser of gold, which we interpret as being motivated by one of two reasons, neither are comforting. One is that there is no currency alternative to dollar based holdings, and at a ministerial level their confidence in the dollar, and perhaps the country that prints dollars, is coming undone.

Interestingly, Robert Prechter at Elliott Wave International has suggested that precious metals may be at a major top, based on a Fibonacci ratio analysis of other historical highs.

Is this time different, and if so, what might be different this time?

We tend to believe that a second scenario might be worth considering, that gold is not only being accumulated at the state treasury level, but also as a hedge by wealthy Chinese in case the Great Expansion doesn’t work out exactly as planned.

When we looked at the Global Integrity Index for 2008 for “practical implementation” of their legal framework, they were graded in the lowest quartile, below say, Serbia, Azerbaijan, and Ecuador. This suggests that, despite enormous strides, there is weak confidence that everything is as stable as it may seem.

In addition, we did a small study of the Consumer Price Index dating from 1914, taking through economics in its Classical, Keynsian, Neo-Classical, and Wherever We Are Now phases. This is very instructive, as it allows us to see American history unfolding in terms of price stability.

This becomes clearer when we convert this data into year-over-year changes and see that we never have dipped into negative territory since the economy stabilized and got moving around 1955. Until last year that is. Clearly deflation is perceived as a danger to be avoided at all costs. Whether it CAN be avoided is another question.

The world is in a most precarious condition when China must figure out a way to contain a potential runaway inflation and we must contrive to do the opposite. Should either zone lose control of the process, the opposing zone may also be thrown into a chaotic condition.

Which is all quite speculative. However, our friends at Petroleum Intelligence Weekly have somewhat ominously noted, American refineries are running at only 80% of capacity, and Japanese refineries are running at about 70% capacity, suggesting very weak demand for energy. China on the other hand is trying to get hands on all available energy sources, with very large refinery runs.

We took the CPI yoy data from 1914 and ran a Fourier transform to see if it might give us some hints about the future. Obviously this is only one possible model based on past economic cycles, so consider it one scenario out of many possibilities.

If there are long term cycles that became ironed out to a degree with the emerging US-China relationship, they may be reasserting themselves in this era.

It may also be worthy of note that a recent Supreme Court ruling on campaign finance reform was poorly received, to put it mildly. President Obama lashed out in language rarely heard directed by a President toward the court.

The intensely populist language points to a growing culture of populist resentment and radicalism in the American electorate, which makes for interesting times and impulsive legislation, typically leading to a reduced appetite for risk, at exactly the time that risk aversion may be leading us into a liquidity trap.

Public debate lurches from the timid to mediocre to the bizarre to the incoherent, a symptom of the intellectual incoherence of our age.

Which leaves us where? The political process appears to be slowly coming unglued, the media incapable of communicating anything like a clear understanding of the realities and perils we face, and the financial system uncertain as to whether there is another boot left to drop.

Although we are in no wise where we were in 1932, history, as Mark Twain said, doesn’t repeat but it rhymes. The core problem of the 1930s was incoherence. Established models such as the gold standard had broken down, the finance ministers and governors were products of an earlier era with no maps to guide them, and the world had entered a procedural vacuum.

Once again a generation of free market philosophers is having to improvise an interventionist strategy with inadequate models from a vastly different set of circumstances.

“A man may be sharper than another, but not all others”

-La Rouchefoucauld

“Nothing on earth consumes a man more completely than the passion of resentment”

-Nietzsche

“People who bite the hand that feeds them, usually lick the boot that kicks them”

-Eric Hoffer

We are well to hold in mind that every political moment is an economic moment is a social moment. Long periods of prosperity create formulaic thinking, banal entertainment culture, speculative energy distracting from a general ennui, a certain nostalgie de la boue, an indifference to corruption, a fondness for idiocy, a displacement of common sense and common courtesy by trivial rules and regulations, by tinpot “outrage” in place of penetrating insight. This won’t be the first time we’ve been in these parts.

