Doug: I just don’t know where they find these people… On the other hand, Slime magazine has always said that those named Person of the Year are not necessarily the most laudable people, but those who’ve had the greatest impact on the events in a given year. That would explain Hitler’s achievement of the same honor, and Stalin getting the nod twice.

L: Not to mention Bin Laden.

Doug: Yes, let’s not mention him. This is different: Bernanke isn’t being held up as a villain, but as a hero.

L: The tagline Time puts on it is: ”The story of the year was a weak economy that could have been much, much weaker. How the mild-mannered man who runs the Federal Reserve prevented an economic catastrophe.”

Doug: Right. And Bernanke is always presented as a Ph.D., a scholar of the Great Depression, its causes, and how to cure such an economic downturn. But he hasn’t prevented an economic catastrophe — he’s done just the opposite of what needs to be done, and there’s going to be hell to pay.

It’s quite perverse. Look at Alan Greenspan. In the 1960s, he was an acolyte of Ayn Rand and wrote a famous essay defending the gold standard, which I read in her book, Capitalism: The Unknown Ideal. And then he goes on to become the most inflationary Fed chairman in history until Bernanke superseded him.

The really shameful thing about Greenspan is, not only were his policies the igniters of the giant bubbles we saw in the stock market and then in real estate, but since he was associated with pure capitalism through Rand, his failures through government intervention in the market have falsely discredited capitalism as a system in many people’s view.

L: The same could be said of Ronald Reagan. He got elected on a libertarian platform, speaking of free enterprise and getting the government off the back of the little guy. So now many people think that the chronic deficits and other problems of the Reagan years proved that limited government doesn’t work. It’s the same swindle you see in intro economics courses that teach young people that the Great Depression proved that laissez-faire capitalism doesn’t work when it was, again, government intervention in the market that created the Great Depression.

Doug: That’s right. Reagan allowed Congress to run gigantic, greater-than-ever-seen-before deficits that still have to be paid for, either through higher taxes or debasing the currency, or both or selling off the assets of the United States to foreign creditors. The Reagan deficits are nothing, of course, compared to the current ones.

L: I wonder how much we could get for the Statue of Liberty? She’s got to be feeling uncomfortable in a country that no longer wants anyone’s tired, poor, huddled masses, yearning to breathe free.

Doug: That’s a good question. The copper alone is worth a lot of money at this point.

L: A quick web search shows two frequently cited figures for Miss Liberty’s copper skin: one of about 60,000 pounds, the other 179,000 pounds. At three bucks a pound of copper, that’s either $180,000 or something over half a million bucks — a drop in the ocean of America’s national debt.

Doug: I would have thought it was more, but of course the dollar isn’t worth a damn anymore. The real value would be as a work of art, of course. Although it must be said that considerations like that didn’t stop peasants in the Middle Ages from melting down Roman bronzes and disassembling classical buildings because they needed the raw materials. I wonder what it would fetch at a Sotheby’s auction? I’d guess the Chinese might be willing to pay half a billion or even a billion dollars to take the lady home. It’d be a good deal, since the ideals behind the statue are as dead as the Constitution itself.

L: Yes… we’re not using the Constitution either, maybe we should sell that to them as well. But even a billion dollars would still be a drop in America’s ocean of debt.

Doug: A billion is only a thousandth of a trillion, and they’re now thinking in trillions. Obama may soon have to ask his science czar what comes after a trillion.

Getting back to Bernanke, the situation just shows one more time how corrupt the U.S. educational system is. That someone can get a Ph.D. and become known as a scholar of the depression era, and draw exactly the wrong conclusions about absolutely everything concerning it — what caused it, how to cure it — and then be held up as a model of relevant and useful academics… It just goes to show how utterly beyond hope the situation is.

L: Well, given what you’ve said about the education system teaching mostly worthless BS, especially when it comes to business and economics, why should we expect anything other than BS from someone who’s got it Piled High & Deep?

Doug: [Chuckles] Yes, that is what Ph.D. stands for, after all. In areas other than hard science, it has value mostly as a trade credential with the chattering classes. Its value in the real world is usually negative.

