A society, or even a person or household, gets richer by saving.  It would be very difficult, or perhaps impossible, for a society to get richer if everyone consumed everything and saved nothing.  The same generally holds true for a person or household, although someone could make a higher income and have a higher standard of living (at least as long as the higher income lasted) without saving anything.

Savings is required for capital investment.  Capital investment is what leads to better production and better technology.  In an advanced society, it leads to higher wages, lower prices, and an overall higher standard of living.

If someone were stranded on an island alone, let’s say he could catch two fish every day.  It took him from sunrise to sunset to catch just two fish.  At sunset, he had to go into his cave and sleep and stay safe from wild animals.  If he always consumed two fish every day, then he would never get ahead.

Let’s say the guy on the island consumed only one fish per day and found a way to preserve the second fish he caught.  The next day, instead of fishing, he might have some time to build a better shelter.  He wouldn’t need to fish the whole day, as he would be able to eat from his prior savings.  The guy could also spend a day building a fishing net.  This might help him catch 4 fish in a day, instead of just 2.  The fishing net is capital investment.  He was able to make it because of his prior savings (a fish).  He deferred consumption of a fish so that he could build a net.  Through savings and capital investment, he has increased his productivity.  Now he can fish for just half a day, consume two fish, and still have time to do other things.

Some people who don’t understand economics, finance, and even math, think that if you save some money, that you will always have a lower standard of living until you tap into that savings.  They don’t understand the benefits of compounding interest.

Henry Hazlitt made a point similar to this in his classic book Economics In One Lesson.

If you make $100,000 per year (after taxes for the sake of this argument) and you always save 10% of your income, let’s see what happens.  The first year you save $10,000 and you spend $90,000.

The second year, you still make $100,000 and you save $10,000 again.  But let’s also say that you make a 5% return on your initial $10,000 that you saved last year.  So you actually made an extra $500 or $100,500.  You could simply decide to consume 90% of the $500 and continue to save 10%.  So your consumption in year two would actually be $90,450 and your savings after year two would be $20,050 ($10,000 in savings for two years, plus $50 saved from your first year returns).

If this situation continues, then eventually your consumption will be over $100,000, while the savings continue to add up.  By deferring consumption, you are actually able to have a higher standard of living than when you started off, even if you had consumed everything in the first year.

Of course, you could save even more aggressively and consume less of your return, which in this case starts out at $500.  Once you get your total savings up to $200,000, then just a 5% return would be enough to make up for the $10,000 in income that you save each year.  At that point, you could consume the full $100,000 you earn each year and your savings would continue to grow just from the interest.

While interest rates are currently very low, there are still ways to get a positive return on your savings.  The magic of compounding interest has not gone away.  It is a wonderful thing.  Compounding interest is what enables many people to get wealthy and it also enables societies to get wealthier.

I recently wrote a post about the decline in the gold price.  I said that it could mean one of two things.  The first scenario is that it is a temporary downturn before we see another big run in the gold price.  The other possible scenario is that we are headed into another recession.

In response to this, I received the following comment:

“In general I agree with your expectation for gold to rise in price.  But I note that there is a 3rd possibility… that we are emerging from the deflationary recession depression and in the early stages of a return to prosperity.  If that is the case gold could be on the express elevator ride to the basement.  Remember the 80’s and 90’s.”

He is technically correct that this third possibility exists.  But I give it no more than a 1% chance.  The only way I see this happening is if we have some major technological breakthrough in tandem with Congress finding fiscal discipline.  Perhaps I should say that I give it no more than a .01% chance.

So what is my reasoning for this?  First and foremost, the Federal Reserve has more than tripled the monetary base since 2008.  It is on its way to being quadrupled.  This is unprecedented.

We had a major recession in 2008 and the federal government, along with the Fed, did not allow the full liquidation to take place.  Instead, it propped up failing companies, tried to prop up housing, and has continued to bail out banks and create massive amounts of new money out of thin air.  We are actually in a worse situation now than we were in 2007, at least in terms of distortions in the economy.