So far the Venture Capital Association reports that ventures are still getting funded. That’s a good sign, because it means that there is still great confidence in the long term for America to creatively respond and sophisticated investors do see the long term payoff as deserving of the risk. If venture money had dried up altogether, that would have been a far more ominous long term sign. Assuming that the VCs are better informed and more intelligent than the average investor, and have longer time lines with fewer constituencies to placate, we will take this as a positive sign of confidence in the deeper future.

However, for the moment, VCs don’t seem to be doing IPOs, we assume that their view of the current market is that now is not the time. We take that as a medium term negative. Perhaps a strong negative.

Or a large change in direction.

According to Ari Levy and Dakin Campbell in their January 19 blurb on Bloomberg:

Veteran venture capitalist Dixon Doll predicts that more U.S. technology companies will start holding initial public offerings in other countries as economic growth in Asia outpaces domestic expansion.

“In the next 10 years, I expect more portfolio companies to list on foreign exchanges,” said Doll, founder of Menlo Park, California-based firm DCM, in an interview last week. China “will become a big deal.”

The U.S. venture-capital industry is coming off its slowest two-year stretch for IPOs since the mid-1970s, with only 19 in 2008 and 2009, according to the National Venture Capital Association. Doll said that while U.S. companies may not flock to China in the next year or two, the world’s third-largest economy will be increasingly attractive for technology start-ups as its capital markets mature.

China’s gross domestic product will expand 8.5 percent this year and 9.3 percent next year, according to Bloomberg surveys of economists. That compares with average predictions for U.S. growth of 2.7 percent in 2010 and 3 percent in 2011, according to Bloomberg.

Doll, 67, said he expects 40 to 50 venture-backed companies in the U.S. to go public this year, because the “system is so constipated” from two years of inactivity. The financial crisis wiped out investment banks such as Lehman Brothers Holdings Inc. and Bear Stearns Cos., and forced more than 850 hedge funds to shutter in the first nine months of 2009. That left fewer banks to lead IPOs and fewer investors to buy shares in them.

In the words of Jim Morrison, “the future’s uncertain and the end is always near.” We simply may have to go through a painful schooling in the next few years as we unlearn many of the lessons we took to heart as we moved from what appeared to be a Keynesian orthodoxy undone by a great inflation to a Chicago school era that began brilliantly and ended in chaos. Until the new synthesis of economic theory, social expectations, political frames, and a stable contract between economic stakeholders in in place, we should brace ourselves for a witches ride.

China may successfully break with a historical pattern and successfully manage its’ way through a period of hyper-expansion. It is our belief, however, that stable institutions require a long time to develop, and a longer time to become uniformly internalized beliefs about the nature of social and economic reality.

The great downturn beginning in 2007 forced China to re-imagine itself as a nation of internal markets. Wise policy level figures have long understood the need to gorge expanding social classes on tempting distractions lest they become overly curious about the mechanism of the state itself. Which requires a rapid expansion of credit so that this new class CAN indulge itself in new toys.

We made this error between the Clinton and Bush administrations when we made the political choice to buy off the electorate with a fantasy world of palatial homes and (imported) consumer goods, founded on the substrate of a corrupt and unstable credit allocation mechanism. Will China be capable of discovering another, less Minsky flavored path ?

Just when it seemed the small government ideal was dead and buried and Americans have fully embraced Euro-style socialism, Scott  Brown’s win of the Senate seat for Massachusetts has sparked a new hope.

The Republican’s victory has dealt a shocking blow to Obama on the first anniversary of his inauguration. It was the third defeat for the Obama administration after Virginia and New Jersey elected Republican governors in November.

It is even more significant considering the largely unknown Brown won the seat held by Ted Kennedy for nearly five decades. And, Massachusetts is the bluest state in America – registered Democrats outnumber Republicans three to one. The last time a Republican won a Senate seat representing Massachusetts was in 1972. Both houses of the state’s legislature have been under Democratic control since the 1950s.