L: Is it possible that he actually does know what really caused the Great Depression and our current economic difficulties, but is caught by politics and can’t do or say anything other than what he is doing? Back in Greenspan’s day, there were people who thought Greenspan still believed everything he wrote in his essay on the gold standard and was trying to balance what was politically feasible with what he knew to be right that he was doing things he knew were harmful because if he didn’t do them, someone worse would do much more harm.

Doug: I asked Barbara Branden that one time, and that was her opinion.  She thought he still believed in the free market and gold money. But a person who believes one thing and does another is usually called a hypocrite.

L: I think it was Ron Paul who once told me that he’d asked Greenspan about his essay defending the gold standard, and that Greenspan had told him that he still believed everything he wrote in the essay.

Doug: I think I’ve heard that story too. It’s an interesting conundrum. I’ve thought about what I’d do if I were president of the United States, or chairman of the Fed, if my choices were limited to what’s politically possible. The right thing now, which is to bring on a deflationary collapse that would liquidate much of the malinvestment of recent decades, is not politically possible. With more than 50% of the people in the United States being net recipients of government largesse, no one can get elected, nor stay elected, who applies the breaks to the gravy train. The system is totally corrupt at this point.

I think I read the other day that something like 15% of the population is now on some level of food stamp subsidy, and another 15% are eligible but don’t know it, or are not yet willing to accept the stigma.  In the face of these kinds of facts, if anyone in power did what was necessary to liquidate past mistakes and get the economy back on a sound and sustainable path upwards, it would probably bring on a social revolution.

We’re going to have a social revolution anyway, and it’s probably better to have it sooner rather than later. This whole house of cards should have been collapsed back in the ‘60s, as opposed to having been built 40 stories higher since then. That just means it’ll be an even bigger mess when it does collapse. But it would take immense courage to set that collapse off deliberately. Whoever did it might well end up dead. And the same people who are cheerleading the current leadership’s disastrous moves would blame that courageous person for bringing on the United States’ second and Greater Depression. So, from at least a personal point of view, there’s nothing to be gained by doing the right thing. Although history would vindicate you, you’d be ostracized now.

L: That just raises an already impossibly high bar. The U.S. won’t be able to pay, when the bill comes due.

Doug: Yes. One of the most distressing things about this whole debacle is the total lack of intellectual honesty among any of the participants and decision-makers responsible for what’s going on with Bernanke being perhaps the worst of all.

On July 1, 2005, Bernanke stated with great confidence that the U.S. was not experiencing a housing bubble, saying: ”I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit.”

L: Wow could he possibly have been more wrong about anything more important?

Doug: In November of the same year, he talked about derivatives, saying, ”With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly.” He also said, ”The Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk in their institutions.”

And a couple months after that, back on housing again, he said, ”Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”

L: So much for the wisdom of the expert…

Doug: Well, he’s not stupid, not in the sense of being unintelligent (he’s obviously very intelligent) but I would say he’s stupid in a better, more sophisticated sense of the word. One that I think is more useful, that being: an unwitting tendency towards self-destruction. And I’m afraid his stupidity is not just going to drag down the U.S. financial system, but the U.S. itself with it.

What he said about the housing and derivatives bubbles shows that he either has no idea what’s going on, or he’s a pathological liar. Reality was totally absent from those two statements.

And in February of 2008, he said, ”I expect there will be some failures of smaller banks.” Bear Stearns collapsed just a couple weeks later…

L: You’re kidding!

Doug: I wish I were. I’d like to believe the second most powerful man in the world weren’t either a knave, or a fool, or both. Remember, this is the same guy who told the world that Fannie and Freddie were ”adequately capitalized” and ”in no danger of failing.”

Earlier this year he said, ”Currently, we don’t think [the unemployment rate] will get to 10 percent.” Wrong again and if you actually count people who are out of work, rather than the government’s phony subset of that number, we already have over 17% unemployment.

This guy is truly pathetic but nobody points any of this stuff out. That he can be so dead wrong about so many vital things and not get called on it is simply amazing to me it makes me feel like I’m living in some sort of demented parallel universe.