All of this massive malinvestment will have to be corrected at some point.  If it is not, then our living standards will decline immensely.  Until we see a shakeout of all of the misaligned resources, we are not going to return to prosperity.  We may see false prosperity in terms of higher housing prices and higher stock prices, but that is only because of the massive monetary inflation that has taken place and continues to take place.

The last sentence in the comment above is: “Remember the 80’s and 90’s.”  But this is a perfect example of why we will not return to real prosperity any time soon.  This can’t be like the 80’s and 90’s.  If anything, we are in the early 70’s right now.  It would not surprise me to see us advance into something like the late 70’s with high price inflation and high unemployment.

While a part of the boom of the 80’s and 90’s was false prosperity from a loose monetary policy, it was, at least relatively speaking, good economic times.  But the reason we were able to have good times is because we took the right medicine before that.  Paul Volcker came in at the Fed and halted the printing presses.  He allowed interest rates to rise to what would be unthinkable levels today.  With no more monetary inflation to prop things up, he essentially saved the dollar, which also resulted in severe recessionary conditions in the early 80’s.  We went through the pain of the correction.  Resources realigned to better uses and we saw a new wave of investment and productivity.  We were only able to return to prosperity when the malinvestment was flushed out.

We have not taken the right medicine yet today.  Instead, Bernanke and friends keep putting poison in our bodies.  Sometime the poison has an illusion of masking the painful symptoms, but it is actually making us sicker.  Until we stop taking the poison and start taking the medicine (while experiencing some pain), we are not going to return to prosperity.

I recently wrote a post on booms and busts and interest rates.  I received the following comment/ questions from this post:

“Assume that we haven’t seen the level of inflation that one would expect given the tripling of the monetary base since 2007.  Further, assume that, in large part, the reason for that is a lack of velocity.  If we assume both of these things, how are they squared with the argument that in a artificially created low interest environment, people tend to spend rather than save?  If people are spending, that’s velocity, right?”

Let’s take the first two sentences first.  I assume that the commenter’s use of the term “inflation” is referring to price inflation.  We don’t really have to assume that we haven’t seen significant price inflation after a tripling of the monetary base.  This is in fact what has happened.

Secondly, we don’t have to assume that velocity is a large reason for this.  If there is a huge increase in the supply of money and it hasn’t translated into significantly higher prices, then there must be a higher demand for money (lower velocity).  The other major reason, which really goes along with a higher demand for money, is that bank reserves have increased dramatically.

So with everything going on, we would expect to see higher velocity, meaning money changing hands faster.  This would mean more consumer spending.  It would lead to higher prices.

But there is an assumption in the comments that I don’t completely agree with.  The commenter used the phrase “artificially created low interest rate environment”.  But we cannot really know how much is artificial and how much is not.  While the Fed has been buying a lot in the way of government debt and mortgage-backed securities, and this has certainly contributed to lower interest rates, I’m not so sure we wouldn’t have seen low interest rates anyway, given the previous mess created by the Fed.

We are in an environment of fear and we mostly have been for almost 5 years now.  The general public is scared of recession and unemployment.  People are not generally as scared about price inflation.  In some ways, this can be a self-fulfilling prophecy by the general public.

In a recessionary environment, it is common to see low velocity.  Cash is usually king in a recession.  This means there is a high demand for money.  People are afraid of losing their jobs and they try to build cash and pay down debt.  This is not to say that things can’t change quickly if enough money floods the system.

Right now, real interest rates (rates adjusted for inflation) are negative.  But they are not negative by a lot.  We still have relatively low price inflation, at least as stated by the government’s CPI numbers.  If price inflation were at 10% and interest rates were still really low, then we could be more certain that they are being kept down artificially.  Such a scenario would also likely result in much more spending (higher velocity), even in recessionary conditions.  We saw this happen in the late 1970’s.

I think we will likely see much higher velocity, and hence higher price inflation, in the future, assuming that the Fed keeps creating new money out of thin air at a rapid rate.  We have to get to a point where the general public is more fearful of a depreciating currency than it is of a recession.  At that point, we can expect to see significantly higher prices.  We can also expect another huge run in the gold price.

