Monday, November 2, 2009

When Owing Money Means Nothing and Speculating is Everything

How Quantitative Easing Is Destroying the Economy, and We Are the Enablers

Radio ads can be a good barometer of the true state of mind of a populace.  This is especially true today.  “The big banks got their bailout”, says one.  “You can get yours”.  “You have the right to have your debts settled for pennies on the dollar”, says another.  Others proclaim “Rebuild your 401K”.  “These days, you must be a smart investor”.  “Buy and hold is dead”.   These ads now occupy perhaps 25% of the radio and television airtime in certain markets.  They are a very visible sign of a trend – that owing money means nothing in our society today, and speculation is everything.

Before we examine the ramifications of this, we must check our politics at the door.  Both left and right will find reasons to be offended and reasons to cheer what is discussed here. The destruction of the economy is not a typical left vs right issue, though politics certainly plays its part.  Rather, by following misguided ideals and belief systems, policymakers and populations of all stripes are causing a feedback loop (or unstable system) that is destroying the economy. This feedback loop is simple to diagram.  It looks like this:

The economy is being sucked into a black hole

Three groups are shown:  (1) The government and central banks (who are considered one for this discussion and who are largely unable to separate themselves from one another in the minds of the populace anyway), (2) individuals and businesses (the real economy of goods and services, or ‘Main Street’), and (3) credit giving institutions (primarily large investment banks, or ‘Wall Street’).  The straight arrows between groups represent the principal behaviour or obligation of the group to other groups.  Red arrows and bubbles represent decrease, green represents increase.  The curved green arrows represent self-reinforcing trends, or ‘inner loops’.
Setting the Stage. Maturing economies such as the US, Western Europe, and Japan, have transitioned from manufacturing and production to services. Emphasis has shifted towards consumer goods, real estate, and financial products and away from manufacturing.    Labor earnings have become flattened. Globalization, information flow, and population demographics have increased this trend, as emerging economies have embraced manufacturing for both their own needs and those of the developed economies.  As capital has flowed away from real economic activity toward services, the financial economy and emerging economies, a situation of over-indebtedness at all levels of mature economies has developed.  This is the giant debt bubble that policy makers are trying to keep inflated.  These trends have been evident for perhaps 20 years, and they set the stage for the current unstable feedback loop we are experiencing.  The cause and effect relationships causing the feedback loop are characterized by the following, all of which can be easily derived from the diagram:

1)      Easing Reduces Authority.  Governments and central banks have universally used low interest rates, money printing, bond sales, etc. to respond to over indebtedness, following a set of economic theories that they hold dear.  They use this money to give low interest loans on favourable terms to banks in the hopes banks will lend. But, as easy terms are extended to banks, government’s authority and legitimacy goes down.  This is because the populace (especially debtors) observe the government giving breaks to the banks and demand the same breaks for themselves.  They want their home loans modified.  They default, sometimes intentionally, on their credit cards. They choose bankruptcy.  They consider credit repayment unimportant. Owing money means nothing.  Governments and banks attempt to counter this, through stigmatizing non-repayment and placing too much emphasis on concepts such as ones ‘credit score’.  But the trend remains, and grows worse. Since the economy and businesses are made up of individuals making individual choices, this erosion of authority matters very much in the performance of the economy. Economists call this ‘moral hazard’, and may decry it, but few observe its very real negative effect on the economy.
2)      Speculating Replaces Credit. As economic conditions worsen and authority goes down and credit repayment goes down banks balance sheets worsen.  Banks respond by turning to ways to generate money that do not involve businesses or individuals (speculating in markets).  They also make less credit available. After all, who will loan money when owing money means nothing? Instead, they speculate.   Increased speculating is marked by the repeated blowing and deflating of asset bubbles, such as house prices, energy, and equities, as speculative money flows back and forth between asset classes.  It gives the illusion of economic activity, but it is not.
3)      Main Street Joins the Party. Some parts of the real economy may start speculating in order to try and join the party.  They do this through their ‘investments’, most of which are merely speculation on the movement of asset prices.  Even governments join the speculation through such mechanisms as retiree pension plans.  Speculation becomes the only game in town.  The financial component of the economy becomes bloated. Systems used to enable dearly held societal institutions, such as ‘home ownership’ and ‘retirement plans’ are set up to benefit speculation.  Speculation becomes an accepted norm in society as a part of a ‘financial plan’.  Individuals and businesses willingly give more and more of their money to the speculators, not wanting to miss out.  This also makes it very difficult to unwind speculation because doing so would impact parts of the real economy that are now entangled with speculators.
4)      Banks Turn to Influence Peddling. As repayment goes down and banks derive less and less of their money from credit extended to individuals and businesses, they turn to influence peddling to enable themselves to gain more ability to speculate and stay afloat and to game regulation to work in their favor.  This causes government authority to erode even further, as the populace comes to believe their government is ‘run by bankers’. 
5)      Taxes Drop.  As credit availability goes down and economic conditions worsen and government authority worsens, tax revenues to the government go down.  This is both due to declining business conditions and to tax avoidance.  After all, if the government has no legitimacy, why should one be obligated to pay taxes to it? Again, moral hazard affects the real economy.  Taxes on gains from speculation are unable to make up the difference, due to influence peddling by banks to gain tax-preferential treatment. 
6)      Main Street Turns to Subsistence. Businesses and individuals turn to subsistence behaviours such as saving, cutting expenses, etc.  These behaviours may be beneficial, but often the populace is forced into situations where subsistence becomes very difficult, marked by high unemployment, downward pressure on wages, and rising costs for essentials like food, shelter, medical care, and energy. This, in turn, lowers credit demand even further, forcing banks to speculate and more and more of the economy to become speculators. Businesses and individuals curtail risk and innovation, preferring a protective, muddle-through stance, which drops their tax revenues, and reduces their hiring.  ‘Zombie’ organizations become the norm.
7)      Government Increases Fiscal Risk and the Cycle Repeats. As tax revenues worsen, governments turn increasingly to fiscally risky behaviour, like foreign deficits, bank credit guarantees, and money printing. In other words, they do more easing. Under the current ideals and belief systems, money generated this way is largely turned over to the banks for use in speculation.  Some makes its way into the real economy as stimulus and relief, but by a large margin, it goes to the speculators, because policy makers are following belief systems that ignore the negative feedback loop.  This in turn drives the government authority down further, because the populace has enough information sources at its disposal to derive what is going on.  Economists are fond of making arguments as to why government money printing is OK, however, their arguments cannot account for the real economic effect of the erosion of authority and negative feedback loop that this causes.
The destabilizing feedback loop that is destroying the economy is evident.  The more governments respond to economic distress by easing monetary terms to banks, the worse the economic situation gets, and the more they cause the real economy to either turn to subsistence behaviours or to increased speculation.  Owing money means nothing. Speculation becomes everything. More and more money will accumulate in the speculative inner loop, and more and more parts of the economy will become entrapped in this loop. Speculators will survive for a while but the real economy worsens and becomes entrapped in the subsistence inner loop, where they may remain, even for a generation or more, as opportunity evaporates.

