This summary of my economic theory traces how
industrial capitalism has turned into finance capitalism. The finance,
insurance and real estate (FIRE) sector has emerged to create “balance sheet
wealth” not by new tangible investment and employment, but financially in the
form of debt leveraging and rent-extraction. This rentier overhead is
overpowering the economy’s ability to produce a large enough surplus to carry
its debts. As in a radioactive decay process, we are passing through a
short-lived and unstable phase of “casino capitalism,” which now threatens to
settle into leaden austerity and debt deflation.
This situation confronts society with a choice either to write down
debts to a level that can be paid (or indeed, to write them off altogether with
a Clean Slate), or to permit creditors to foreclose, concentrating property in
their own hands (including whatever assets are in the public domain to be
privatized) and imposing a combination of financial and fiscal austerity on the
population. This scenario will produce a shrinking debt-ridden and tax-ridden
economy.
The latter is the path on which the Western nations are pursuing today.
It is the opposite path that classical economists advocated and which
Progressive Era writers expected to occur, given the inherent optimism of
focusing on technological potential rather than on the political stratagems of
the vested rentier interests fighting back against the classical idea of free
markets and economic reforms to free industrial capitalism from the surviving
carry-overs of medieval and even ancient privileges and essentially corrosive,
anti-social behavior.
Today’s
post-industrial strategy of “wealth creation” is to use debt leveraging to bid
up asset prices. From corporate raiders to arbitrageurs and computerized
trading programs, this “casino capitalist” strategy works as long as asset
prices rise at a faster rate than the interest that has to be paid. But it
contains the seeds of its own destruction, because it builds up financial
claims on the assets pledged as collateral – without creating new means of
production. Instead of steering credit into tangible capital formation, banks
find it easier to make money by lending to real estate and monopolies (and to
other financial institutions). Their plan is to capitalize land rent, natural
resource rent and monopoly privileges into loans, stocks and bonds.
This leads the banks to act as lobbyist for their rentier clients, to
free them from taxes so that they will have more available to pay interest. The
resulting tax shift onto labor and industry adds a fiscal burden to the debt
overhead.
This is not a natural and even inevitable form of evolution. It is a
detour from the kind of economy and indeed free market that classical writers
sought to create. With roots in the 13th-century Schoolmen discussing Just
Price, the labor theory of value was refined as a tool to isolate economic rent
as that element of price that had no counterpart in actual or necessary costs
of production. Banking charges, monopoly rent and land rent were the three
types of economic rent analyzed in this long classical tradition. These rentier
charges were seen as unnecessary and exploitative special privileges carried
over from the military conquests that shaped medieval Europe. A free market was
defined as one free of such overhead charges.
This classical view of free markets as being free of an unearned “free
lunch” was embodied in the Progressive Era’s financial and tax reforms. But the
rentiers have fought back. The financial sector seeks to justify today’s
deepening indebtedness on the ground that it “creates wealth” by debt
leveraging. Yet the banks’ product is a debt overhead, leaving debt deflation
in its wake as debtors try to pay debts that can’t be paid without drastically
reducing consumption and investment. A shrinking economy falls further into
arrears in a debt spiral.
The question today is whether a new wave of reform will arise to restore
and indeed complete the vision of classical political economy that seemed to be
shaping evolution a century ago on the eve of World War I, or whether the epoch
of industrial capitalism will be rolled back toward a neofeudal reaction
defending rentier interests against reform. What is up for grabs is how society
will resolve the legacy of debts that can’t be paid. Will it let the financial
sector foreclose, and even force governments to privatize the public domain
under distress conditions? Or will debts be written down to what can be paid
without polarizing wealth and income, dismantling government, and turning tax
policy over to financial lobbyists pretending to be objective technocrats?
To provide a perspective on the financial sector’s rise to dominance
over the industrial economy, Part I reviews how classical economists developed
the tools to measure how finance now plays role that landlords did in
Physiocratic and Ricardian theory: as beneficiaries of feudal privileges that
oblige society to pay them for access to credit as well as land. As land
ownership has been democratized, new buyers obtain credit to purchase homes and
office buildings by pledging the rental income to bankers. About 80 percent of
bank loans in the United States, Britain and other English-speaking countries are
real estate mortgages, making land the major bank collateral. The result is
that mortgage bankers receive the rents formerly taken by a hereditary
aristocracy in post-feudal Europe and the colonies it conquered.
Whatever the tax collector relinquishes is available for this end. This
has led the financial sector to subsidize popular opposition to taxing property
– reversing the ideology of free markets held by the classical economic
reformers. And with the financialization of real estate providing the postindustrial
model, corporate raiders since the 1980s have adopted the speculator’s motto,
“Rent is for paying interest,” using corporate cash flow to make a deal with
their backers to obtain loans to take over companies already in place – and
bleed them.