L: This has to be the worst case of ”the emperor’s new clothes” on record.

Doug: Quite possibly. After all, who can gainsay the word of the second most powerful man on the planet? And a Ph.D. expert on the Great Depression to boot. Which makes perverse sense, as only an expert can screw things up as royally as he has.

I’m afraid the U.S. dollar is going to be totally destroyed. The consequences of that are going to make everything that’s going on now pale by comparison. I mean, as bad as the consequences of propping up all these dinosaurs like General Motors and AIG and General Electric and Goldman Sachs, among many others, might be next through direct theft from the U.S. taxpayer are, that’s nothing compared to what will happen when things get really bad, which they haven’t yet.

It’s really going to be bad when they destroy the dollar that’s when it’s really going to hit the fan. Runaway inflation is bad enough in a place like Zimbabwe, where most of the people are still living on a subsistence level. And it was bad enough in Germany in the 1920s, when most Germans were still living on farms or making things with their own hands. But in an advanced industrial society, as heavily urbanized as the U.S. is, runaway inflation is going to be unbelievably disastrous. As dim as the average American is, he’s bound to get perturbed when his quality of life nose-dives, and who knows what the social consequences of that will be.

L: Social revolution… Massive social change.

Doug: Yes. Runaway inflation in the U.S. would be the ultimate disaster. Think about all those people who have dollars set aside, which is to say the prudent middle class; they’ll be totally wiped out. Even huge corporations that have massive cash reserves, like Microsoft and McDonald’s, if they don’t hedge that cash with the utmost skill, could find those hoards wiped out and themselves bankrupted as well. Remember that people all over the world are holding U.S. dollars. There’s far more U.S. currency outside the U.S. than there is inside the U.S., and all those foreigners are going to resent it personally and hold it against Americans when their U.S. dollars are wiped out. On top of that, most central banks around the world hold U.S. dollars as their main asset, and that will be wiped out as well. It’s going to be a complete, worldwide disaster.

It’s going to be much worse than what happened in Germany or Zimbabwe. This is a couple orders of magnitude greater seriousness and it seems to me that this is almost certain to happen with a monumentally stupid person like Bernanke steering the ship of state into a reef.

L: Is there really any possible way he could not see the reef he’s got the U.S. pointed straight at?

Doug: Another interesting question, because, as I say, he’s not an unintelligent man but a stupid man, as I use the word.

L: But some people don’t see the world the way we do. Is it possible that he actually believes his own spin? Some people see price destruction and asset devaluation in some areas offsetting the inflation of the money supply, and believe there is some super-economic formula that really smart people like Bernanke can figure out, for the U.S. to spend its way back into prosperity.

Doug: I just don’t see how someone who’s studied the history of economics can so completely set aside its most pertinent lessons. It’s possible that he knows he’s caught between a rock and a hard place in technical economic terms, that he knows he and the economy are totally screwed and sees no choice but to carry on as long as he can and hope for a miracle. He probably knows that giving the economy the medicine it really needs would bring on a deflationary collapse, and losing his job would be the least of his worries.

As I’ve explained before, deflation is not only not a bad thing, it can be a very good thing. In a deflationary environment, the purchasing unit the dollar becomes worth more. That rewards people who have saved dollars, the prudent middle class upon which so much in modern society depends, and makes them prone to save more. Inflation makes people very loathe to save because what they’re saving is going down in value. And the solution to this depression we’re entering is not more spending, it’s not more consumption, it’s just the opposite of what these morons in Washington are saying: it’s less consumption and more savings. Savings are capital accumulation, and that’s what’s needed to start new businesses, create more jobs, and so forth in a sustainable way. Creating phony make-work jobs with more debt only serves to make things worse, come reckoning day.

So, switching from an inflationary policy to a deflationary one would be the right thing to do, but it would be such a sharp adjustment, this whiplash would hurt a huge number of people in the short term. And though most people don’t see it, the U.S. is on such a shaky political foundation at this point… It’s really become a question of ”Do you want to die by fire or by ice?” Either way, the U.S. is going to crash into a brick wall at high speed.