Sometimes it is important to take a step back and look at the big picture.  It is also good to help others do the same.  We get bogged down in these debates about tax rates, deficits, and specific programs, and part of this is due to the media and the politicians.  But let’s take a broad look at where we are today in nice round numbers.

The federal government (this doesn’t include state and local spending, unless it was money that came directly from the federal government) spent almost $3.8 trillion in fiscal year 2012.  It likely won’t be any lower in 2013.  There are approximately 315 million people living in the United States.  This means that each individual’s share of government is approximately $12,000 per year.  Of course, this is for each person, which includes 90-year old people in nursing homes and little babies.  Again, remember that this doesn’t even include state and local government.

If you are a family of four, then your share is $48,000.  That is every year.  Of course, it is not distributed equally.  Your share may be higher or lower than $48,000.  A guy who is unemployed and homeless is not paying $12,000, although he is probably paying some share in some way.

If you go by the number of households, the numbers just look worse.  There are approximately 115 million households in the U.S.  This is an estimate.  That would make the average household’s share of government spending at the federal level about $33,000 per year.  Would you be willing to give up your favorite federal programs for an additional $33,000 per year?

You could ask a proponent of big government how much the average family should spend to fund government each year and I’m guessing at least 9 out of 10 would not answer anything higher than what it actually is.  That is why this is such an important statistic.

Most people make the mistake of just looking at their income tax.  Perhaps they might also look at their payroll taxes too.  But we pay in some fashion for every dollar that the government spends.  Taxes that employers pay lower our wages.  Corporate taxes lower wages, make prices higher, and also hurt investors.  There are a lot of hidden sales taxes and excise taxes that we pay.  And of course there is the hidden tax of inflation that devalues our money over time.

That is why it is so critical to look at overall government spending and not just taxes.  Total government spending gives us a better picture of how much the government is consuming in the way of resources.  Most government spending, even if it isn’t completely wasteful or harmful, is still a misallocation of resources.  This makes us poorer than we would otherwise be.

Even if state and local government stayed about the same and the federal budget were cut in half, that would mean an extra $16,500 for the average household.  That is every year.  What would you do with an extra $16,500 every year?

I’ll bet that would make a huge difference in a lot of lives.  It would probably mean a lot less stress for millions of people who struggle to pay their bills.  It would allow most people to live better.  You could save more, give more to charity, pay off debt, get a bigger house, send your kids to private school, help out a loved one, start a new business, take a family vacation, and the list goes on.  But it would be your choice.  It is your money that you earned.  It doesn’t belong to the government.  We should not be shy in pointing this out.

The Austrian Business Cycle Theory (ABCT) teaches us that a loose monetary policy, with low interest rates, will send false signals to the marketplace.  The extra money and artificially low interest rates misleads people to believe that there has been more prior savings than what has actually occurred.  This leads to artificial booms in certain sectors.  When the loose monetary policy ends, or at least tightens somewhat, then the previous false signals become evident and the boom turns to bust.

We saw this happen with real estate.  It boomed up until about 2006 or 2007.  When it became evident that it was unsustainable and that the long-term savings just weren’t there, then the housing boom turned into a housing bust.

Interestingly, the Federal Reserve buys mostly government debt.  It has, just in recent years since the housing bust, bought some mortgage-backed securities.  Therefore, the Fed has a significant impact on interest rates.  By buying government bonds, it bids up the price of the bonds.  As long as there is no major expectation of severe price inflation, then the Fed’s buying will generally lower interest rates.  Again, this sends false signals to the marketplace, although we are in a much different economy now than when the rates were artificially low 10 years ago.

So what would happen if the Fed created money out of thin air, but did it in a way that didn’t directly affect interest rates?  The Fed, with a monopoly over the money, can buy almost anything.  It could decide to buy big screen televisions, although I’m not sure what it would do with them all.  It could buy stocks.  It could buy gold, which ironically, just like buying stocks, would bid the price up through its actual buying and from the monetary inflation.

But let’s even say that the Fed could create monetary inflation more uniformly.  It is impossible to do it completely uniformly because the new money has to go somewhere first.  And if you just handed out new money to everyone, do you do it with equal amounts to everyone or do you do it on a proportional basis of how much each person already holds?