This phenomenon is called financialization, and Part II of this book
describes how it has transformed the economics of real estate, industry and
pension fund saving into a Bubble Economy based on debt-leveraged asset-price
inflation – leaving debt deflation in its wake. The banker’s business plan,
after all, is to turn as much of the economic surplus as possible into a flow
of interest payments. But this must be self-defeating. Paying debt service
diverts revenue away from being spent on consumption and tangible capital
investment. This causes debt deflation and imposes financial austerity. Capital
and infrastructure are bled to squeeze out the revenue to pay bankers and other
creditors, depleting the economy’s reproductive powers.
What is unique to the post-1980 Bubble Economy is the tactic by which
austerity has been averted, by new credit creation to inflate asset prices in
what is rightly termed a Ponzi scheme. (The appendix at the end of this volume
defines the terms and concepts by which I describe this process.) Instead of
interest rates rising to reflect the increasing risks of the debt-ridden
economy, banks kept the financialization process going by easing credit terms:
lowering interest rates and the amortization rate (culminating in “interest
only loans), and also lowering down payments (for zero down payment loans) and
credit standards (appropriately called “liars’ loans”).
The direct effect of collateral-based lending is to bid up prices for
the real estate, stocks and bonds pledged as collateral for larger and larger
loans. An asset is worth whatever a bank will lend against it, and easier
credit terms serve to preserve the market price of assets pledged for debt.
This is the case even as the economy diverts more of its income – and transfers
more of its capital and future income – to the financial sector, which
concentrates wealth in its own hands.
Federal Reserve Chairman Alan Greenspan encouraged mortgage borrowers to
think of themselves as getting richer as the market price of their homes rose
in the early 2000s. But the “wealth creation” was debt-leveraged, and easy
credit obliged new buyers to take on a lifetime of debt to afford housing.
After 2008 their mortgages had to paid even as a quarter of U.S. residential
real estate fell into negative equity when market prices plunged below the
level of the mortgages attached to it.
A similar phenomenon has occurred as education has been financialized.
Students must take on decades of student-loan obligations and pay them
regardless of whether the education enables them to get jobs in an economy
shrinking from debt deflation. The magnitude of these loans now exceeds $1
trillion – larger even than credit-card debt. Instead of being treated as a
public utility to prepare the population for gainful work, the educational
system has been turned into an opportunity for banks to profiteer from a debt
market guaranteed by the government.
The economy’s circular flow becomes a vicious circle as paying debt
service leads to smaller market demand for goods. Investment and employment are
cut back, government budgets move into deficit, forcing cutbacks in revenue
sharing with localities and subsidies for education. Schools raise their
tuition levels, obliging students and families to take on more debt, creating
yet more debt deflation.
Other public infrastructure is sold off to pay down debts, and the
buyers raise access prices and tolls on roads and other privatized
transportation – and so on throughout the economy. Debts mount up increasingly
as a result of arrears in making payments, losing all relationship with the
realistic ability to pay.
What has gone relatively unremarked by economists is how
financialization of the economy has transformed the idea of saving. In times
past, saving was non-spending on goods and services – in the form of liquid
assets. Typically on a national scale, between one-sixth and one-fifth of
income would be saved – and invested in capital on the other side of the
balance sheet. But since the 1980s, as banks loosened lending standards on real
estate and made and the financial sector in general turned increasingly to
financing corporate raiders, mergers and acquisitions, the way to create future
wealth was not to save, but was to go into debt. The aim was capital gains more
than current income. Indeed, after 2001 many families “made more” on the rising
market price of their homes than they made in salary (not to speak of being
able to save out of their salary).
Under financialization, the strategy was to seek capital gains, riding
the wave of asset-price inflation being fueled by Alan Greenspan at the Federal
Reserve Board. Investment performance was measured in terms of “total returns,”
defined as income yield plus capital gains. And the way to maximize these gains
was to borrow at a relatively low interest rate, to buy assets whose price was
rising at a higher rate. For the first time in recorded history, large numbers
of people went into debt not out of need, not involuntarily and as a result of
running arrears as a result of inability to pay, but voluntarily, believing
that debt leveraging was the quickest and easiest way to get rich!
The national income accounts were not designed to trace this process.
Using debt leveraging to obtain capital gains meant that bank loans found their
counterpart in debt on the other side of the balance sheet, not new tangible
investment. The result was a wash. So the nominal savings rate declined – to
zero by 2008. Yet people thought of themselves as saving, as long as their net
worth was rising. That is supposed to be the aim of saving, after all: to
increase one’s net worth. The result was a financial “balance sheet boom,” not
the kind of expansion or business cycle that industrial capitalism generated.
As this process unfolded “on the way up,” financial lobbyists applauded
the asset-price inflation for real estate, stocks and bonds as “wealth
creation”. But it was making the economy less competitive, as seen most clearly
in the de-industrialization of the United States. Debt-leveraged real estate
required families to pay higher prices for housing – in the form of mortgage
interest – and pension funds to pay higher prices for the stocks and bonds they
buy to pay retirement incomes. That is the problem with the Bubble Economy. It
is debt-driven. This debt is the “product” of the banking and financial sector.