L: So, caught between the rock and the hard place, maybe he doesn’t believe anything he’s saying he’s just trying to hold off the noose as long as he can.

Doug: That’s a possibility. You and I will never get an interview with him, of course, and whoever does get an interview with him will get the kind of meaningless convoluted answers that Fed chairmen are notorious for giving. Answers so opaque as to be worthless. The only solution to this problem is, ultimately, to abolish the Federal Reserve. As we’ve argued many times in The Casey Report, it serves no useful purpose whatsoever it’s nothing more than a convenient instrument for inflation, which is to say, indirect taxation. But is that going to happen? I don’t think so. And that’s why I think the whole socio-political system in the U.S. is on the ragged edge of being overturned at this point.

L: The hollow oak that looks so mighty to all but is so rotten through its core that it collapses in the next storm. Do you suppose Bernanke could be doing it on purpose? Could he and Greenspan before him (who apparently claims to still believe in the gold standard) be orchestrating this crash on purpose, deliberately doing everything opposite of what’s necessary, carefully postponing the catastrophe each time to make it bigger and bigger, so that when it finally does all come crashing down, it does so in such a spectacular way, it teaches the world an unforgettable lesson on why you should never ever use paper for money?

Doug: That might explain their actions, but the odds on that scenario are slim to none. And Slim is out of town. Besides, I’m not a fan of conspiracy theories. I don’t think anyone could pull such a scheme off… But the bankruptcy of the U.S. government is baked in the cake. And that’s a good thing, in that they’ll have less ability to intervene in everyone’s lives domestically and in foreign countries. The bad news is that the government may bankrupt the country in a vain effort to keep itself alive.

L: So… Investment implications?

Doug: Everything we’ve been saying for years now and as Casey Report readers know, we did see and write about a credit crisis leading to a currency crisis before it happened about rigging for stormy weather is all the more vital now that the storm is upon us.

What, specifically, does that mean?

First and foremost, all of your savings, money that you don’t want to lose but need in a liquid form, should be in gold or gold proxies. To a lesser degree, silver as well, silver being a sort of poor man’s gold. That’s number one. You should have a very large position in these two things.

Second, regarding the speculative funds that you have, remember how much money Washington is creating. That’s definitely going to inflate other speculative bubbles to be on the watch for. I think it’s possible to make serious money spotting these early and cashing in before they pop. That’s number two: position yourself for taking advantage of speculative opportunities.

Third and I can’t emphasize this enough is that since what we’re really looking at is a political disaster causing the economic disaster, you must diversify your assets politically. And since the epicenter of this meltdown is the U.S., it’s absolutely vital that you diversify your assets, including the gold and the speculative investments, outside the U.S. That’s number three, but not third in importance there will be foreign exchange controls, and once we have those, your alternatives will be severely circumscribed.

These are the three most critical pieces of advice I can think of to give to anyone.

L: Heavy stuff, Doug thanks for laying it out so clearly.

Doug: You’re welcome. I just hope our readers will actually act on this, because it can not only make the difference between going under and surviving, but this basic approach and the details we spell out in The Casey Report can help them to turn crisis into opportunity. Some people will prosper during these difficult times; I hope it’s our readers who do.

Gary’s Endnote: This Conversation with Casey was originally released in December of last year, just after Time announced Ben Bernanke as its Person of the Year.

January 27, 2010

Bernanke Versus Deflationary Collapse was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The problem with households not saving is that over the long run, it ruins the economy.

Lack of savings means there are not enough long-term private bank reserves. Broadly, it translates into lack of investment in new business capital. Over time, that runs down the capital base of the economy. And improving business capital is, of course, the key to increasing productivity within an economy.

If productivity doesn’t increase, wages and living standards will stagnate – at best. Eventually, living standards decline. Don’t believe me? Have you been to Detroit lately?

Decades-Long Trends

Last year’s lack of savings was not a short-term phenomenon. The savings deficit was part of a long-term cultural phenomenon. The low savings rate in 2008 was one more data point in a string of many bad years for savings.