I suppose the Fed could simply pay for the government’s bills without formally buying government debt, but even here there would be booms in whatever the government spends it on.

Regardless of how the Fed creates new money out of thin air, I contend that it would have some kind of impact on interest rates.  But even if that were not the case, the monetary inflation would still cause distortions in the marketplace.  So maybe the booms and busts would take on a different way of playing out.  Maybe we would see different sectors experiencing the bigger booms and busts.  But no matter how you cut it, there will be a misallocation of resources.

Just with the presence of inflation, certain behavior is affected.  It encourages more debt.  It encourages consumption at the expense of saving.  If your money is continually devalued, you are less likely to save it and watch it lose value.  You are more likely to buy something that will more likely hold its value or that you can at least use.

So while manipulating interest rates plays a big role in the Fed’s policies, I contend that monetary inflation alone, no matter how it is done, will misallocate resources.  As long as we get monetary inflation from the Fed, our standard of living will be less than it should be.

There is a trap that libertarians often fall into.  It is a trap set by someone challenging the libertarian philosophy, whether it is intentional or not.  Sometime the challenger is simply asking, with no ill intentions, and is looking for a serious answer.

The trap is when libertarians feel the need to have all of the answers.  But that is actually the great thing about libertarianism and we should use it to our advantage.  You don’t really have to know much in the way of answers at all.  The only answer you need to provide is for the free market, consisting of peaceful individuals, to solve the problem, if there even is a problem.

For example, let’s say you get into a discussion about roads.  As a libertarian, you suggest that roads would operate better without the government.  Maybe you go so far as to say that the government, at all levels, should get out of the road building and operation business entirely.  Now someone will challenge you, asking how you would build roads and asking how much the tolls will be.

It is important not to fall into the trap.  You don’t have to have all of the answers.  You don’t have to have any of the answers, other than letting the free market work its magic.  It would help convince the challenger though if you could provide some examples of possibilities.

Maybe different housing subdivisions would handle their own roads.  Maybe businesses would get together and build roads so that customers can access their stores.  Maybe some charities would build roads to better their community.  Maybe some entrepreneurs would build roads and sell an annual pass to travel on them, or else pay a one-time toll.  With modern technology, you could probably pay a toll without stopping your car.

Just because roads would be built and operated outside of the realm of government, it doesn’t mean that everyone will necessarily pay for them directly.  You don’t have to pay to park at most shopping malls. The malls actually provide these parking spots for free, in hopes that you will be more likely to go to the mall and buy things.

It is important to point out to your challenger that you are not a road entrepreneur.  You don’t really know the best way to build roads or operate them.  But even if you are an expert in building roads, you still don’t have all of the answers.  Only feedback via the marketplace can answer what is right.  Only the consumers know what is right.  You may build an excellent road that is much better and safer than the average government road.  But someone else may come along and use your ideas and improve on them and make an even better road.

Again, you don’t have to have all of the answers.  It is helpful if you can provide suggestions and possibilities.  But it is always important to point out that not having all of the answers is central to your libertarian philosophy.  You understand your own limited capabilities.  You understand that it is not possible for one person or one small group of people to centrally plan in an effective way.  We must rely on prices and profits and losses, as dictated by consumers, to send information as to what works and what doesn’t.

Of course, this doesn’t just apply to roads.  It applies to most issues.  That is the great thing about libertarianism.  You don’t have to know how everything works and you don’t have to know the answers.  Why do you have to know the answers when you don’t want to centrally plan other people’s lives?  Why do you have to know the answers when there are billions of other people in the world, some of whom do know the answers?

I have always found it curious that some people will advocate government spending in a particular area, yet they would never spend any of their own personal money to fund it.  While it doesn’t seem to make any sense, I can see some rationale behind it.

For instance, it would be an interesting survey to ask 100 people if they think that NASA should be abolished.  My guess is that a good majority would say no.  Then ask them if they are interested in contributing money to a charity that is involved in space study and sending people and satellites into orbit.  My guess is that a majority would not contribute anything out of their own pocket.  Perhaps some might donate a few bucks.  There might even be a few who donate hundreds of dollars, thinking it is a worthy cause with a lot of potential.  But it is rather obvious that the responses to the two questions would not match in a lot of cases.

