Wednesday, December 24, 2008

Good Investments Bad Investments

There is another interesting post by Michael Hudson in yesterday's counterpunch. Here are some useful quotes:
The recent stock market and real estate bubbles are much like pyramid schemes in the sense that what is bidding up stock and property prices is an exponential inflow of new money from pension plans and mutual funds (for shares) and bank credit (for real estate). Venture capitalists are “cashing out” while corporate managers exercise their stock options.

Suppose that mortgage-packaging companies are honest in their appraisals of current price trends. The real estate bubble is nonetheless speculative and postindustrial. The analogy is found when financial managers endorse government policies that encourage the inflation of price for stocks and bonds, stamps and coins, Rembrandts and modern art by claiming that this creates wealth and hence, by definition, pulls living standards and culture onward and upward.

What is wrong with this picture? For starters, it fails to define value as distinct from price, windfall and capital gains as distinct from earned income. It also neglects the fact that market prices rise and fall, but the debts remain in place. And when debts cannot be paid, savings are wiped out. ...

What does this have to do with true capital formation? Individuals are getting rich while the economy is polarizing between creditors and debtors, property owners and rent-payers. Unproductive investment occurs when it takes the form of windfall “capital” gains, and when it involves going into debt for real estate, stocks or bonds, or “collectibles.” Unproductive credit occurs when commercial banks make loans that merely finance the purchase of property, companies or financial securities already in place.
As I have been driving around Southern California, I am stunned by the sheer amount of real-estate development that has occurred in the last ten years. Development has occurred in all sectors, residential, commercial, and government. The value of residential and commercial real-estate is now plummeting as anyone who reads or pays attention to local conditions can tell. Land values were raised with really no productive advantage attached to them. Now, the properties sit increasingly empty of tenants, rents will or are plummeting and it will take a long, long time (if ever) to make those properties income generators again.

Here in Orange County, the signs (literally and figuratively) are ominous. Just about every commercial strip center & building one sees in this land of sprawl has a "for lease" sign, or the whole property itself is for sale. Empty units abound. There are thousands of residential properties that are either bank owned or in the stages of the foreclosure process. In my little track of a few hundred houses, about 20 are now either bank owned or in the process, an increase of 6 since the start of the month. Given these trends, there will be NO recovery in the housing market any time soon. It is a good thing too! As Hudson points out in his article, there is no real productive economic value in increasing property values, it creates a sort of false capital gains based wealth and generates NO economic labor investment based value on its own.

The government building spree is no doubt in similar straits, the LA Times this morning has an image of county workers protesting announced job cuts in the unfinished $300,000 refurbishment of the Board Supervisor's lobby in the hall of administration. The image speaks volumes for how out of control the developer-based economy has become. New paint, pictures, and furniture add absolutely nothing to the functional use of the supervisor's lobby, just baubles or eye candy to false inflate the County Supervisor's sense of self-importance. But the $300,000 will certainly line the pocket of some contractor who no doubt will spend the money on other baubles for his home or office.

A recent trip to UC-Irvine further underscores this developer-contractor economy. The university has been on a building bonanza since I graduated there in 1999. Older buildings (less than 30 years old in many cases) have come down, new buildings have replaced them. All this new construction (simply replacing older contruction that was still functioning just a decade ago) in a state that projects a yawning 49 billion dollar deficit over the next 18 months. the UC system will be hit hard, layoffs will inevitably be massive and these buildings will sit, under utilized (and redundant anyway). Contractors pockets have been lined, but no real added value to the productive work of the university's mission has been created. Indeed, the debt based development is actually choking off the ability of the university to realize its mission as its operating budget falls into a black hole.

During this ecnomic downturn, we must wean ourselves off of the developer-contractor economy. It is a false economy that dooms us to the sort of wealth polarization that Hudson has been writing about. We must once again learn to distinguish the difference between investment of past gains into future productive returns, and the use of debt to gamble on rising value of nonproductive false wealth inthe future.

Monday, December 1, 2008

Some Thoughts on Money as Debt

I watched Paul Grignon's short video, Money as Debt, again last night and it finally dawned on me how money is created in our current system. I may have understood before, but then I forgot again.