These trends seem destined to increase until (1) the populace tires of being forced into the Faustian choice of either subsistence or speculating, and revolts or (2) the speculation becomes unsustainable causing a massive, uncontrolled unwind.  Both conditions seem to be rapidly approaching, portending some truly frightening consequences.  This may happen soon, or it may take years.  But we are definitely moving toward some very unhappy outcomes. Unfortunately, due to the amount of erosion of authority that the government has brought upon itself, the government’s efforts to intervene will be less and less meaningful to the populace.  More of the populace will slide into subsistence or turn to speculation, not realizing that by joining the speculators they are enabling the very banks they blame for the problem and reinforcing the feedback loop that is destroying their economy. The only mechanism that could possibly reverse the feedback loop are:

1)      Government would have to re-establish authority and the notion that owing money does indeed mean something.  This could only be done by establishing this first for the banks – ie – reversing the bailouts, credit guarantees, favourable credit terms, etc. that have been granted in the name of the ‘emergency’ credit crisis.  Bank’s assets would need to be reckoned truthfully, instead of allowing them to make overly rosy assumptions that serve only to allow them to keep speculating. Since this would probably cause some part of the financial system to fail, so this could only be done by having alternative mechanisms of credit made available to the real economy while the cancer of the big banks is cut out and its entanglement with the real economy unwound.
2)      Individuals and businesses would have to realize that by willingly joining the speculation, they are in fact reinforcing the cycle that is destroying the economy.  They would have to rediscover the meaning of the term ‘investment’ and start investing their money in things that benefit the real economy rather than just joining speculators.  Innovation, not speculation. Notions like ‘timing the market’, ‘inverse positions’, diversification’, ‘managed risk’, etc,  would have to be reckoned for what they really are – non-value added speculation.  A new class of ‘economically responsible’ investment behaviour would have to emerge.  Thus starved of their fuel, the speculative large banks would die or shrink into institutions that benefitted society.
3)      Main Street would have to embrace new forms of economic activity. Deteriorating economic situations are marked by poverty in the midst of plenty.  This is where we are headed.  But the populace still has economic resources, in the form of labor, innovation, and capital.  These resources must be harnessed towards building new systems, new ideas, new economies.  Once we take it back from the speculators, we can put it to work.  We can connect with one another to rebuild what misguided behaviour has destroyed.
So there we have it.  Owing money means nothing and speculation is everything, which is a predictable outcome of the behaviour of governments, banks, and the real economy.  As long these trends continue, the feedback loop will ensure we remain in a worsening economic situation, which easing behaviours by governments will only make worse.  And, as long as the real economy sees fit to join the speculators, they will continue to willingly participate in their own economic destruction.  Every individual has choices to make.  They can choose to force their government to re-establish authority, which is clearly the right course.  They can choose to put their politics aside, roll up their sleeves, and do what is right to rebuild their economy. These are the easy choices, but the moral choices are more difficult. Each must choose whether to join the speculators or not. And each must choose whether their debt obligations are meaningful or not.  These are choices that are not easy to make, for they cross moral and financial welfare boundaries, and fundamentally affect livelihood. 

1 comment:

  1. Well, I feel like you have the causation wrong. But I don't want to go there because you have the end results right and the causation hardly matters. But there is, IMO, a much more clear explanation.

    The symbiotic relationship between finance and the economy becomes simply parasitic when finance becomes so large a part that the benefits of matching savors to investors is outweighed by the costs. It seems clear to me that the costs now outweigh the benefits and the financial sector should be reduced. I shouldn't have to look too far to provide examples. The fed & gobbernments "no banker left behind" policy prevents that adjustment and sacrifices savers and the productive part of the economy to the parasites.

    aka free Tibet