Obama's Stimulus Doomed to Failure

There are just a few reasons rational people take on debt.   Other than making your life more comfortable, the main reason people take on debt is because they think they will make money with the debt.  If you were just going to add to your debt, without a chance of making money, you would be better off staying in bed every day, instead of going into more debt.   According to Professor Antal Fekete, the U.S. has already reached this stage, where any additional debt is not only not productive, it is actually destroying savings.  This will doom President Obama’s stimulus package, with its $2 trillion deficit that will be expended in 2009.

Incremental analysis, that is examining those dollars being borrowed in excess to those previously borrowed lead to his “The Marginal Productivity of Debt”, that is those incremental dollars borrowed in excess of those already borrowed.   This is important to watch because…

the significant ratio to watch is additional debt to 

additional GDP, or the amount of GDP contributed by the creation of $1 in new 

debt. It is this ratio that determines the quality of debt. Indeed, the higher the ratio, 

the more successful entrepreneurs are in increasing productivity, which is the only 

valid justification for going into debt in the first place. 

…Professor Ankete confirmed that these numbers can be calculated from publicly available GDP and debt figures — this information is hidden in plain sight and available for anyone to surmise, were it not for the constant distraction provided by the political chattering class and news media with another agenda.  Common sense, something sorely lacking in Washington these days, should make obvious the fact that adding more debt to a situation where the marginal productivity of debt is negative can actually make things worse…

Why is a negative marginal productivity of debt a sign of an imminent economic 

catastrophe? Because it indicates that any further increase in indebtedness would 

necessarily cause economic contraction. Capital is gone; further production is no 

longer supported by the prerequisite quantity and quality of tools and equipment. 

The economy is literally devouring itself through debt. The message, namely that 

unbridled breeding of debt through the serial cutting of the rate of interest to zero 

was destroying society’s capital, has been ignored. The budding financial crisis 

was explained away through ad hoc reasoning, such as blaming it on loose credit 

standards, subprime mortgages, and the like. Nothing was done to stop the real 

cause of the disaster, the fast-breeder of debt. On the contrary, debt-breeding was 

further accelerated through bailouts and stimulus packages. 

…scary stuff that probably won’t have a happy ending.  Read all of Professor Ankete’s article below, here at Before It’s News.

 

 

 

 

 

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THE MARGINAL PRODUCTIVITY OF DEBT  

 

Why Obama’s Stimulus Package Is Doomed to Failure 

 

Antal E. Fekete 

Professor of Money and Banking 

San Francisco School of Economics 

 

 

Paper mill on the Potomac 

 

The paper mill on the Potomac is furiously spewing up new money. According to 

the manager of the mill, as indeed according to the Quantity Theory of Money, 

this should 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 of a flood of new 

debt, is tantamount to pouring gasoline on the fire, making prices fall and the 

economy contract even more. The Obama administration has missed its historic 

opportunity to stop the deflation and depression inherited from the Bush 

administration because it entrusted the same people with the task of damage- 

control who had caused the disaster in the first place: the Keynesian and 

Friedmanite money doctors in the Fed and the Treasury.  

 

Watching the wrong ratio 

 

The key to understanding the problem is the marginal productivity of debt, a 

concept curiously missing from the vocabulary of mainstream economics. 

Keynesians take comfort in the fact that total debt as a percentage of total GDP is 

safely below 100 in the United States while it is 100 and perhaps even more in 

some other countries. However, the significant ratio to watch is additional debt to 

additional GDP, or the amount of GDP contributed by the creation of $1 in new 

debt. It is this ratio that determines the quality of debt. Indeed, the higher the ratio, 

the more successful entrepreneurs are in increasing productivity, which is the only 

valid justification for going into debt in the first place. 

    Conversely, a serious fall in that ratio is a danger sign that the quality of debt 

is deteriorating, and contracting additional debt has no economic justification. The 

volume of debt is rising faster than national 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 in imminent. Not only does more debt add nothing to the GDP, in fact, it 

causes economic contraction, including greater unemployment. The country is 

eating the seed corn with the result that accumulated capital may be gone before 

you know it. Immediate action is absolutely necessary to stop the hemorrhage, or 

the patient will bleed to death. 

Keynesians are watching the wrong ratio, that of debt-to-GDP. No wonder 

they constantly go astray as they miss one danger signal after another. They are 

sailing in the dark with the aid of the wrong navigational equipment. They are 

administering the wrong medicine. Their ambulance is unable to diagnose internal 

hemorrhage that must be stopped lest the patient be dead upon arrival. 

