Fictitious capital, debt deflation and the global crisis
• 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 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 behaviour.
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 labour 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 labour 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, The Bubble and Beyond 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 post-industrial 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 my 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 fuelled 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.
The Bubble and Beyond 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.
Michael Hudson is President of The Institute for the Study of Long-Term Economic Trends (ISLET), a Wall Street Financial Analyst, Distinguished Research Professor of Economics at the University of Missouri, Kansas City and author of The Bubble and Beyond (2012), Super-Imperialism: The Economic Strategy of American Empire (1968 & 2003), Trade, Development and Foreign Debt (1992 & 2009) and of The Myth of Aid (1971). ISLET engages in research regarding domestic and international finance, national income and balance-sheet accounting with regard to real estate, and the economic history of the ancient Near East. Michael acts as an economic advisor to governments worldwide including Iceland, Latvia and China on finance and tax law. He gives presentations on various topics at conferences and meetings. Google his many You Tube videos and listen to some of his radio interviews to hear his hyperspeed analysis of the geo-political machinations of global economics.