The personal savings rate in the U.S. makes for an interesting chart (see below, for 1930 to the present). The first thing that pops out is that savings were very high (near 25%) during World War II, when there were few consumer goods available to purchase.

All that wartime saving had much to do with kick-starting the U.S. economic explosion after the war ended. While the war was raging, many economists expected a postwar crash. That’s what had happened all the way back to the days of Napoleon.

In fact, the prospect of postwar mass unemployment, involving millions of demobilized soldiers, was one of the key drivers behind creating the G.I. Bill of Rights. It was better to send former soldiers off to college for a few years than to have them sitting around with no jobs, muttering into their beer mugs.

Instead of a postwar crash, however, the large pool of U.S. aggregate savings aligned with pent-up demand to spark a historic economic revival. In the 1950s and into the 1960s, the World War II generation settled down to raise its baby boom offspring. While savings rates cooled down, they still averaged a very respectable 8.5%. And this was in an era of very low inflation.

The national savings rate actually increased toward 10% during the 1970s and early 1980s. But from the mid-1980s onward, the national savings rate declined steadily. The rate was in the low single digits – and falling – by the early 2000s, and went negative in 2006 and 2007. For the U.S., these recent numbers were the lowest savings rate since the Great Depression.

What Was Going On?

Let’s review some large-scale trends that occurred during the past four decades. Starting in the 1970s, many women entered the U.S. labor force. More accurately, women exited the unpaid world of homemaking and entered the paid labor force.

The demographic shift of women into the labor force started as a trickle, but turned into a flood. Indeed, over the past 30 years, many traditionally male-dominated occupations and professions opened wide for women to pursue careers. Enrollments in U.S. law and medical schools, for example, are now well over 50% women. Just this year, over 50% of undergraduates majoring in earth sciences in the U.S. are women.

More women in the work force led to a fast-growing number of two-income households. But as pointed out by Elizabeth Warren, a professor and bankruptcy specialist at Harvard Law School, those extra paychecks often went to consumption, rather than savings.

For example, working couples took the second paycheck and bought a second car, if not a second house or condo. Working couples took more high-end vacations, as you can observe by driving past the cruise ship terminals at most major U.S. port cities. And the average size of new homes has increased during the past 25 years, even as average family size declined from over three to about 2.1 children per couple.

In short, Americans saved less over the past 35 years. But U.S. consumer spending took off and grew faster than the broad economy. Consumption accounted for 62% of gross domestic product (GDP) in the 1960s. But consumption grew to 70% of GDP between 2000-2007.

Looking at the numbers another way, “investment” in the economy plummeted from 38% of GDP to 30% – a drop of over 21% from the 1960s baseline. So it makes sense that much of the increase in consumption in recent years was of imported goods. Thus did high consumption and low savings help to decapitalize the nation, as trillions of dollars wound up in foreign accounts.

And Then What Happened?

With high consumption and low savings, when the current recession hit, it hit hard. In fact, the effects of the recession were aggravated by the national pattern of high consumption and low savings over the past decades.

Let’s begin with the fact that many households spent every dollar that came in. Then they borrowed against the so-called “equity” in their house (often as not, the equity was mostly a product of inflation) to finance further consumption. But there’s a funny thing about borrowing money. Usually, the lender wants it paid back.

As Harvard’s professor Warren has pointed out, many two-income households painted themselves into a “two-income trap.” That is, when both wage-earners devote their entire paycheck to consumption, with nothing going into savings, the loss of one job can be a financial catastrophe. A household at the margin almost instantly goes underwater.

Also, it’s becoming clear that in the past year, many job losses in the U.S. economy are permanent. Instead of temporary layoffs, many jobs are being eliminated as part of a structural retrenchment of the U.S. economy. Think about the job losses in the auto and auto parts industries, in banking and finance, or in real estate. Many of these jobs are just plain history. These industries will never recover to the glory days of old.