 

 

Melchior Palyi’s early warning 

 

In the 1950’s when the dollar was still redeemable in the sense that foreign 

governments and central banks could convert their short-term dollar balances into 

gold at the fixed statutory rate of $35 per ounce, the marginal productivity of debt 

was 3 or higher, meaning that the addition of $1 in new debt caused the GDP to 

increase by at least $3. By August, 1971, when Nixon defaulted on the 

international gold obligations of the United States (following in the footsteps of 

F.D. Roosevelt who had defaulted on its domestic gold obligations 35 years 

earlier) the marginal productivity of debt has fallen below the crucial level 1. 

When marginal productivity fell below $1 but was still positive, it meant that total 

debt (always ‘net’) was rising faster than 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 output of goods and services by $1. An increase in total debt by $1 

could no longer reproduce its cost in the form of an equivalent increase in the 

GDP. Debt lost whatever economic justification it may have once had.  

    The decline in the marginal productivity of debt has continued without 

interruption thereafter. Nobody took action, in fact, the Keynesian managers of 

the monetary system and the economy stone-walled this information, keeping the 

public in the dark. Nor did Keynesian and Friedmanite economists at the 

universities pay attention to the danger sign. Cheerleaders kept chanting: “Gimme 

more credit!† 

I learned about the importance of the marginal productivity of debt from the 

privately circulated Bulletin of Hungarian-born Chicago economist Melchior 

Palyi in 1969. (There were altogether 640 issues of the Bulletin; they are available 

in the University of Chicago Library). Palyi warned that the tendency of this most 

important indicator was down and something should be done about it before the 

debt-behemoth devoured the economy. Palyi died a few years later and did not 

live to see the devastation that he so astutely predicted.  

 Others have come to the same conclusion in other ways. Peter Warburton in 

his book Debt and Delusion: Central Bank Follies That Threaten Economic 

Disaster (see references below) envisages the same outcome, although without the 

benefit of the concept of the marginal productivity of debt. 

 

The watershed year of 2006 

 

As long debt was constrained by the centripetal force of gold in the system, 

tenuous though this constraint may have been, deterioration in the quality of debt 

was relatively slow. Quality caved in, and quantity took a flight to the 

stratosphere, when the centripetal force was cut and gold, the only ultimate 

extinguisher of debt there is, was exiled from the monetary system. Still, it took 

35 years before the capital of society was eroded and consumed through a steadily 

deteriorating marginal productivity of debt. 

    The year 2006 was the watershed. Late in that year the marginal productivity 

of debt dropped to zero and went negative for the first time ever, switching on the 

red alert sign to warn of an imminent economic catastrophe. Indeed, in February, 

2007, the risk of debt default as measured by the skyrocketing cost of CDS (credit 

default swaps) 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 imminent economic 

catastrophe? Because it indicates that any further increase in indebtedness would 

necessarily cause economic contraction. Capital is gone; further production is no 

longer supported by the prerequisite quantity and quality of tools and equipment. 

The economy is literally devouring itself through debt. The message, namely that 

unbridled breeding of debt through the serial cutting of the rate of interest to zero 

was destroying society’s capital, has been ignored. The budding financial crisis 

was explained away through ad hoc reasoning, such as blaming it on loose credit 

standards, subprime mortgages, and the like. Nothing was done to stop the real 

cause of the disaster, the fast-breeder of debt. On the contrary, debt-breeding was 

further accelerated through bailouts and stimulus packages.  

  In view of the fact that the marginal productivity of debt is now negative we 

can see that the damage-control measures of the Obama administration, which are 

financed through creating unprecedented amounts of new debt, are counter- 

productive. Nay, they are the direct cause of further economic contraction of an 

already prostrate economy, including unemployment.  

 The head of the European Union and Czech prime minister Mirek Topolanek 

has publicly characterized president Obama’s plan to spend nearly $2 trillion to 

push the U.S. economy out of recession as “road to hellâ€. There is absolutely no 

reason to castigate Mr. Topolanek for this characterization. True, it would have 

been more polite and diplomatic if he had couched his comments in words to the 

effect that “the Obama plan was made in blissful ignorance of the marginal 

productivity of debt which was now negative and falling. In consequence more 

spending on stimulus packages would only stimulate deflation and economic 

contraction.â€Â 

 

 

Hyper-inflation or hyper-deflation? 

 

 

Most critics the Obama plan suggest that the punishment for the bailouts and 

stimulus-packages will be a serious loss of purchasing power of the dollar and, 

ultimately, hyperinflation, as evidenced by the Quantity Theory of Money. 

However, the quantity theory is a linear model that may be valid as a first 

approximation, but fails in most cases as the real world is highly non-linear. My 

own theory, relying on the concept of marginal productivity of debt, predicts that 

it is not hyperinflation but a vicious deflation which is in store. Here is the 

argument. 