When asset prices finally collapse to reflect the debtor’s ability to
pay (and the falling market price of collateral bought on credit), these debts
remain in place. The “final stage” of the Bubble Economy occurs when
foreclosure time arrives and debt-ridden economies shrink into Negative Equity.
That is the stage in which the U.S. and European economies are mired today.
Economic jargon has called it a “balance sheet recession” – the counterpart to
the “balance sheet boom” that was the essence of the preceding Bubble Economy.
The process became political quite quickly. Banks and high finance
sought to shift their losses onto the economy at large. As debts went bad in
2008, Wall Street turned to the government for bailouts, and demanded that the
Federal Reserve and Treasury take their bad loans onto the public balance
sheet. This has occurred from the United States to Ireland. The effect was to
increase U.S. federal debt by over $13 trillion – without running a deficit of
this magnitude, but simply by taking Fannie Mae and Freddie Mac onto the public
balance sheet ($5.3 trillion), by the Federal Reserve swapping $2 trillion in
newly created deposit liabilities in a “cash for trash” swap with Citibank,
Bank of America and other banks that were the worst offenders in making junk
mortgages, and with other policies confined to the balance sheet, not current
spending.
This vast increase in money and credit was not inflationary. At least,
it did not increase consumer prices, commodity prices or wages. The aim was
indeed to increase asset prices, but the banks were not lending, given the fact
that debt deflation was engulfing the entire economy. So the traditional
monetary formula MV=PT became irrelevant. Asset prices were the key, not prices
for goods and services – and asset prices could not rise as long as so many
assets were in negative equity. So money creation became a pure giveaway to the
financial sector – a “transfer payment,” not a payment for the purchase or sale
of a consumer good or investment good.
Part III discusses the global dimension of “socializing” (or more to the
point, oligarch-izing) unpayably high debts. The world’s money supply now rests
ultimately on government debt – and the government’s acceptance of this debt as
money in payment of taxes and public services. Yet there is something
fictitious about all this: the debts can’t be paid!
The most obviously unpayable are those of the U.S. Government. This
makes these debts “fictitious,” inasmuch as dollar holders are unable to
convert their savings into tangible assets, goods or services. Gold
convertibility was ended in 1971 in response to the Vietnam War’s drain on the
U.S. balance of payments. Yet the dollar has remained the foundation of most
central bank reserves even as the U.S. trade deficit deepened as the economy
was post-industrialized while overseas military spending has escalated. This
military dimension grounds the global financial system in U.S. military
hegemony.
This has prompted the BRIC countries (Brazil, Russia, India and China)
to seek an alternative payments and debt-settlement system so as not to base
their international savings on a system that finances their military
encirclement. As it stands the dollar standard provides a free lunch for the
U.S. economy (“debt imperialism”), above all for its government to create money
without regard for the ability (not to mention the will) to pay.
If the dollar deficit were used to promote peaceful economic development
in an atmosphere of global disarmament, the rest of the world would be more
willing to see the U.S. Treasury act as global money creator on its electronic
computer keyboards. But when this is done for national self-interest that other
countries see as being at odds with their own aspirations, the system becomes
politically as well as financially unstable. That is the position in which the
world economy finds itself today.
It became even less stable when the Federal Reserve provided $800
billion in credit to U.S. banks in 2011 under the Quantitative Easing (QE2),
which the banks used to make easy money on international interest-rate and foreign
currency arbitrage. Given the refusal of Congress to permit China or other
countries to buy major American industrial assets (e.g., as when CNOOK was
blocked from buying Unocal), and financial deregulation leading to
decriminalization of financial frauds (as in the “toxic waste” of subprime
mortgage packages), the world’s monetary system is in the process of fracturing
into regional blocks.
What is not clear is what kind of regulatory, financial and tax
philosophy will guide these blocs. At best, the world will return to the
debates that marked economic discussion a century ago on the eve of World War
I. At issue is whether the financial sector will translate its recent gains
into the political power to take debt and financial policy out of the hands of
elected government representatives and agencies and shift economic planning and
tax policy into the hands of a super-national central bank authority controlled
by bank lobbyists.
The lesson of history is that this would be a disaster of historic
proportions, because the financial time frame is short-term and its business
strategy is extractive, not productive. I hope the papers in this volume will
serve as an antidote to the head start that financial lobbyists have achieved
in sacrificing economies to austerity in what must be a vain attempt to pay
debts under adverse financial conditions that make them less and less payable.
By distinguishing tangible wealth creation from debt overhead and other rentier
overhead – the task of classical political economy, after all – the policy
debate can be cast in a manner that reverses the financial sector’s attempt to
replace realistic analysis with euphemistic lobbying efforts and what best can
be characterized as junk economics rather than empirical science.
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