Along these lines, a recent survey conducted by The Wall Street Journal reveals that 52% of companies polled expect to employ fewer people over the next five years. That can hardly be reassuring to the rapidly expanding ranks of the unemployed in large states like California, Michigan, Illinois and others. Big states with large numbers of jobless people make for big, long-term, intractable social and political issues.

The “Recovery-Less Recovery”

So the job cuts, and long-term unemployment, are here to stay. Much of this has to do with the previous lack of savings and long-term investment. After two decades of falling savings, and related underinvestment in new business capital, there is not enough momentum within the job-creation engine of the U.S. economy. The machine is stalled.

It’s not like you can accelerate the process of job creation, either. Sure, government can spend a lot of money (borrowed money, as it turns out) in a hurry on so-called “stimulus” programs. But what will that accomplish? People still can’t find long-term employment – let alone careers and employment security – in industries that don’t exist or never took root. Nobody gets hired in a firm or factory that never got built. So now we’re experiencing what many economists are calling a “jobless recovery.”

Jobless recovery? That might be whistling past the graveyard. Indeed, the lack of job creation going forward could also lead to a “recovery-less recovery.” Or to paraphrase former President Richard Nixon, speaking of the idea of Keynesian economics, we’re all living in the Rust Belt now.

Some Households Are Saving Again

There is some good news from the savings front, however. As 2009 unfolds, it appears that debt-burdened American households are desperately beginning to save. In April 2009, the national savings rate jumped to 5.7%, the highest level in 14 years.

Still, savings has to come out of something else. Households “saved,” but the other side of the coin is that “consumers” ratcheted down their spending – and did so even faster than aggregate incomes fell. That means empty shopping malls and auto lots. It’s a vicious cycle.

“Americans have learned a cruel, cold, hard lesson,” according to Bernard Baumohl, an economist for the Economic Outlook Group of Princeton, N.J. “People are scared. And that’s led them to replenish their savings because they now realize that their retirement nest eggs will no longer increase on automatic pilot.”

There’s no disputing the extraordinary shock to household wealth in the U.S. From mid-2007-March 2009, according to the Federal Reserve, household net worth plunged $14 trillion, or 21.5%. Just during the second half of 2008, household net worth plummeted nearly $8 trillion – with an eye-popping $4.9 trillion dip in the fourth quarter.

Meanwhile, the broad-based Standard & Poor’s 500-stock index shed 57% of value between October 2007-March 2009. While the S&P 500 has increased 36% since its March low, it is still 41% below its 2007 peak.

According to Mr. Baumohl, the economist, “There has been a fundamental shift in the behavior of American households.” That is, savings are now a priority of financial planning. Mr. Baumohl believes that we’ll continue to see the savings rate increase to between 7-9%, where it will likely hold steady for at least several years. Many of the 75 million baby boomers are now revising their retirement plans, figuring out how to work longer, save more and spend less. (Meanwhile, the federal government is working to figure out how to pay lower Social Security and Medicare benefits to those baby boomers.)

All in all, we should expect to see U.S. consumer spending grow more slowly than GDP over the next decade. As a percent of GDP, investment will increase as some fortunate households replenish savings. But any recovery will be slower than most observers expect – particularly the politicians, who cannot abide large numbers of unemployed people near Election Day.

Rooting for the Savers

The good news is that over the long-term, more savings will translate into more business investment. That should create new jobs and raise productivity, which are the basic building blocks for a rising standard of living.

Of course, there are problems with any significant shift in the direction of capital flow in the U.S. economy. But despite any issues, the unemployed of the U.S. need to root for the savers. And the politicians, of course, need to respect the process of saving. Because without those savings, the economy will continue to wind down.

And what if the political rhetoric descends into class warfare? What if the savers of the nation become objects of ridicule, subject to punitive levels of taxation and regulation? In that case, we get back to the idea that capital is portable.

If savings cannot find a safe harbor in the U.S., then the capital flows will keep moving offshore. And if that happens, all bets are off for the U.S. economy. We can just sit back and listen as the band plays “Nearer, My God, to Thee.”

