Paper mill on the Potomac - The paper mill onthe Potomac is furiously spewing up new money. According to the managerof the mill, as indeed according to the Quantity Theory of Money, thisshould stop prices from falling and the economy from contracting.


In this article I present an argument why this conclusion is not valid.On the contrary, I shall show that new money created on the strength ofa flood of new debt, is tantamount to pouring gasoline on the fire,making prices fall and the economy contract even more. The Obamaadministration has missed its historic opportunity to stop thedeflation and depression inherited from the Bush administration becauseit entrusted the same people with the task of damage-control who hadcaused the disaster in the first place: the Keynesian and Friedmanitemoney doctors in the Fed and the Treasury.

Watching the wrong ratio

The key to understanding the problem is the marginal productivity ofdebt , a concept curiously missing from the vocabulary of mainstreameconomics. Keynesians take comfort in the fact that total debt as apercentage of total GDP is safely below 100 in the United States whileit is 100 and perhaps even more in some other countries. However, thesignificant ratio to watch is additional debt to additional GDP , orthe amount of GDP contributed by the creation of $1 in new debt. It isthis ratio that determines the quality of debt . Indeed, the higher theratio, the more successful entrepreneurs are in increasingproductivity, which is the only valid justification for going into debtin the first place.

Conversely, a serious fall in that ratio is a danger sign that thequality of debt is deteriorating, and contracting additional debt hasno economic justification. The volume of debt is rising faster thannational income, and capital supporting production is eroding fast. If,as in the worst-case scenario, the ratio falls into negative territory,the message is that the economy is on a collision course and crash inimminent. Not only does more debt add nothing to the GDP, in fact, itcauses economic contraction, including greater unemployment. Thecountry is eating the seed corn with the result that accumulatedcapital may be gone before you know it. Immediate action is absolutelynecessary to stop the hemorrhage, or the patient will bleed to death.

Keynesians are watching the wrong ratio, that of debt-to-GDP. No wonderthey constantly go astray as they miss one danger signal after another.They are sailing in the dark with the aid of the wrong navigationalequipment. They are administering the wrong medicine. Their ambulanceis unable to diagnose internal hemorrhage that must be stopped lest thepatient be dead upon arrival.

Melchior Palyi's early warning

In the 1950's when the dollar was still redeemable in the sense thatforeign governments and central banks could convert their short-termdollar balances into gold at the fixed statutory rate of $35 per ounce,the marginal productivity of debt was 3 or higher, meaning that theaddition of $1 in new debt caused the GDP to increase by at least $3.By August, 1971, when Nixon defaulted on the international goldobligations of the United States (following in the footsteps of F.D.Roosevelt who had defaulted on its domestic gold obligations 35 yearsearlier) the marginal productivity of debt has fallen below the cruciallevel 1. When marginal productivity fell below $1 but was stillpositive, it meant that total debt (always 'net') was rising fasterthan GDP. For example, if the marginal productivity of debt was ½, then$2 in debt had to be incurred in order to increase the nation's outputof goods and services by $1. An increase in total debt by $1 could nolonger reproduce its cost in the form of an equivalent increase in theGDP. Debt lost whatever economic justification it may have once had.

The decline in the marginal productivity of debt has continued withoutinterruption thereafter. Nobody took action, in fact, the Keynesianmanagers of the monetary system and the economy stone-walled thisinformation, keeping the public in the dark. Nor did Keynesian andFriedmanite economists at the universities pay attention to the dangersign. Cheerleaders kept chanting: "Gimme more credit!"

I learned about the importance of the marginal productivity of debtfrom the privately circulated Bulletin of Hungarian-born Chicagoeconomist Melchior Palyi in 1969. (There were altogether 640 issues ofthe Bulletin; they are available in the University of Chicago Library).Palyi warned that the tendency of this most important indicator wasdown and something should be done about it before the debt-behemothdevoured the economy. Palyi died a few years later and did not live tosee the devastation that he so astutely predicted.