So why would some people want to fund NASA through the government, yet they would never spend a personal dime on such a thing?  There are different possible explanations.

Some people don’t want to pay for something when others are not.  Someone might want to contribute his own money to NASA, but he also wants everyone else to contribute too.  The only way to get everyone to contribute a little is by using the force of government.  People like this don’t want any “freeloaders”, even though they are the ones who are advocating force.

Ironically, we live with freeloaders our whole lives.  You are probably a freeloader yourself.  You don’t have to shop at Ebay or at Walmart, yet you probably benefit from these entities in that they provide competition and get other stores to lower their prices.

You could also be a freeloader if you walk into a mall or a store and browse and don’t buy anything.  You might even enjoy some of the Christmas decorations or something else visually pleasing, yet you haven’t paid anything.

Ironically, it is usually the rich who pay more, while the freeloaders tend to be the lower and middle classes.  When a new technological gadget comes on the market, rich people will pay thousands of dollars to be the first ones to have it.  They are the guinea pigs.  The prices eventually come down.  Now we can buy a big screen television for under a thousand dollars.

Another reason someone may advocate a government program, yet never pay for it voluntarily, is that he sees his tax money as a set number.  If you asked people for a choice between getting rid of NASA or paying twenty five dollars out of their wallet on the spot, then a lot more people would want to get rid of NASA.  Most people, and probably correctly so, realize that NASA could be defunded, yet they probably wouldn’t see any of the extra money.  From this standpoint, taking differing positions might actually make a little sense.

I think a third reason for this seeming contradiction is that many people simply do not think about it enough.  Some people assume that if government didn’t fund NASA, that all space exploration would come to an end.  Libertarians should be able to relate to this, because we witness a lot of lazy thinking.  As a libertarian, it is common to be accused of being in favor of drugs, just because I favor drug legalization.  It is common to be accused of being against education, just because I don’t favor government run schools.  It is common to be accused of being unsympathetic towards the poor, just because I don’t think anyone should be forced to “give”.

I think this contradiction of some people advocating government spending on a program that they would never voluntarily fund is a good example to point out to others.  It is a good technique to have a conversation about libertarianism, without making it into an argument.  You don’t even have to take a position upfront.  You can just say that you find it interesting that many people favor war, yet they would be unlikely to voluntarily donate money to the government to fund going to war.  You can use this for any government program that is up for discussion.  And even if someone were willing to voluntarily fund a particular program, does it mean that everyone should be forced to fund it?

In Obama’s state of the union speech, one of the things he touched on was the deficit.  He said the following:

“Over the last few years, both parties have worked together to reduce the deficit by more than $2.5 trillion, mostly through spending cuts, but also by raising tax rates on the wealthiest 1 percent of Americans.  As a result, we are more than halfway towards the goal of $4 trillion in deficit reduction that economists say we need to stabilize our finances.”

Is this man nuts or does he just think everyone else is that stupid?  How can he possibly say that the deficit has been reduced by more than $2.5 trillion over the last few years?  The annual deficit is still over $1 trillion per year.  This is impossible that it has been cut that much.

The only thing he could possibly be referring to, especially since he also talked about raising tax rates on the wealthiest 1 percent (it should be top income earners, not wealthiest), is that the future projected deficit has been reduced.  Talk about playing word games.  How can you say that you have reduced a deficit that is set to occur sometime in the future?

Obama has no idea what the actual growth rate will be.  He has no idea what the actual spending will be.  He has no idea how much money will be collected by the government.  But the most amazing thing about this is that immediately after saying these words, he goes on to say that the parties need to work together to avoid these “sudden, harsh, arbitrary cuts” that will go into effect.

So Obama takes credit for cutting the deficit in the future, but then immediately says that we need to stop the future cuts that would actually translate into this deficit reduction.  You got that?  He didn’t even wait until five minutes later in his speech to contradict himself.  He does it immediately.