The voters have made it clear where they stand on the trillion dollar health care reform, growth dragging climate change and energy policies, exploding public spending and tax increases. They don’t identify with Obama’s tax & spend crusade that is leading the country to certain ruin.

Scott Brown’s was a message of lower government spending and across the board tax cuts to spur economic growth. A contrast to Obama’s trillions of dollars spending explosion and massive growth of government and government employment.

A recent Washington Post poll showed that, by 58 to 38%, Americans want smaller government and fewer government services.

People are dismayed at the scale of the debt and money printing. Most understand severe belt tightening is the only viable option for the country. It is now quite obvious that the discussed second stimulus bill will not become a reality. The people have said ‘enough’.

Brown’s victory resulted in a loss of the 60 vote super-majority Senate Democrats needed in order to prevent  Republican filibusters. That could kill the health care bill as well as cap-and-trade, card check, tax hike plans and, most importantly, Obama’s aims to impose big-government rules on the free markets.

Still, it’s too early to say health care reform is dead. Obama may attempt to drive through the legislation regardless. The President is clearly unable to listen – to voters or any voice of reason, much less change direction from a defective strategy. Instead he opted to silence the noise about a dying health care bill by promptly announcing yet more ill thought out bank regulation.

However, one thing is clear. If Americans are once again lending their support to limited government, tax and spending cuts and free enterprise (as opposed to government) employment, the country’s future is bound to be brighter than the current situation might suggest.

UK heading into fiscal crisis

Meanwhile, no such good news from Gordon Brown’s Britain.

A new report by McKinsey shows that the combined UK public and private debt is now at 449% of GDP. Britain has seen the largest rise in debt to GDP of any western nation over the last 10 years. Even excluding the liabilities of UK based foreign banks the ratio is still at 380% – far higher than any country except Japan. See international debt chart here.

Given that the UK seems to have no clear plan or ability to reduce its monstrous deficit, a full blown fiscal and currency crisis is a near certainty.

The public sector deficit as percentage of GDP is now more than twice what it was in 1976 when Britain was bailed out by the IMF. Apart from being at a record level, much of the deficit is structural, as the financial and housing sectors will account for a significantly smaller portion of the economy compared to recent years. OECD believes about ¾ of UK’s deficit is structural, and as such unlikely to prove responsive to any cyclical recovery.

To make matters worse, spending on health care and pensions will also increase significantly in the coming years and decades, due to massive demographic challenges.

As the budget deficit has swollen to nearly 13%, the UK has had to keep issuing gilts at a breathtaking pace to finance the gap. The markets are unlikely to be patient with our policy makers for too long. Overseas holders of gilts (accounting for nearly a third of outstanding government debt) are increasingly reluctant to put up with the risks of UK’s disastrous public finances.

The world’s largest bond investor Pimco, as well as BlackRock, have recently started to sell off their gilt holdings. Pimco stated an 80% probability of a UK ratings downgrade this year. Thanks to a (still ongoing) massive quantitative easing program the Bank of England now holds almost 30% of outstanding gilts (compared to just over 5% in March 2009).

As the IMF expects UK’s net debt to GDP to rise to over 100% by 2014, things are bound to continue deteriorating. Investors will undoubtedly demand higher risk premiums on UK debt, further worsening the fiscal situation. A full blown debt crisis, and resulting currency crisis, are increasingly likely.

The Bank of England is unlikely to exit extremely loose policies and hike rates or withdraw liquidity soon. The markets will of course force it to act eventually. The pound has already fallen some 25% from its highs and the gilt/Bund spread is now wider than 70bp.

And it’s not just Gordon Brown’s government’s fiscal consolidation strategy that lacks any credibility; the Conservative plans aren’t faring much better at the moment.

Instead of much needed expenditure cuts the December Pre-budget report offered more spending (or ‘investment’ as Labour prefers to label it) and commitments to ring-fence many areas from any cuts.

Public spending makes up 47% of UK GDP, more than in 1976. Yet instead of coherent and detailed plans on expenditure control and public pension system reform we’ve got soak-the-rich class war policies, tax raids on banks and political posturing.

