Our age has embraced an intellectual mindset that sees only a limited view of reality. By adopting a totalitarian attitude, intellectuals become trapped in a spirit of irrationality by attempting to justify a limited viewpoint, without even considering a greater perspective.

Economic theory is dominated by a GDP methodology which fails to consider other factors that may be relevant in assessing the economic and financial well being of a community. John Maynard Keynes stated that loans do not affect economic activity; as for each borrower there is a lender. Following from this, modern economic thought believes that GDP is affected solely from real factors, with financial flows having no long-term effect.

Real economic activity co-exists with the financial system. With each real economic activity there corresponds a financial transaction. Often, it is these financial transactions that dictate real economic activity. For most people, houses and cars cannot be purchased without a bank loan.

Despite our everyday experience that financial transactions dictate real economic activity, an analysis of financial cash flows, or an examination on how bank lending affects GDP are considered irrelevant by most economists. However, the crisis now gripping national economies is really a crisis of cash flows. Failure to understand this crisis of cash flow, is the prime reason that most economists failed to predict the economic crisis, and is the reason that they are wrong in projecting a sustainable economic recovery.

Cash flow is the difference between income and cash expenses. When cash flow is positive, cash balances increase and expenditures are sustainable. When cash flow is negative, cash balances decrease, and when they are depleted, expenditures must be reduced. If expenditures cannot be reduced, bankruptcy will follow. In this way, negative cash flow is a warning sign that future GDP could contract.

This goes to the heart of the present financial crisis, which is really a crisis of cash flows. With loans growing at a much faster rate than GDP for an extended period of time, there is not the cash flow for debt repayment. The slowing of growth of private credit results in a fall to GDP, making the cash flow crisis more severe, leading to greater loan delinquencies, and a further contraction in private credit. The government response to the crisis of massive government deficits provides for temporary relief for falls in GDP while increasing the overall cash flow crisis by dramatically increasing public debt at a time when government income is falling. Consider the following two charts.

U.S. trends in personal, corporate, and government cash flows can be determined by examining governmental receipts of personal and corporate income tax as reported by the Treasury Department, and loan delinquencies as reported by the Federal Reserve Board.

Most economists now believe that the current recession started in December 2007. Personal tax receipts in 2009 are down 21% and corporate tax receipts are down 63% from 2007. This would indicate a substantial decrease in personal and corporate income, which would negatively affect cash flows, being reflected in a substantial increase in loan delinquency rates.

A major collapse in 2009 GDP has only been adverted by a substantial increase in government expenditures. Compared to 2007, government outlays have increased by $792 billion, a 29% increase. Government receipts decreased by $462 billion, an 18% decrease, resulting in a $1255 billion or 775% increase in the deficit.

Those economists who now believe that a collapse in personal income and corporate cash flow, an explosion in loan delinquency rates, and out of control government deficits create the basis of a sustained economic expansion are delusional. The recent increase in the stock market would also appear not to be supported by fundamentals.

The continual rise in loan delinquency rates would suggest that there is continuing pressure on individuals and corporations to decrease expenditures, leading to lower GDP, and lower wages, corporate cash flow, and tax receipts. The only way to maintain GDP is to further increase government expenditures and deficits, relying totally on the generosity of the bond market.

What economists fail to understand is that there can be a conflict between GDP and financial stability when GDP growth is based on loan growth, especially where cash flow is not sufficient to repay the debt. This is currently being played out in the private sector, where large debt levels not only lead to downward contribution to GDP, but also will lead to the bankruptcy of the banking system.

There have been major falls in the value of residential and commercial real estate. Moody's/REAL Commercial Property Price Index shows commercial values down 29% during 2009, and down 41% from the October 2007 peak. With real estate loan delinquencies of 10.80% on residential and 8.67% on commercial, on a market-to-market basis, most banks are likely insolent. To obscure the reality of the banks financial position, the Financial Accounting Standards Board has eased the rule on market to market accounting, allowing the banks to state the value of over 50% of their assets. Banks are in a state of self-denial if they think that incomes and property values will increase sufficiently to repay loans at 100% on the dollar. The reality is that with loan values substantially above the market value of the real estate security, there will be strategic defaults even by borrowers with sufficient cash flow to meet debt repayments.

Eventually, the same situation will occur with respect to government debt. With an over-indebted and aging population, and trillions in unfunded liabilities, there will never be the cash flow to repay government debt. When bondholders realise that they are never going to be repaid, and stop financing government deficits, there will be a large contraction in public expenditures, and GDP.

The present perception that bank deposits and government debt are safe investments is false. A cash flow analysis indicates that these financial liabilities will never be repaid. As this financial reality becomes better understood, investors will exit these liabilities in favour of commodities, particularly gold.

This crisis in cash flow is global in nature, with many governments running unsustainable deficits to support faltering economies. The IMF estimates that Japan's gross public debt will reach 227% of GDP in 2010. The present level of government expenditures will require the bond market to finance a greater portion of government expenditures than tax receipts. A rise in interest rates to 4 % on government debt would consume 100% of tax revenue. This debt will never be repaid. Collectively, the U.S., Japan, and European governments will borrow over U.S.$5 trillion in 2010 to finance budget deficits.

The recent increase in GDP in China was entirely the result of a massive increase in bank loans (U .S. $1.4 trillion). However, it must be questioned where the cash flow will be generated to repay the debt. For example, in Pudong, (the central business district in Shanghai) office vacancy rates are as high as 50% and they are still building new skyscrapers. This increases GDP, but sows the seeds of a financial crisis.

Economists should not totally abandon their GDP methodology, but include an understanding of cash flows. In particular, they should become familiar with the actual financial transactions used by commercial banks, and study the effect of these transactions on economic activity. It is only by expanding their understanding of factors affecting economic activity that solutions to the present economic crisis can be put forward.

While the global economy is facing a major cash flow crisis, the source of this problem is the very nature of the financial instruments created when banks advance loans. The global community must move away from a financial system dominated by commercial banks creating bank deposits (being evidence that the bank is in debt) in situations when no debt actually exists. There is a pressing need to cease using bank deposits as currency, replacing the current currency structures with government created money, much of which should be created in an electronic format.

However, if governments continue to be dominated by policies directed by the self-interest of commercial banks, a global meltdown of economies and financial institutions will occur. The cash flow position of individuals, companies, and governments is now much worse than when the financial crisis first began, and will continue to deteriorate under present policies.

John Kutyn
February 25, 2010