Thursday, December 25, 2008

The real cost of not living within our means.

An interesting article, which attempts to explain the current monetary crisis using reasonably understandable terms.

The Oil Drum
Herman Daly: The Disconnection Between Financial Assets and Real Assets
Posted by Nate Hagens on December 25, 2008 - 1:07pm

...The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth—pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy—paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt.

As we have recently discussed, one way to think of this is the "full faith and credit" of the US as an example. The "imaginary" financial assets have to have some relation to "real world" assets like gold or property. In this case, the disconnect got to be really, really huge - which is bad.

...The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two‐legged Wall Street pigs, but that is another matter.


In other words, we kept on buying on credit, and buying more on credit, and putting off paying back the credit, and then putting it off some more, and then buying more on credit...we thought we could put it off indefinitely, expecting our homes or wages or who-knows-what to increase and cover all the debt. Or, we just figured we would keep paying the minimums forever and never worry about paying off the debt - doesn't everybody have credit payments? We thought it was just normal to have them. But in reality, when we got something on credit, in the end, nobody ever paid for it.

...Growth in US real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so‐called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.

All that stuff that never really got paid for? The people who made the stuff and the companies that extended the credit are now figuring out that the stuff will NEVER be paid for - not for 10 generations, as we opined recently, and maybe not even then. The US is amassing debt so fast it is now meaningless to even discuss actually paying back the debt. The interest payments alone are already enough to bankrupt the country.

...What allowed symbolic financial assets to become so disconnected from underlying real assets? First, there is the fact that we have fiat money, not commodity money. For all its disadvantages, commodity money (gold) was at least tethered to reality by a real cost of production. Second, our fractional reserve banking system allows pyramiding of bank money (demand deposits) on top of the fiat government‐issued currency. Third, buying stocks and “derivatives” on margin allows a further pyramiding of financial assets on top the already multiplied money supply. In addition, credit card debt expands the supply of quasi‐money as do other financial “innovations” that were designed to circumvent the public‐interest regulation of commercial banks and the money supply.

I would not advocate a return to commodity money, but would certainly advocate 100% reserve requirements for banks (approached gradually), as well as an end to the practice of buying stocks on the margin. All banks should be financial intermediaries that lend depositors’ money, not engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved we would restore the classical economists’ balance between investment and abstinence. Fewer stupid or crooked investments would be tolerated if abstinence had to precede investment. Of course the growth economists will howl that this would slow the growth of GDP. So be it—growth has become uneconomic at the present margin as we currently measure it.


He might not advocate a return to commodity money, but without such a return there will be nothing keeping banks from continuing their practice of loaning out money they don't have to loan - they will simply find another way around any regulations. Remember the 5 large firms that got "exceptions" from the Fed?

...The agglomerating of mortgages of differing quality into opaque and shuffled bundles should be outlawed. One of the basic assumptions of an efficient market with a meaningful price is a homogeneous product. For example, we have the market and corresponding price for number 2 corn—not a market and price for miscellaneous randomly aggregated grains. Only people who have no understanding of markets, or who are consciously perpetrating fraud, could have either sold or bought these negative pigs‐in‐a‐poke. Yet the aggregating mathematical wizards of Wall Street did it, and now seem surprised at their inability to correctly price these idiotic “assets”.

Better yet, require that the banks or brokerages that originate mortgages have to keep them at least half the life of the mortgage, which would generally be about 15 years. They won't make pig-in-a-poke loans if they know they'll be stuck with them for a decade and a half.

...And very important in all this is our balance of trade deficit that has allowed us to consume as if we were really growing instead of accumulating debt. So far our surplus trading partners have been willing to lend the dollars they earned back to us by buying treasury bills—more debt “guaranteed” by liens on yet‐to‐exist wealth. Of course they also buy real assets and their future earning capacity. Our brilliant economic gurus meanwhile continue to preach deregulation of both the financial sector and of international commerce (i.e. "free trade"). Some of us have for a long time been saying that this behavior was unwise, unsustainable, unpatriotic, and probably criminal. Maybe we were right. The next shoe to drop will be repudiation of unredeemable debt either directly by bankruptcy and confiscation, or indirectly by inflation.

Ah, globalization - the con game of the century. Globalization is a ponzi scheme on the Trillions of Dollars scale - run amok. You can't continue to purchase consumer goods with decreasing income base UNLESS you do it on credit. Since we've already seen that we cannot continue to buy on credit (we don't have any more credit, and we can hardly afford the minimum payments as it is), that just leaves, ummm, greatly reducing our buying.

That means the whole consumerist materialistic more-is-more mentality is at epic FAIL status. Nobody NEEDS to get rid of perfectly good clothes and buy new ones every year. Nobody NEEDS to buy a new car every two or three years. Nobody NEEDS every latest computer software upgrade when the old ones work well enough. Nobody NEEDS HDTV, Cable, or Satellite. In fact, most people don't NEED a cell phone, either. Nor does anyone but the genuinely handicapped or elderly NEED a lawn service, routine dry-cleaning, or mega-maids to come and do their chores for them. Nobody NEEDS to go on vacation away from home. Nobody NEEDS to go to the movies. Nobody NEEDS an amusement park, either, or the opera, for that matter.

We COULD have supported more arts and entertainment and still live within our budgets, if we hadn't wasted so much money and racked up so much debt BUYING things we did NOT need. If we had only bought clothes and shoes when they wore out, if we had only bought cars when the old one left a string of internal parts strewn down the road, if we had only cooked our own food and done our own chores instead of farming them out. If we had modest weddings and other life events, instead of trying to have the biggest bash on the block. But no, we were greedy and lazy and wanted to be "in fashion," at any cost, because "everybody else" did. We didn't care what we could really AFFORD - we only cared how it LOOKED to people we hardly know.

And what a cost. We're going to be paying it for generations.

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