[R-G] [BillTottenWeblog] The Credit Crisis, Financial Assets, and Real Wealth

[Bill Totten]

by Herman Daly

Posted by Nate Hagens

The Oil Drum (October 07 2008)

Previously, Herman Daly wrote a guest post on the Steady State Economy
{1}, outlining core suggestions on how to overhaul our banking,
financial (and value) systems. I encourage everyone to read it (if short
on time, please read the conclusion). Professor Daly was Senior
Economist at the World Bank before leaving to teach Ecological Economics
at University of Maryland's School for Public Policy. He was also the
catalyst for me to leave my own financial career and return to school to
study the real economy (that is, what we call the human economy is only
a small part of a larger closed system). Below the fold are his thoughts
on the current crisis (current being defined as last thirty to forty
years or so). (For comparison, here are links to what 'mainstream'
economic icons George Soros, and Bill Gross are saying {2}.)

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 times
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. 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.

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 carbon dioxide). 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.

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.

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 two 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".

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 (that is, "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.

Notes:

[1] http://www.theoildrum.com/node/3941

{2}
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Gross+October+2008+Fear.htm


http://www.theoildrum.com/node/4617


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