By Sell on News, a macro equities analyst. Cross posted from MacroBusiness
The global economy is not simply suffering from a European debt crisis. Debt itself is in trouble. This morning on Radio National there was an interview with David Graeber, Reader in Social Anthropology at Goldsmith University London and author of “Debt — the first 5,000 years.” Graeber, who is involved in the Occupy Wall Street movement. He made the point that debt is a promise and then asked the question: ”Why are some promises considered more important than others?” Why is a promise to repay to a bank considered inviolate, while the politicians’ promise to say, eliminate university fees (in the case of the UK) considered something easily broken because “circumstances have changed”.
It is a good question. Why does moral hazard apply to governments, as we are now seeing with Greece, but not to banks? You know, the ones that loaned to Greece. And farmed out the CDOs and the CDSs and on, ad infinitum in lighting the fire that led to the global financial crisis. The Greek debt crisis is still likely to be solved in the usual way: let the country default and then recapitalise the banks that had exposures. But that, again, leaves banks with no moral hazard (and remember, the GFC started when Lehmann Brothers was allowed to go down because regulators were keen to avert moral hazard — lesson, banks are not subject to moral hazard).
Graeber made the point, confirmed by others, that there have been periods in human history when money was driven by intangible agreements, credit. And there have been other periods when it was more a tangible thing to be exchanged, various iterations of what we now call cash. He also made the point that there is usually an institution that oversees the credit creation system to stop it getting out of hand. That is exactly what is lacking in the current global capital markets. There is nothing to oversee the hyper growth of derivatives or high frequency trading or endless debt games, because there is no global institution that equates with the global markets. It is a clash of the market state and the nation state (or regional quasi-state like the EU). The market state is winning, which is probably why we are all on the brink of losing everything.
The problem with the credit version of money is that its growth mens that eventually the sums do not add up. Compound interest always outpaces real economic activity; the two will eventually decouple. And when that happens, someone has to clear up the mess. Herman Maley, formerly an economist with the World Bank, makes this point:
““Capital,” says Frederick Soddy,”merely means unearned income divided by the rate of interest and multiplied by 100” (Cartesian Economics, p. 27). He further explains that, “Although it may comfort the lender to think that his wealth still exists somewhere in the form of “capital,” it has been or is being used up by the borrower either in consumption or investment, and no more than food or fuel can it be used again later. Rather it has become debt, an indent on future revenues…”
In other words capital in the financial sense is the future expected net revenue from a project divided by the rate of interest and multiplied by 100. Rather than magic stuff it is an indent, a lien, on the future real production of the economy — in a word it is a debt to be repaid, or alternatively, and perhaps preferably, to not be repaid but kept as the source of interest payments far into the future.
Of course debt is incurred in exchange for real resources to be used now, which as Soddy says cannot be used again in the future. But if the financed project can extract more resources employing more labor in the future to increase the total revenue of society, then the debt can be paid off with interest, and with some of the extra revenue left over as profit. But this requires an increased throughput of matter and energy, and increased labor — in other words it requires physical growth of the economy. Such growth in yesterday’s empty-world economy was reasonable — in today’s full-world economy it is not. It is now generally recognized that there is too much debt worldwide, both public and private. The reason so much debt was incurred is that we have had absurdly unrealistic expectations about growth. We never expected that growth itself would begin to cost us more than it was worth, making us poorer, not richer. But it did. And the only solution our economists, bankers, and politicians have come up with is more of the same! Could we not at least take a short time-out to discuss the idea of a steady-state economy?”
I am not sure that one should aim for a steady state economy, but there is no doubt at all that the creation of entirely new forms of leverage in the use of derivatives, high frequency trading et al. is not only unsustainable — we are still reeling from the effects of just one type of derivative, CDOs — but it represents an entirely new form of credit growth, a sort of hyper, hall of mirrors credit growth. This is not just the unsustainable curve of compound interest. It is compound interest multiplied several times, using mathematical models and computers.
To repeat, the daily cross border transactions in the global capital markets are about $US3.2 trillion. That is simply laughable, a collective insanity that could only ever have had one outcome and we are now seeing a glimpse of what that is.
Money itself is on the line. Equity capital is already in deep trouble. Peter Strachan, who runs a newsletter in Western Australia, has recently called for an alternative stock market in Australia (to the ASX and ChiX) that bans high frequency trading and CFDs and all the leverage games. Companies are sick, he says, of having price earnings ratios below 10, and dividend yields that are above 10. It may not be long before the Occupy Wall Street movement is matched by an Exit Wall Street movement instigated by big American companies.
But the bigger issue is what will happen to debt? Credit is the lifeblood of any economy, and blind governments have allowed credit itself to be debauched, all in the name of the absurd ideology of “free markets”. And the absurd notion that capital (that is agreements) is scarce. Maley found this out:
When I was in graduate school in economics in the early 1960s we were taught that capital was the limiting factor in growth and development. Just inject capital into the economy and it would grow. As the economy grew, you could then re-invest the growth increment as new capital and make it grow exponentially. Eventually the economy would be rich. Originally, to get things started, capital came from savings, from confiscation, or from foreign aid or investment, but later out of the national growth increment itself. Capital embodied technology, the source of its power. Capital was magic stuff, but scarce. It all seemed convincing at the time.
Many years later when I worked for the World Bank it was evident that capital was no longer the limiting factor, if indeed it ever had been. Trillions of dollars of capital was circling the globe looking for projects in which to become invested so it could grow.
That figure is now hundreds of trillions. It is time to stop these debt games and stop pretending that the tail can wag the dog.