The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (6 page)

We like old things. Old buildings. Old ideas. Old trees. Old rules. Old investors. The older the investor, the more confidence we have in him. He has seen good times and bad times. He has seen bulls and bears.

People who have been around for a long time have had an opportunity to see several cycles. An American born after 1960, on the other hand, barely came of age when the 1982 to 2002 boom began. Until recently he never saw a sustained bear market or a period when the nation was downcast or desperate.Templeton was a young man when Wall Street crashed in 1929. He was an adult in the Great Depression. He recalled the dark days of World War II, when it looked as though the allies might lose. During his life span, there were booms and busts, mass murders, the worst wars in history, famines, hyperinflation, and national bankruptcies. Dozens of currencies and at least five empires had gone defunct. Dozens of coups and revolutions had taken place. Ideologies had come and gone. Thousands of banks and businesses had gone bust. Prominent careers had been ruined and reputations lost.

A man who has seen so much and still has his wits about him is a great treasure. If he is still solvent, that is even better. Somehow, he must have avoided the bad ideas, bad investments, and bad advice.

Innovations are like genetic mutations. Most of them are mistakes. Most fail. Old people tend to reject new ideas, new styles, and new things. This is not simply because these dogs are too old to learn new tricks. What the oldsters know—from experience—is that the new tricks are probably not worth learning.What we have around us are only the innovations that succeeded. Companies, products, ideas, governments, clubs, styles—all that we see are the successful ones. The unsuccessful innovations—thousands and thousands of them—all disappeared.

Even wildly successful innovations, such as heavier-than-air flight, are not successful for everyone.Warren Buffett estimates that if you had owned the entire airline industry from the moment after Orville and Wilbur made the first flight, right up to the day the Concorde made its last flight, you scarcely would have made a dime. Many other industries are the same.There are companies quoted on Wall Street that make money in those industries. But they are the survivors. Many others failed long ago.

Nassim Nicholas Taleb explains it in his book,
Fooled by Randomness:

Mathematically, progress means that some new information is better than past information, not that the average of new information will supplant past information, which means that it is optimal for someone, when in doubt, to systematically reject the new idea, information, or method . . . .

The Saturday newspaper lists dozens of new patents of such items that can revolutionize our lives. People tend to infer that because some inventions have revolutionized our lives that inventions are good to endorse and we should favour the new over the old. I take the opposite view. The opportunity cost of missing a “new new thing” like the airplane and the automobile is minuscule compared to the toxicity of all the garbage one has to go through to get to these jewels (assuming these have brought some improvement to our lives, which I frequently doubt).
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A young man has access to information. With the Internet, he can get all he wants. What he lacks is the “high-proof ” distilled information—the wisdom—that comes with age.

Mr.Taleb continues, “A preference for distilled thinking implies favoring old investors and traders, that is, investors who have been exposed to markets the longest, a matter that is counter to the Wall Street practice of preferring those that have been the most profitable and preferring the younger whenever possible . . . .”
¹²

Testing the proposition using a mathematical model, Taleb “found a significant advantage in selecting aged traders, using, as a selection criterion, their cumulative years of experience rather than their absolute success (conditional on their having survived without blowing up).”
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Distilled information tends to be expressed as moral interdictions. Don’t steal. Don’t lie. Don’t buy expensive stocks or sell cheap ones. Don’t expect to get something for nothing. Don’t neglect your spouse. Don’t forget St. Patrick’s day. Don’t spend too much. Don’t eat too fast. Don’t drink before 6 PM. Don’t mess around with the boss’s wife. Each
don’t
represents lessons learned by previous generations. For every
don’t
, there must be a million sorry souls burning in Hell.

Undistilled information, on the other hand, is nothing more than noise—newspaper headlines, TV babble, cocktail chatter, the latest innovation, the latest business secret, the latest fashion. It is public information, backed by no real experience or private insights. It is not useless. It is worse than useless, for it misleads people into thinking they know something.

David M.Walker, former Comptroller General of the United States, clarified America’s debt situation in late 2004: “The Federal government’s gross debt—the accumulation of its annual deficits—was about $7 trillion last September, which works out to about $24,000 for every man, woman, and child in the country,” he announced. “But that number excludes items like the gap between the government’s Social Security and Medicare commitments and the money put aside to pay for them. If these items are factored in, the burden for every American rises to well over $100,000.”

We add to Walker’s lament: As we will see, $7 trillion was chicken feed. The real debt was far higher. Plus, one out of every four dollars spent by the federal government was borrowed. And for every dollar that came in the door from income taxes, the feds borrowed another 80 cents. Economists used to worry about government using up the nation’s savings. But Americans had no more savings to use. Still, the nation that couldn’t save a dime set out to save the entire planet. In the next four years, the official U.S. debt would grow nearly 50 percent. And then, in an effort to bail out the entire world economy, U.S. deficits would soar over $1.8 trillion per year.

Meanwhile, the private sector already had immense debts. In 2005, for every $19 Americans earned, they spent $20. This difference was recorded in the trade deficit figures, measuring the speed at which Americans raced down the road to ruin.Top speed as of this writing was $58.3 billion.That was the figure for January 2005 when the nation was clocked overspending at a rate of almost $2 billion per day. It was the difference between what Americans sold to foreigners in the month of January and what they bought from them. It was a negative number. On a chart of the nation’s accounts, it would be in red. Or in brackets. Or preceded by a minus sign.

If it were divided among the nation’s families, it would come to about $600 for each one.This represents only a single month’s trade deficit, so we should multiply it by 12 to get the measure of damage on an annual basis: $7,200 per family per year. Compared with the average family’s income, it is such a big number that we wondered if we had done the arithmetic correctly. On a macroeconomic scale, the shortfall was rising to 6 percent of GDP.