Until we meet again,
Byron King

July 2, 2009

Too Much Spending, Not Enough Savings: Destruction of an Economy was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Innovation, Savings, and Demand

“From a fishhook to the space shuttle, every material human advancement has been the result of a combination of technological innovation and capital savings. In other words, we are now building on the savings and innovation of our ancestors.”  — Victor Sperandeo, Trader Vic II: Principles of Professional Speculation

THIS PAST WEEK, the April issue of MIT’s Technology Review hit my desk. Its cover story this month is “World-Changing Ideas…25 Innovations From Around the Globe.” Among the more interesting:

What do these developments have in common? They are all focused on natural resources, and they highlight the intersection of three key forces that form the heart and soul of capitalism. What are those three forces? Drumroll, please…they are innovation, savings, and demand.

• Brazil is making a major commitment to biodiesel, an oilseed derivative with strong potential as a long-run alternative to fossil fuels.
  
•  In China, Shanghai’s Solar Energy Institute is focused on advanced solar technology. The ultimate goal: a home with 70% of energy needs met by the sun.
  
•  Chile hopes to increase its copper reserves substantially through genetic advances in biomining, a process that uses bacteria (rather than noxious heat or chemicals) to extract copper from the ore.

Let’s go over them briefly, because a proper understanding of these forces is imperative for investing success.

The Heart and Soul of Capitalism: Innovation

Innovation is perhaps the most intuitive of the three forces, but it is still overlooked or misunderstood. Through innovation, we become more productive and are thus able to reap greater output from the same or less input. In a rare instance of serendipity, the innovator is able to increase his wealth while increasing the productivity of others at the same time. The first fisherman to use a net would have had substantially greater numbers of fish to trade relative to his peers, without exerting greater effort. Once the idea caught on, greater quantities of fish would be available to the benefit of all. Alternatively, if greater quantities of fish were not desired, then fewer fishermen would be required to bring in the necessary catch, allowing some of them to pursue other productive pursuits. With every additional innovation, we are given the beneficial choice between greater levels of output or a surplus of resources available for alternative pursuits. And so we continue trading up to the present day, where the innovative fisherman’s descendants find themselves engrossed in solar energy and biomining.

Down through the centuries, innovations have shaped history and accelerated progress in sudden jumps. The plow led to agriculture-based societies rather than hunter-gatherer ones, which in turn created the locational stability required to build cities. Gunpowder led to the demise of feudalism and the first stirrings of democracy by bringing cheap weaponry to the masses. The printing press fueled the Protestant Revolution, which in turn sowed the seeds of Western-style capitalism.

This highlights another characteristic of innovation, namely, its incredible disruptiveness. When a promising new idea changes things for the long run, there are always vocal protesters in the short run. The term “Luddite” honors the memory of Ned Lud, a noted loser in the innovation process, who led mobs of workers in the destruction of British textile mills between 1811 and 1816 out of fear that they would destroy jobs. Ned has many descendants, in spirit if not in blood, and they are equally vocal today. Unfortunately for Ned and his descendants, the short-term pain of disruption is unavoidable, and in fact vital, in the pursuit of progress. In 1942, Joseph Schumpeter immortalized the concept by coining the phrase “creative destruction.”

The Heart and Soul of Capitalism: Savings

Savings are required to pursue innovation. Innovation is essentially an investment in future production, and one cannot make an investment without savings. This investment does not have to be in the form of money. It can be time, energy, education, other opportunities forsaken, or a number of other things. And like any investment, there is risk involved. When our intrepid fisherman first conceived of the idea for his net, he had to make a number of investment decisions. Was this idea worth pursuing in terms of energy and effort? Could he afford the time taken away from his regular fishing day? Did he have access and means to acquire the necessary materials? Would he have to budget time for trial and error as he tried different weaving patterns in the construction of the net? Was it worth the opportunity cost of foregoing other avenues of production? All these questions go back to savings (in the form of human capital rather than fiduciary), and a willingness to put a portion of those savings at risk. Without an available surplus of time, energy, and resources, the net would never have seen the light of day.