Others have come to the same conclusion in other ways. Peter Warburtonin his book Debt and Delusion: Central Bank Follies ThatThreatenEconomic Disaster (see references below) envisages the same outcome,although without the benefit of the concept of the marginalproductivity of debt.

The watershed year of 2006

As long debt was constrained by the centripetal force of gold in thesystem, tenuous though this constraint may have been, deterioration inthe quality of debt was relatively slow. Quality caved in, and quantitytook a flight to the stratosphere, when the centripetal force was cutand gold, the only ultimate extinguisher of debtthere is, was exiledfrom the monetary system. Still, it took 35 years before the capital ofsociety was eroded and consumed through a steadily deterioratingmarginal productivity of debt.

The year 2006 was the watershed. Late in that year the marginalproductivity of debt dropped to zero and went negative for the firsttime ever, switching on the red alert sign to warn of an imminenteconomic catastrophe. Indeed, in February, 2007, the risk of debtdefault as measured by the skyrocketing cost of CDS (credit defaultswaps) exploded and, as the saying goes, the rest is history.

Negative marginal productivity

Why is a negative marginal productivity of debt a sign of an imminenteconomic catastrophe? Because it indicates that any further increase inindebtedness would necessarily cause economic contraction. Capital isgone; further production is no longer supported by the prerequisitequantity and quality of tools and equipment. The economy is literallydevouring itself through debt. The message, namely that unbridledbreeding of debt through the serial cutting of the rate of interest tozero was destroying society's capital, has been ignored. The buddingfinancial crisis was explained away through ad hoc reasoning, such asblaming it on loose credit standards, subprime mortgages, and the like.Nothing was done to stop the real cause of the disaster, thefast-breeder of debt. On the contrary, debt-breeding was furtheraccelerated through bailouts and stimulus packages.

In view of the fact that the marginal productivity of debt is nownegative we can see that the damage-control measures of the Obamaadministration, which are financed through creating unprecedentedamounts of new debt, are counter-productive. Nay, they are the directcause of further economic contraction of an already prostrate economy,including unemployment.

The head of the European Union and Czech prime minister Mirek Topolanekhas publicly characterized president Obama's plan to spend nearly $2trillion to push the U.S. economy out of recession as "road to hell".There is absolutely no reason to castigate Mr. Topolanek for thischaracterization. True, it would have been more polite and diplomaticif he had couched his comments in words to the effect that "the Obamaplan was made in blissful ignorance of the marginal productivity ofdebt which was now negative and falling. In consequence more spendingon stimulus packages would only stimulate deflation and economiccontraction."

Hyper-inflation or hyper-deflation?

Most critics the Obama plan suggest that the punishment for thebailouts and stimulus-packages will be a serious loss of purchasingpower of the dollar and, ultimately, hyperinflation, as evidenced bythe Quantity Theory of Money. However, the quantity theory is a linearmodel that may be valid as a first approximation, but fails in mostcases as the real world is highly non-linear. My own theory, relying onthe concept of marginal productivity of debt, predicts that it is nothyperinflation but a vicious deflation which is in store. Here is theargument.

While prices of primary products such as crude oil and foodstuffs mayinitially rise, there is no purchasing power in the hands of theconsumers, nor can they borrow as they used to in order to pay thehigher prices much as though they would have liked to do. The newlycreated money has gone into bailing out banks, and much of it wasdiverted to continue paying bloated bonuses to bankers. Very little, ifany of it has "trickled down" to the ordinary consumers who aresqueezed relentlessly on their debts contracted in the past.

It follows that price rises are unsustainable, as the consumer isunable to pay them. As a consequence the retail and wholesale merchantsare also squeezed. They have to retrench. Pressure from vanishingdemand is passed on further to the producers who have to retrench aswell. All of them are experiencing an ebb in their operating cash flow.They lay off more people, aggravating the crisis further as cash in thehand of the consumers is diminished even more through increasedunemployment. The vicious spiral is on.