When people need to purchase something that costs more than their cash on hand, they turn to the banksters who will create the money and deposit it into their banking account in exchange for the borrower’s signed promise to repay the debt at interest. According to the video 95% of all money in circulation is literally created out of thin air through the extension of credit from the bank and the acceptance of debt on the part of the borrower.

The new money that is created is used to purchase goods and/or services today. The resulting debt is repaid with a percentage of earnings from future earnings. So, through a legal fiction, the debt allows current consumption against future paid labor. The system is built on faith that the future will be prosperous enough to repay the debt.

What is interesting is that the money created today will eventually be returned to zero, over time, as the debt is repaid. What is more the debt will have to be repaid with interest, meaning that the wage earner will have to earn substantially more than the principle on the original debt to pay back the loan plus interest. For example, if you borrowed $5000 and promised to repay the loan in 5 years at 5% interest, then you would need to earn $5661.37 over the five years of the loan repayment period in order to meet your obligation.

Why charge interest? Obviously, that’s where the profit is in the loan making business. But, this creates a dilemma for the money system. When the bank created the $5000 it lent you out of thin air, that is all the new money that was added to the money as debt system. Another $661.37 will need to be added to the system over 5 years in order for you to earn enough money to pay back your debt with interest. So, someone else needs to take out a loan to add that money to the system overall. Trouble is, that person will also borrow at interest, meaning that even more money will need to be created to ensure enough money is in the system to pay for that debt over time. This creates a feedback loop, such that in order for the money supply to grow, so must the amount of debt overall in the system.

I suppose the total amount of money as debt in the system could theoretically infinite, so long as the earnings that workers get for deploying their labor, what earnings business get for deploying their capital, and what tax receipts government gets raises exponentially right along with the amount of money in the system.

If wages, earnings and tax receipts do not keep pace with the rate of money as debt creation, the overall money supply begins to exceed the value of real production in the real economy (the one that relies on productive labor and capital to add value to raw materials in the form of products that enhance human utility). The result … inflation…more and more dollars chasing after the available goods and services in the real economy, which often leads to price increases and a decline in the purchasing power of the wage earner, businesses, and government.

When prices rise faster than earnings a problem emerges for the money as debt system. An increasing percentage of cash earnings must be deployed to meet survival needs and other forms of needed consumption. The ability of the wage earner, business, and government to meet their debt obligations then begins to founder. In other words, the future envisioned in the signed legal fiction that allowed the creation of money as debt in the first place fails to materialize as envisioned. The result, debts cease to be repaid on time or even at all.

This problem is compounded by the tendency for people to try and cover their inadequate cash income by taking on more debt, meaning that there income needs into the future become ever greater. The housing bubble certainly could be read this way. As credit became all too cheap and easy after 2001, the sudden increase in money as debt that resulted got funneled into home purchases, improvements, cars and associated goods and services. Prices increased on homes, leading middle class residents and speculative investors to assume more and more debt in an attempt either to secure a culturally mandated sense of middle class comfort or to score a quick and seemingly ridiculously easy profit (sometimes both motives were at work).

Indeed, at this stage, the system must create more and more debt just to sustain itself. The whole history of financial innovations in recent decades could be read as an attempt to create more and more opportunities for workers, business, and governments to accept more and more debt so that more and more money enters the system to cover expenses associated with the ever growing debt burden on society.

Reality has a way of imposing limits on such a system. Wages, when adjusted for official US Gov’t CPI inflation, have long stagnated, and businesses can only produce so much given real world constraints of transportation, energy, raw material extraction, and productive capital. Moreover, businesses can only raise prices so much if they are to remain competitive given the limited ability of consumers to increase their spending. Government tax receipts are largely dependent on individual and corporate earnings, so its cash revenue is limited by their limits of growth.

If individual wage earners, businesses, and governments are being squeezed in terms of revenue possibilities inherent in the finite world and in terms of rising prices (due to the exponential inflation in money as debt supply), then a tipping point or crisis point in the system is inevitable. At some point, actors in the system must make a choice, either continue paying their debt obligations until they are homeless and starving or simply stop paying their debts in order to survive. Most people, being reasonably attached to living, choose the latter.