The immutable relationship between savings and innovation is now clouded because there are so many hidden links in the chain. Thanks to the modern application of credit, it’s tempting to forget that savings are still required to innovate. After all, don’t entrepreneurs borrow money to start businesses every day? Indeed they do…but it is still someone else’s savings they are borrowing (and putting at risk), as well as their own time, energy, and opportunity cost. Ah, yes, but what about fractional reserve banking and the stimulative “easy money” activities perpetuated by the Federal Reserve? Even here, the circle remains closed. When excess liquidity is pumped into the economy, it only serves to devalue the real savings that previously existed, like a watered-down drink not worth the inflated price.

Coincidentally, America’s great hope is that we will innovate our way out of the current savings straits. In essence, bulls are betting the next long cycle of innovation will pay off big enough to cover the current tab. No matter how you slice it, savings are still required, be they already earned or mortgaged against the future. The only problem is we aren’t investing our borrowed funds in ideas, education, and means of future production; we are loading up on DVD players and SUVs while our next generation’s education rankings slip down the board.

The Heart and Soul of Capitalism: Demand

Demand is where the rubber meets the road. Without it, the innovations produced by way of savings have no benefit. In the case of natural resource development, demand usually comes first, spurring innovation through a sense of urgency or a clear long-range price advantage. When it comes to consumer innovations, like ATMs or iPods, the innovation usually comes first, with demand to follow once the value of the new technology or process is widely recognized. Either way, demand is the catalyst that ultimately allows the innovation to bear fruit. 

Demand is also important enough to stand on its own as an investment concept. As an investor, you can earn your keep simply by gauging fluctuating levels of demand properly. This, in fact, is how fortunes are made in commodity markets. By recognizing critical periods when demand is set to significantly outpace supply for a long period of time (or vice versa), it’s possible to make a great deal of money as prices wax and wane. The same applies to business expansion, in terms of applying a successful idea to a new city, region, or country. We don’t have to reinvent the wheel to make money; in fact, we don’t even have to improve on the wheel. All we have to do is uncover market opportunities where rising demand for wheels has not yet been met.

Of course, there are multiple factors that have to be taken into effect when considering potential demand. Among them are the level of competition, the economics of production, logistics of delivery, comparative substitutes, political risk, barriers to entry, potentially disruptive innovations, and so on. But when it’s all boiled down, the heart of the matter remains relatively simple. Economics deals with the allocation of raw materials and finished products that exist in limited supply, be they crude oil deposits, atomic physicists, or iPods. Demand is the root of the equation.

In part II of this series, we will take a closer look at innovations and economic factors in the world of natural resources. Through this lens, we will uncover some of the predictable ways in which innovation, savings, and demand tend to interact over the long cycle…and see how we can directly apply these observations in our relentless pursuit of profit. “The Death of May, 12 October 1949

And of course, comments and observations are sought with extra emphasis this time around, given my relative newness to the Whiskey & Gunpowder community. Let me know what you think – simply reply to this e-mail!

Justice Litle
March 23, 2005

“In the early summer of 1949 my daughter graduated from the Madeira School in Virginia, and shortly afterwards my wife and the children came to Switzerland, where we spent happy weeks at Pontresina and Saas Fee.  May said occasionally that she could hardly keep up with the children on walks; unfortunately, I paid too little attention to these remarks.  She was never ill, and I took that to mean that her health must be perfect.  In September she returned to Washington with the children, and I was to follow in November

“On 12 October, shortly after noon, May was stricken by a heart attack and died within a few minutes.  The two days that then followed must have been terrible for my children, who had been with their mother that morning; because of fog I was unable to arrive for two days.  I found the children grown up far beyond their years. 

“In my shock, I found myself questioning God’s will: why had my wife, who was so much younger than I, been torn away from me and the children?  Soon I came back to my senses.  Our marriage had brought me deep happiness in middle life.  I had to be grateful for that, bowed down as I was by present sorrow. 

“I pressed the children to me.  They tried to conceal their sorrow in order to comfort me.” 

The Heart and Soul of Capitalism: Innovation, Savings and Demand was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.