While politicians, including Obama, are often ignorant, I don’t believe this is ignorance.  This is a planned speech.  It is meant to deceive.

I remember when George W. Bush, early in his presidency, talked about cutting the deficit in half and giving a time period that wouldn’t occur until he was out of office.  Of course, by the time Bush left office, the deficit had ballooned to unimaginable levels with his bailouts of car companies, banks, and other financial institutions.

These slick politicians, particularly in DC, like to talk about the deficit.  Do not confuse the deficit and the debt.  When they refer to the deficit, it is the annual amount that the government spends in excess of the money it takes in, primarily from taxes.  Obama can talk about some goal of reducing the deficit by $4 trillion over the next several years, but the fact remains that there will still be massive deficits.  The national debt will keep getting bigger and bigger.  Politicians will call for reducing the deficit, but never for reducing the debt.

Obama is the epitome of big government.  And he has to sugarcoat his message with lies and distortions.  His contradictory statements on the deficit should prove that he has absolutely no interest in reducing spending.  The politicians will keep running up the debt and making us poorer until the American people revolt or the Fed stops buying government debt.

I rarely comment on Paul Krugman.  Austrian school economists often like to analyze Krugman and go after him.  I think they give him too much credit for popularity.  It is because he is a Nobel prize winner and a New York Times columnist.  But this doesn’t mean much anymore.  Does Krugman really influence that many people?  Alex Jones, Matt Drudge, Lew Rockwell, Sean Hannity, and the latest American Idol winner each influence more people to a greater degree than does Paul Krugman.

With that said, I can’t resist today.  I rarely read anything he says unless someone with a contrary point of view quotes him.  So I saw Bob Murphy’s post on him today.  I read Krugman’s post.  Krugman is either completely ignorant or he is a liar, or perhaps both.  He is loved by the establishment for his advocacy of big government.

In his latest post, he puts up a chart showing various countries with their change in employment percentages vs. their change in structural balance (what he calls austerity).  You can clearly see that Ireland and Greece have the worst change in employment.  Krugman is indicating that austerity leads to a depressed economy and higher unemployment.

First, I would like to point out that it is a bit of joke to say that Ireland and Greece are implementing austerity.  While the governments in those countries have been forced to cut back in certain areas, or at least forced to stop expanding the welfare state to such a great degree, they are both still massive welfare states.  It is not like they have gone to some kind of a limited government approach.  The taxes and spending in both countries are incredibly high, even by today’s standards.

But even if Krugman were right and both of those countries had implemented massive austerity (spending cuts), does that really prove anything?  This should really be one of the most elementary things for an economist.  Correlation does not mean causation.  A wet sidewalk does not cause rain.

Take a family that makes $50,000 a year and has credit card debt that is $250,000.  At a certain point, just the minimum monthly payments become so great that that alone will exhaust most of the income.  If the family doesn’t file for bankruptcy, then it must make drastic cuts to its budget.  That doesn’t make the $250,000 in debt disappear.  The interest payments alone will make this family poor for many years to come, assuming no bankruptcy and no major increases in income.  The family will be in a recession for years to come.

While this isn’t exactly a perfect analogy, it is enough to get the point across.  Of course Ireland and Greece are in depressed states.  Even if they had implemented major spending cuts in government, it will take time to recover.  The welfare states there are a giant misallocation of resources.  These resources must be reallocated by the market.  Then there must be savings and investment, which will eventually lead to increases in production.  When the government has messed things up that much, the economy cannot recover instantaneously.  It has to go through a correction.

Unfortunately, that is not even what is happening in Ireland and Greece.  They have just gotten to a point where big government has completely devastated their economies.  It means a dramatically lower standard of living for the people living there.  The governments, through their policies, discouraged saving and encouraged consumption.  It caused a total lack of savings and investment that has severely decreased production.  It has made virtually everyone living there poorer.

There should be a chart showing what happens to countries that follow Krugman’s advice.  Greece and Ireland can be at the top of the list.  They would still follow Krugman’s advice if it were possible, but it is impossible to spend something that is not there.  Socialist policies eventually don’t work any more because there is no more wealth to be distributed.