Economic Truth and the Bailout

To the surprise of absolutely no one, the Congress passed the bailout bill, now renamed a “rescue” act. Mind you, they did not do this easily. At first, they rejected the idea. Apparently, the original bill was far too stingy to the rich, so the Congress had to sweeten the deal by giving them another $100B in tax breaks, subsidies, and other earmarks. Nevertheless, the $800B package would actually be worth it if, as the candidates claim, it would really cure our financial hangover.

But it won't.

Or not for long. Congress has given $700B in booze to the Wall Street alcoholics; it will make them feel better for a bit, but it will cure neither their disease nor the country's illness. For a while, they will make loans. But the same underlying causes of the crises will quickly overtake the market once again and we will be right back were we started, only $700B further in debt. Or rather, more than a trillion further in debt, because we have already spent $350B+ in previous bailouts, none of which seemed to work very well; AIG, for example, has already burned through $61B of their $85B package and it is no closer to being stabilized. This is how collapses work: everything done to fix the problem makes the problem worse, because the real problem is not understood.

What is the real problem, the real cause of the crises? First, let us talk about the apparent cause, which isn't the real cause but only the symptom of a deeper cause. Nevertheless, any good doctor starts his diagnoses with the symptoms. And the obvious symptom that we see is the so-called subprime mortgage mess. Yes, it truly is a mess, a sizable mess. But is it sizable enough to be causing this problem by itself? There are, perhaps, $1.4T in outstanding subprime loans (out of a total mortgage market of perhaps $11T), of which 20% are likely to go into foreclosure. But let us say that twice that, or 40%, goes into the tank. That would still only amount to $560B in losses, even if every penny is lost, which of course it isn't. This is insufficient to explain the need for a trillion in bailouts.

But on top of the subprime loans, Wall Street built a vast pyramid of speculative bets, called “derivatives.” The loans were packaged into Mortgage Backed Securities and sold to investors; good loans were mixed with bad ones. But the presence of the bad loans undermines the whole package and makes it difficult to price. But the rot doesn't stop there. The mortgage bonds were “hedged” with complex instruments such as Credit Default Swaps, by which speculators are able to place bets on the direction of the markets. How big is this derivatives market? No one really knows, since it is completely unregulated and even unregistered. But there are at least $600T of nominal values in derivatives. By comparison, the GDP of the entire planet only comes to some $50T. Granted, the amounts at risk are far lower than the nominal values, less than 1%, but this is still a very large number. Huge amounts of money was lent to make these bets, and when the underlying security (the subprime loan) went bad, the whole structure collapses.

This gives us a good view of the immediate problem. However, if we stop our analysis there, we will miss the deeper and more pervasive cause. For now we have to ask, “Why did the banks and others make so many speculative loans?” These are, after all, intelligent and well-educated folks. Why make such absurd subprime loans in the first place, and why “double-down” on those loans with such complex speculative instruments? To blame it all on greed would be to miss the real point, to miss the deep predicament in which the bankers find themselves. Why did they make all these bad loans?

The answer is simple: “They have to. They have no other choice.”

Banks must lend money to stay in business. Ideally, they lend money for productive purposes, money to expand production and provide jobs, goods, and services to the economy. Second best is lending money to finance consumption. But suppose there is not enough productive uses for all the money. Suppose people do not have good enough jobs for the banks to finance consumption. The banks must still lend, productive capacity or not. In these circumstances, the banks must turn to speculators to absorb the excess lending capacity. They must lend or die, and if no one has a productive use for the funds, they must turn to non-productive uses.

Speculation is non-productive. True, a person can get very rich by speculation and many do. But in a speculative bet, one man's gains are measured precisely by another's losses; there is no net gain to the economy. You can get rich at the race track only because others got a little poorer; for every winning bet there are dozens of losers. But at least the race track track adds a real value—entertainment—to the economy. The derivatives add nothing.

Here is the Great Economic Truth that bankers and economists have forgotten: A nation grows wealthy only by producing things. Only through its farms, fisheries, forests, factories, and mines can real wealth be produced. Everything else, insurance, banking, education, housing, armies, government, churches, entertainment, etc., must live off the wealth produced in the fields, forests, factories, fisheries and mines of a nation. Without these, there can be no original wealth to support all of the other things.

Lending for speculation creates another problem. When a bank lends money it actually creates the money it lends. If it is lending for productive purposes, this is not a problem; the amount of money in circulation and the productive capacity of the nation will be tied together. But with loans for speculation, money is created with no corresponding increase in productive capacity. That is to say, the whole process is inflationary, and the root cause of the financial bubbles; prices go up in some sector for no apparent reason, and must sooner or later deflate; the bubble must pop. This is what happened in housing. When the economy began to falter in the early years of the Cheney-Bush regime, Alan Greenspan encouraged the banks to lower their lending standards and promised them that the regulators would look the other way. He urged them to provide new and exotic loan products. And the banks complied, because there didn't seem to be a better use for the money. Hundreds of billions were provided to the housing market, but there weren't enough solvent borrowers to absorb all that money. Hence, the banks continued to lend to weaker and weaker customers. The flood of funds drove up housing prices, and the housing sector drove the economy.

But this is economic nonsense. The housing sector should never drive the economy; rather, the economy should drive the housing sector. People should buy homes because they have good jobs and are getting good raises. But throughout this period, the median wage actually declined by $2,000 in real terms. The housing bubble occurred not because the real economy was improving, but because the banks were providing loans to an increasingly weakened consumer. And on top of these shaky loans, they were building a vast speculative pyramid. Now it is coming apart, for reasons which should be obvious to banker, politician and economist. But few of them comprehend the real problem.