      While prices of primary products such as crude oil and foodstuffs may 

initially rise, there is no purchasing power in the hands of the consumers, nor can 

they borrow as they used to in order to pay the higher prices much as though they 

would have liked to do. The newly created money has gone into bailing out banks, 

and much of it was diverted to continue paying bloated bonuses to bankers. Very 

little, if any of it has “trickled down†to the ordinary consumers who are squeezed 

relentlessly on their debts contracted in the past. 

   It follows that price rises are unsustainable, as the consumer is unable to pay 

them. As a consequence the retail and wholesale merchants are also squeezed. 

They have to retrench. Pressure from vanishing demand is passed on further to the 

producers who have to retrench as well. All of them are experiencing an ebb in 

their operating cash flow. They lay off more people, aggravating the crisis further 

as cash in the hand of the consumers is diminished even more through increased 

unemployment. The vicious spiral is on. 

    But what is happening to the unprecedented tide of new money flooding the 

economy? Well, it is used to pay off debt by the people who are desperately 

scrambling to get out of debt. Businessmen in general are lethargic; every cut in 

the rate of interest hits them by eroding the value of their previous investments. In 

my other writings I have explained how falling interest rates make the liquidation 

value of debt rise, which becomes a negative item in the profit/loss statement 

eating into capital that has to be replenished as a consequence. Worse still, there is 

no way businessmen can be induced to make new investments as long 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 rate of interest fell further in the wake of 

“quantitative easingâ€. 

 

Self-fulfilling speculation on falling interest rates 

The only enterprise prospering in this deflationary environment is bond 

speculation. Speculators use new money, made available by the Fed, to expand 

their activities further in bidding up bond prices. They pre-empt the Fed: buy the 

bonds first before the Fed has a chance; then turn around and dump them in the 

lap of the Fed. This activity is risk-free. Speculators are told in advance that the 

Fed is going to move 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 the next 

six months, and probably much more after that. Speculation on falling interest 

rates becomes self-fulfilling, thanks to the insane idea of open market operations 

of the Fed making bond speculation risk-free. Deflation is made self-sustaining. 

(For another view of risk-free bond speculation, see the article by Carl Gutierrez’ 

in Forbes mentioned in the References below.) 

   Note also the crescendo of the dumping of equities and the desperate attempt 

to redeem toxic assets by private parties, sending the demand for cash sky high. 

The dollar, at least the Federal Reserve note variety 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 of that? Well, just consider this. The market 

will separate vintage Federal Reserve notes from the new issues with Bernanke’s 

signature on them. In a classic application of Gresham’s Law people will hoard 

the first, bestowing a premium on it relative to the second variety, which will fall 

by the wayside. 

 

 

Bernanke can create money but cannot make it flow uphill 

 

 

Already some tip sheets openly advise people to hoard Federal Reserve notes in 

amounts up to twenty-four months of estimated household expenditure, while 

cleaning out all deposit accounts. Depositors are urged to forget about the 

$250,000 limit on deposit insurance, which is rendered literally worthless as the 

resources of the F.D.I.C. have been hijacked by Geithner and diverted to 

guaranteeing the investments of private parties that were foolish enough to buy 

into toxic debt at the behest 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 make the economy shrink 

more, increasing unemployment and squeezing prices. Bernanke can create all the 

money he wants and more, but he cannot make it flow uphill. 

 

Bernanke is risking something worse than a depression 

 

The newly created money will follow the laws of gravity and flow downhill to the 

bond market where the fun is. Risk-free bond speculation will further reinforce 

the deflationary spiral until final exhaustion occurs: the economy will collapse as 

a pricked balloon. Instead of hyperinflation and the destruction of the dollar, 

you’ve got deflation and the destruction of the economy. 

      Denninger says that the “death spiral†will lead to fire sales of assets in a mad 

liquidation dash and, ultimately, to the collapse of both the monetary and political 

system in the United States as tax revenues evaporate. He opines that probably not 

one member of Congress understands the seriousness of the situation. Bernanke is 

risking something much worse than a Depression. He is literally risking the end of 

America as a political, economic, and military power.  

      Indeed, the financial and economic collapse of the last two years must be seen 

as part of the progressive disintegration of Western civilization that started with 

government sabotage of the gold standard early in the twentieth century. Ben 

Bernanke, who should have been fired by the new president on the day after 

Inauguration for his part in causing irreparable damage to the American republic 

may, in the end, have the honor to administer the coup de grâce to our 

civilization. 

 

March 28, 2009 

 

 

References 

 

No Time for T-Bonds by Carl Gutierrez, March 28, 2009, www.forbes.com  

 

Bernanke Inserts Gun in Mouth, by Carl Denninger, March 20, 2009,  

   market-ticker.denninger.net  

 

Debt and Delusion: Central Bank Follies That Threaten Economic Disaster,  

   by Peter Warburton, first published in 1999; WorldMetaView Press (2005)