It’s clear that if the UK is to get the situation under any sort of control, sacred cows need to be sacrificed. And yet all main parties are competing to ring-fence the bloated and inefficient NHS with its £120 billion annual budget (up from £29 bil in 1990 and £49.5 bil in 2000) as well as areas like overseas aid, and commit to unaffordable and unnecessary climate change spending.

Preventing a bigger crisis will require considerable political leadership and courage, and we aren’t seeing much of those at the moment. Any significant action would also prove near impossible should the UK get a minority/coalition government, which is a possibility after the (May or June) general election.

McKinsey sees three possible directions for the UK – outright default, high inflation or severe belt-tightening. While voluntary austerity would clearly be the best solution for the long term health of the economy, the short term pain – and voter resentment – it would bring make it a rather unlikely choice.

Sacrificing short term growth and employment in order to generate a more sustainable growth for the future doesn’t appeal to a population that has, for too long, been used to times of prosperity and welfare largesse. The bill will, I’m afraid, come in a few years time. And the pain is likely to be far more severe and prolonged than anything we’ve seen in the last couple of years.

Walter Bagehot wrote the following in 1876. Despite a slight patina of grammatical distance between the Victorian age and our own, his fundamental insights remain as clearly stated as anything that might have been written in today’s New York Times. Bagehot was distinct from many of his contemporaries, as he would be distinct from many of those who would be his natural community today, in that he had a firm grounding in both the humanities and the sciences, a true renaissance man in ways difficult to appreciate or understand in our era of hyper-specialization.

The Bagehot shape of mind is precisely what is missing in all too much of what passes for public thought. The question is, where is Bagehot now that we need him?

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“Years ago I heard Mr. Cobden say at an Anti-Corn Law League meeting that ‘political economy was the highest study of the human mind, for that the other physical sciences required by no means so hard an effort’. An orator cannot be expected to be exactly precise, and of course political economy is in no sense the highest study of the mind – there are other things which are much higher, for they are concerned with things much nobler than wealth or money; nor is it true that the effort of mind which the political economy requires is nearly as great as that required for the abstruser theories of physical science, for the theory of gravitation, or the theory of natural selection; but nevertheless, what Mr. Cobden meant had – as usual with his first hand mind – a great fund of truth.

He meant that political economy – effectual political economy, political economy which in complex problems succeeds – is a very difficult thing; something altogether more abstruse and difficult, as well as more conclusive, than that which many of those who rush in upon it have a notion of. It is an abstract science which labors under a special hardship.

Those who are conversant with its abstractions are usually without a true contact with its facts; those who are in contact with its facts usually have little sympathy with and little cognizance of its abstractions. Literary men who write about it are constantly using what a great teacher calls ‘unreal words’ – that is, they are using expressions with which they have no complete vivid picture to correspond.

They are like physiologists who have never dissected; like astronomers who have never seen the stars; and in consequence, just when they seem to be reasoning at their best, their knowledge of the facts falls short. Their primitive picture fails them, and their deduction altogether misses the mark – sometimes, indeed, goes so far astray, that those who live among the facts, boldly say that they cannot comprehend ‘how anyone can talk such nonsense’.

While, on the other hand, these people who live and move among the facts often, or mostly, cannot of themselves put together any precise reasonings about them. Men of business have a solid judgment – a wonderful guessing power of what is going to happen – each in his own trade; but they have never practiced themselves in reasoning out their judgments and in supporting their guesses by argument; probably if they did some of the finer and correcter parts of their anticipations would vanish.

They are like the sensible lady to whom Coleridge said, ‘Madam, I accept your conclusion, but you must let me find the logic for it.’ Men of business can no more put into words much of what guides their life than they could tell another person how to speak their language. And so the ‘theory of business’ leads a life of obstruction, because theorists do not see the business, and men of business will not reason out the theories.

Far from wondering that such a science is not completely perfect, we should rather wonder that it exists at all.”