But what is happening to the unprecedented tide of new money floodingthe economy? Well, it is used to pay off debt by the people who aredesperately scrambling to get out of debt. Businessmen in general arelethargic; every cut in the rate of interest hits them by eroding thevalue of their previous investments. In my other writings I haveexplained how falling interest rates make the liquidation value of debtrise, which becomes a negative item in the profit/loss statement eatinginto capital that has to be replenished as a consequence. Worse still,there is no way businessmen can be induced to make new investments aslong as further reductions in the rate of interest are in the cards.They are aware that their investments would go up in smoke as the rateof interest fell further in the wake of "quantitative easing".

Self-fulfilling speculation on falling interest rates

The only enterprise prospering in this deflationary environment is bondspeculation. Speculators use new money, made available by the Fed, toexpand their activities further in bidding up bond prices. Theypre-empt the Fed: buy the bonds first before the Fed has a chance; thenturn around and dump them in the lap of the Fed. This activity isrisk-free. Speculators are told in advance that the Fed is going tomove its operations from the short to the long end of the yield curve.It will buy $300 billion worth of long dated Treasury issues during thenext six months, and probably much more after that. Speculation onfalling interest rates becomes self-fulfilling, thanks to the insaneidea of open market operations of the Fed making bond speculationrisk-free. Deflation is made self-sustaining. (For another view ofrisk-free bond speculation, see the article by Carl Gutierrez' inForbes mentioned in the References below.)

Note also the crescendo of the dumping of equities and the desperateattempt to redeem toxic assets by private parties, sending the demandfor cash sky high. The dollar, at least the Federal Reserve notevariety of it, will be increasingly scarce. Rather than falling through the floor as under the hyper-inflationary scenario, the purchasing power of the dollar will soar.You say that Ben Bernanke and his printing presses will take care ofthat? Well, just consider this. The market will separate vintageFederal Reserve notes from the new issues with Bernanke's signature onthem. In a classic application of Gresham's Law people will hoard thefirst, bestowing a premium on it relative to the second variety, whichwill fall by the wayside.

Bernanke can create money but cannot make it flow uphill

Already some tip sheets openly advise people to hoard Federal Reservenotes in amounts up to twenty-four months of estimated householdexpenditure, while cleaning out all deposit accounts. Depositors areurged to forget about the $250,000 limit on deposit insurance, which isrendered literally worthless as the resources of the F.D.I.C. have beenhijacked by Geithner and diverted to guaranteeing the investments ofprivate parties that were foolish enough to buy into toxic debt at thebehest of the Obama administration.

Karl Denninger envisages unemployment in excess of 20%, with cities going "feral" as showcased by downtown Detroit (see References below).

What has all this got to do with the marginal productivity of debt?Well, once it is negative, any further addition of new debt will makethe economy shrink more, increasing unemployment and squeezing prices.Bernanke can create all the money he wants and more, but he cannot makeit flow uphill.

Bernanke is risking something worse than a depression

The newly created money will follow the laws of gravity and flowdownhill to the bond market where the fun is. Risk-free bondspeculation will further reinforce the deflationary spiral until finalexhaustion occurs: the economy will collapse as a pricked balloon.Instead of hyperinflation and the destruction of the dollar, you've gotdeflation and the destruction of the economy.

Denninger says that the "death spiral" will lead to fire sales ofassets in a mad liquidation dash and, ultimately, to the collapse ofboth the monetary and political system in the United States as taxrevenues evaporate. He opines that probably not one member of Congressunderstands the seriousness of the situation. Bernanke is riskingsomething much worse than a Depression. He is literally risking the endof America as a political, economic, and military power.

Indeed, the financial and economic collapse of the last two years mustbe seen as part of the progressive disintegration of Westerncivilization that started with government sabotage of the gold standardearly in the twentieth century. Ben Bernanke, who should have beenfired by the new president on the day after Inauguration for his partin causing irreparable damage to the American republic may, in the end,have the honor to administer the coup de grâce to our civilization.