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The Only Way To Live In A Free Society

We are dealing with waste and extravagance, incompetency and inefficiency, the only way we have in a free society is to take losses from time to time. This is a loss economy as well as a profit economy.

-- Former Fed chairman William McChesney Martin, Jr. (1958)

As Nietzsche might have said, if he'd thought of it, little corrections leave us stronger and smarter.

Why do we need corrections? Because people make mistakes.

Are corrections beneficial? Yes, they get rid of the mistakes... the dead wood... the weak businesses... the poor investors... the misfits... the maladroit... and the unfortunate mutations. What survives is better adapted to current conditions.

What happens when we avoid or repress a correction? The mistakes continue. And get worse.

How does this eventually resolve itself? Disastrously.

Mistakes are not like head colds. They don't go away if you ignore them. Bad money doesn't turn into good money because you add more to it.

If you turn the wrong way when you are driving, the longer you go on the further you will be from where you want to go. Or if you drink too much on Monday night, you won't feel better if you drink too much on Tuesday and Wednesday too.

Repetition doesn't make mistakes disappear; it makes them worse. Nothing gets worse forever. So there must be a day of reckoning.

Then what must happen "sooner or later" does. And it usually isn't pretty. And the longer the correction has been dodged and denied, the uglier it gets.

But uncorrected mistakes don't simply get "worse and worse," gradually and obviously. Often the damage is not apparent... until disaster comes.

Under the Influence

Imagine that you have had too much to drink and you are driving too fast through a crowded city. That is a mistake. Your wife warns you to slow down. Annoyed, you step on the accelerator and go even faster.

Keep this up and the chances of a disastrous outcome multiply.

Every additional minute that you speed may have exactly the same risk component as the minute that preceded it. But the odds of an accident accumulate. Keep making the same mistake, and a terrible result is almost guaranteed.

In other words, the negative feedback goes from zero to 100% in the bat of an eye.

This phenomenon is like the consequences of another mistake: jumping out of a window 30 stories up. The first few moments are probably uneventful. As Percy Sledge put it, "But it's not the fall... that hurts him at all... it's the sudden stop."

The stop is when the mistake is corrected. The further you fall without correction, the faster you're going when you hit the street.

Negative consequences are asymptotic. They do not rise regularly. They rise suddenly. And hugely. Viewed on a graph, you would see a flat line leading to what looks like a brick wall on the right-hand side. That is the brick wall into which all uncorrected mistakes eventually run.

The average moment of your descent may be more or less agreeable. It's the final moment that ruins the adventure.

And as the scale of the mistake increases, the eventual collision with reality becomes much more dramatic. It is one thing for a single business or single household to make a mistake. When millions of them make the same mistake, it is a different sort of problem. Not just bigger... different.

You may look at it this way. People die all the time. In a nation of 300 million people, you can assume that more than 2 million a year must go to their graves. And over a period of about 100 years, almost all of them will. They can do so in an orderly fashion, with no disruption to the rest.

Suppose the death rate suddenly went up. Suppose 20 million died in a single year. Or 100 million. At 2 million deaths a year, the pain is local and private. Acceptable. Those who have no death in their immediate families are not especially affected.

At 100 million deaths, it's an entirely different thing. Trains stop running; restaurants shut down; the mail is no longer delivered. The whole society gets whacked.

Deficits Without Tears

And so we turn to another example: debt.

That there are no visible bad consequences to America's growing public debt is widely celebrated. In the words of France's great post-war economist Jacques Rueff, the U.S. enjoys "deficits without tears."

Thanks to the willingness of people all over the world to take in dollar credits and hold them dear, as though they were worth something. (They are in fact worth something. And they will continue to be worth something until they are suddenly not worth a single cent.)

Treasury bonds -- Washington's proliferating IOUs -- have been going up for 32 years. Long-dated T-bonds yielded 15% in 1981. Since then, total outstanding U.S. government debt has gone from $1 trillion to $16 trillion. But the price of bonds has gone up too... so much so that they only yield 3% today. (Prices move inversely to yields.)

So too is the stock market delighted. The S&P 500 has gained 120% since March 2009. The self-same leap of faith on the part of the central banks is largely responsible: QE1, QE2, QE3, LTRO1, LTRO2, Operation Twist... and now the Bank of Japan's promise to shift to the kind of limitless stimulus embraced by the Fed. (The more Bernanke, Draghi, Shirakawa and the others defenestrate investors, the more investors seem to like it.)

The accumulation of public debt is accelerating. Total U.S. government debt stands at 16 times what it was a generation ago. It took 64 years for the feds to build up a $1 trillion debt pile (a milestone it hit in 1981). The feds added another $1 trillion in the following four years.

A person jumping out of a skyscraper would notice the same thing. The first few floors go by relatively slowly. Lower floors go by in a blur.

The Real Debt Toll -- Far Greater Than You Think

In his eight years in office, President George W. Bush added $800 billion of public debt a year. And in his first term, President Obama saw a $1.2 trillion increase every year.

Federal debt has been growing more than twice as fast as tax receipts for the last 10 years... and four to five times as fast as the economy during President Obama's first term.

When you look at the debt in real terms -- that is on GAAP-basis accounting terms and including unfunded liabilities as well as cash in and out the door -- the velocity of the debt buildup increases rapidly.

Instead of a deficit of about $1 trillion for 2012, you find one of $7 trillion. And instead of a national debt of $16 trillion, as widely reported, you are staring in the face of total debt and unfunded financial obligations of $238 trillion. And instead of growing four to five times as fast as GDP, debt... properly accounted for... is growing 20 times as fast.

Although the ground is rushing up to meet them at a faster and faster pace, neither investors nor economists are alarmed. Consumer prices are barely rising. Stocks and bonds are flying high. The economy is growing. Bond buyers, aided by Fed... which is now buying more bonds than the U.S. government needs to sell... show no sign of panic.

But that is how a real disaster works. Uncorrected, it runs flat and fast until it finally meets its immoveable object. Now, fluttering past perhaps the eighth or ninth floor, no pain is registered by bond holders or stock market investors. On the contrary, they find the whole thing a delicious hoot.

But when it ends, the weight of so many bodies in free fall will crack the sidewalks.


Bill Bonner