If growing numbers of individuals and businesses stop repaying their debts due to increasing financial strain and fewer new debts are being created for similar reasons, the overall money system must contract as a consequence. This set up another feedback loop where money literally disappears from the system. This is because some existing debts are repaid causing the money that was created when the loan originated to disappear along with the payment. On the other hand, less new money is added to the system to cover the interest payments that are expected on the debts currently in existence throughout the system. Recall, that the interest on loans is paid with new money as debt that is added to the system after you the borrower accepted the principal inherent in your debts.

Now enter the banks. Banks need interest income to pay interest on savings accounts, run their day to day operations, to service their own short term debts, and to earn profits that underlay the value of their investors’ shares in the bank (perhaps even pay a dividend) – although, banks can also charge borrowers all sorts of up front fees in addition to interest over time for the privilege of creating money as debt in the form of loans to individuals, businesses, and government.

If banks are not getting the interest payments they had expected when creating the loan in the first place, and they are creating fewer new loans because borrowers either can’t be counted on to pay the loan back or because there simply is lower demand for credit as a result of growing austerity in the real, productive economy, then their entire business model is at risk. Their investors will run for the doors, leaving the bank poorly capitalized with declining income, and, ultimately, unable to meet its operating costs, service its debts, report profits, etc. etc.

Banks that are in financial trouble are in no position to make new loans, since doing so would place them at even greater risk for insolvency. Thus, what started as a collapse in demand for new money as debt driven by the inability of debtors to service their debts, turns into a supply crunch, where very credit worthy borrowers cannot get loans as banks are no longer in a sound financial position to lend.

The result, deflation or a lowering of the overall supply of money leading to rising unemployment, falling wages and prices as the result of fewer and fewer dollars chasing the available goods and services in the economy. In other words, a depression.

All of this leads to a final concern. Banks can certainly create massive amounts of money as debt in this system. But the government can create money as well. By fiat, the government can simply print new money into existence. Certainly, the government could invent money of its own to offset the money as debt that the banking system is no longer able to create, right? Deflation can be counter acted, right?

Remember government expenditures are made possible by (1) taxing property, current earnings or dollars spent when purchasing goods and services and (2) creating new money as debt, which the government promises to repay with future tax receipts (with fewer and fewer new receipts able to service new debts due to receipts already being committed to current principle and interest payments on existing).

In a declining economy, tax receipts likely also decline, meaning any new government money must be created as new money as debt. The government must get a bank to loan it some new money as debt with a promise that is will repay the debt with interest well into the future. But, here, the government runs into the same problem, lenders must have faith in the government’s ability to repay the debt plus interest into the future. Once that faith runs out, so does the government’s ability to borrow new money as debt into existence.

What’s more, the way government spends money is very different from the way individuals and businesses spend money. It is unlikely that much of this new money the government borrows into existence will come to the aid of many citizens, since existing government contractors already enjoys special ties for government expenditures.

There is the Zimbabwe Option! The government creates its own money which it has the power to do. Then the government uses this money to save the economy by giving it straight to the citizens and business to help make up for their own shortages of earned income. This approach would be a radical break from the current system of money as debt. As a radical break, the faith the still sustains the value inherent in the current money system could evaporate overnight. Such an action would run the risk of causing a collapse in the trust of the value of this new government money to be exchanged for goods and services. Radical increases in prices would result … the images of wheelbarrows of cash in Weimar Germany in the 1930’s come to mind. Indeed, this has been the experience of Zimbabwe in the present era.

Why, people will be uncomfortable accepting the “New Dollars” as actually representing items of value, since the government can, quite literally, invent a nearly infinite supply of New Dollars that would not be tied by legal fiction to either production or labor as was the case in the money as debt system that we currently have. Without these ties to labor and production, the limits of the real world that create problems for the infinite growth of the money as debt system do not apply. The government is free to create unlimited amounts of fiat money, but its value in terms of exchanging it for real goods and services will diminish rapidly as the value of real goods and services grow at much lower rates, remain stagnant, or, more likely at this time, decline sharply. Radically escalating prices would be the natural result.