In the old days of the gold standard, the nation on the plus side of this exchange would pile up its excess foreign currency and take it to the other nation’s central bank. Gold was the common reference and an uncommon restraint. It was real money. If a nation ran out of gold, it ran out of money. It could no longer borrow. It could no longer run trade deficits, because when the foreign currencies were presented to it, it would have no means of settling up. It would have to declare bankruptcy, which happened from time to time.

But it had been 34 years since the United States settled its overseas obligations in gold. Since then, it has found it far easier to offer U.S. dollar-denominated Treasury bonds. Remarkably, the foreigners accepted them as if they were as good as gold. More remarkably, for most of that time the bonds were not only as good as gold—they were better. Gold fell in price for two decades following Ronald Reagan’s first presidential election. Overseas central bankers took the Treasury bonds and felt grateful, even lucky, to have them.

The United States was just too lucky. It could spend without really paying. It could borrow without ever really paying back. It could dig itself into such a deep hole of debt, it could find no easy way out.

Among the noisy headlines of 2005 was the remarkable information that China—a Third World nation—lent the United States $300 billion per year. Without Chinese support, the dollar would have already collapsed, bond yields would have soared, and the U.S. economy would be in a recession, if not a depression.

Where did the money come from? The Chinese got the dead presidents from selling products to live Americans, who seemed ready to consume anything that came their way. First, the dollars came rolling off U.S. printing presses, then they made their way into the hands of Chinese and other manufacturers, and finally, they returned to their birthplace as loans.

China was fast becoming America’s “company store,” to whom we owed our standard of living and maybe even our soul. By the end of 2004, two central banks—Japan and China—held almost a trillion dollars’ worth of U.S.Treasury bonds. On their willingness to save and to recycle savings into U.S.Treasury bonds stood the U.S consumer economy. A single word from either central bank could send the U.S. economy into a severe slump: “sell.”

And thus came an even more remarkable curiosity:

“In an era of free trade,” began a complaint from Treasury Secretary John Snow, “we should not have to confront the issue of countries distorting their currencies to gain unfair trade advantages.”

The specific country to which Snow referred was China.The trade advantage the latter enjoyed was that it sold much more to the United States than the United States sold to it, by a ratio of 5 to 1.And the unfair distortion was that China pegged its own currency to the dollar. In the spring of 2005, the exchange was called “manipulation”; the United States demanded that China revalue by 10 percent.

How were the Chinese manipulating the yuan? By fixing it to the imperial currency! Oh, that was clever, wily, diabolical. The Chinese insisted on maintaining their 10-year-old policy of pegging the yuan to the dollar.The United States counted on a steady devaluation of its money. It bought from overseas and paid in dollars. Then, in effect, it printed up more dollars to replace those it had shipped overseas. The resulting inflation of the currency—reflected in the increase in prices of oil, gold, and other internationally traded goods—was a form of imperial tribute. It was America’s only way of making the empire pay. As the dollar went down, the trillions of dollars held in foreign accounts became less valuable. An “exorbitant privilege,” said Charles de Gaulle.

But the Chinese refused to play along. As the dollar went down, so did their yuan. Instead of raising prices on Chinese goods and lowering the value of Chinese dollar holdings relative to its own currency, everything remained even.The Chinese weren’t paying their tribute.

Americans were indignant. A Senate committee said it would rewrite the law of the land to make what the Chinese were doing qualify as currency manipulation. Bush administration officials gave the Chinese a deadline to shape up. In the summer of 2005, the Chinese finally announced that they were giving up the dollar peg, or at least widening “the channel” a little. But the problem was never caused by China.

An entire American generation had grown up being told that it could spend its way to prosperity. Snow, McTeer, Greenspan, Bernanke—they all still believed it. Debt was no problem, they said. Spend, spend, spend.

American spending created a boom in China, where the average person works in a sweatshop, lives in a hovel, and saves 25 percent of his earnings. Americans had come to believe there was something unfair about China’s trade practices, that they must be stealing jobs with a distorted currency, instead of competing for them fair and square.

Meanwhile, in the United States, the average man lived in a house he could’t pay for, drove a car he couldn’t afford, and waited for the next shipment from Hong Kong for distractions he couldn’t resist. He saved nothing and believed the Chinese would lend him money forever, on the same terms.

That this could go on forever hardly seemed worth pointing out. The world created in the pax dollarium era had to end. Then the dead could cluck: “I told you so.”

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Empires of Dirt

Long is the historical record of empires. Short is the list of common elements. There are “good” empires. And bad ones. There are ones in which the imperialists get rich and others in which they become very poor.There are some in which the imperium functions with the brute elegance of a guillotine; in others, the complexities and subtleties baffle historians. But among all the empires that have come and gone, the U.S. imperium stands out as the most absurd.

The absurdity arises at the most basic level. Seeking to deceive, the Ivy League Alexanders and the Plain State Caesars deceived themselves more than anyone. From the very beginning, they knew not what business they were in.

We can enjoy a superior chuckle at the screwball humbug of it. Historians of the future are likely to get cramps from laughing. But economists—when they finally come to their senses and realize what is happening—are the ones who will revel in the biggest joke. The only reason they are not palsied with mirth already is that they have missed the punch line. This is the funniest and most preposterous scheme of imperial finance the world has ever seen; when they finally get it, they will laugh till it hurts.

At the risk of spoiling a great joke, we will explain it. The typical program for imperial finance is simple. The imperial power, the
imperium,
provides—at its own initiative—a public good; it extends security and order. In return, the groups that benefit pay tribute. The imperium should not merely break even; it should make a profit. Living standards in the homeland should rise, compared with those in vassal states. Even the Austro-Hungarians got that right, as a trip to Vienna will easily confirm. The city got rich in the nineteenth century.