The most frightening words one hears about our economy are the words one hears nearly every day: 2/3rds of the economy is consumption. No one seems to notice the frightening absurdity of this statement. If 2/3rds is in consumption, then no more than 1/3rd can be in production. This means that we consume twice (at lest) what we produce. This is, obviously, a recipe for disaster. And that disaster is now overtaking us.

The foolish doctrines of “free trade” and unregulated markets have denuded the country of good jobs and productive capacity. Our factories are shipped overseas, our farms are gathered into or dependent on vast corporate collectives known a “agri-businesses,” our mines and oil fields are played out or insufficient to support our consumption, our forests are not competitive with cheap foreign products, and our fisheries are over-fished and non-productive. These are the underlying problems we must face, and “fixing” the subprime mess will fix nothing, or at least nothing important.

To fix the problem, to restore our prosperity, we must restore our productive capacity. But to do this, we will have to break the power of the corporate collectives and the money-center banks. We have to ensure that no enterprise is “too big to fail,” and can hold the whole nation for ransom. But mostly, we will have to break the power of false economic theories, theories that have brought the country to the edge of disaster. If we do not repair the sources of our wealth, we will soon have no wealth. We will leave our children an economic desert.


Anonymous,  Saturday, October 4, 2008 at 12:09:00 PM CDT  

Only in America does the poor people paid more taxes than the wealthy class, but (for a while) everyone seemed to think (or to be fooled) that it was OK (because the wealth is trickling down). Only in this country does everyone sink deep into debts, borrow money (or for more catchy term "re-financing") to live but think that they're all in the "middle class" and on the way up and up (only if they work harder and have the so called "worker bee ethics"). To repay the debts, most people spent more time at work than at home. Without the job, there would be no affordable health insurance, and no social security safety net. Yet they were considered as "family values" and "Christian values". Anyone who has different opinion was shouted down as "liberal". And why "liberal" is bad? Most people have no idea what liberal means, but they think it was bad because lot of well-paid, corporate whores, talk show hosts told them so. The current economic truth is just a consequence of the nation's stupidity.

Ray Saturday, October 4, 2008 at 1:17:00 PM CDT  

Despite the stats, I still see high paying jobs posted on employment sites - (networking) (aggregated listings) (matches you to jobs)

good luck to those searching jobs.

Chuck Saturday, October 4, 2008 at 6:23:00 PM CDT  

It seems to me that another part of the solution is returning to what John Taylor of Caroline advocated at the beginning of the Republic: a wall of separation between business and the state. Businesses "too big to fail" got they way via privilege and patronage.

Excellent article.

David Sunday, October 5, 2008 at 12:18:00 PM CDT  

Is there a political candidate/party that we, as distributists, can vote for this November?

Donald Goodman Monday, October 6, 2008 at 11:49:00 AM CDT  


No political party that I know of that really matches distributism. The closest you'll come is the Constitution Party's candidate, Chuck Baldwin.

I think the best thing a distributist can do in these times is live our ideal, most especially, of course, the Faith.

In the practical realm, grow whatever food you can; learn a trade; become *productive* again. So many of us have lived for so long never producing anything of value (I'm an prosecutor, for example) that we forget that it's the bedrock of any sane society.

Garden; grow in pots if you don't have any land. Learn some productive trade if you can. That's the ticket out. Make yourself valuable not because of what you can get from others, but because of what you can *give* to others, namely, what you produce.

The Guild Master Monday, October 6, 2008 at 1:01:00 PM CDT  

An excellent summary of the problem that is simply not heard in the mainstream media. In Britain we have been following the attempts to get the bailout bill through Congress and were told that if America's economy were stabilised, it would mean more stable European economies. Of course, no such thing happened, and now we are in a worse mess with the German, Spanish and Irish governments underwriting all savers' deposits in all their countries' banks, causing an exit of deposits from British banks as they chase "security". Our own UK government is talking about taking a shareholding (with our tax money, please note) in all British banks! Nationalisation of the banking system by the backdoor and all to no good effect for the economy. Three years ago, I was talking to an acquaintance after Sunday Mass and we agreed then that the whole economic "boom" was built on an ocean of consumer credit, i.e. unearned pseudo-wealth. If we could see it back then, surely others could have done. As they say, there are none so blind...

A. Walsh,  Monday, October 6, 2008 at 6:37:00 PM CDT  

Thanks for your insightful comments John.
What really astonished me about the Bill (in addition to its core problems) was that congress members seemed to have a field day attaching their own pork barreling projects. For example: funding help for racing cars?!!?

Anonymous,  Monday, October 6, 2008 at 9:36:00 PM CDT  

You know nothing about economics.

Why did they make all these bad loans?

The answer is simple: “They have to. They have no other choice.”

Banks must lend money to stay in business.

Nonsense. If a company will lose money by making loans, then they won't make the loan in the first place. It doesn't matter if not making loans means not making money--they'll make money other ways. Banks also make money by investing. Have you taken a look at commodity prices? That would have been a great investment. Government bonds also yield an interest rate above zero.

Here is the Great Economic Truth that bankers and economists have forgotten: A nation grows wealthy only by producing things.

Also not true. Look at the countries with highest GDP per capita. What do they produce? Nothing. It's all about services. Some of them have no natural resources to speak of. GDP, by definition, is a measure of goods and SERVICES produced in a nation's territory. Services can bring in plenty of wealth.

Consider a book. You can learn from the book, and pass the book on to others. Hundreds of people can learn from the same book. Those people have a wealth of information that can give them skills that can be traded to other people. That's a service.

I'm not going to waste any more time with this. If you want to learn about the current economic crisis or how economies work, there is plenty of quality commentary out there, if you know where to look.

John Médaille Monday, October 6, 2008 at 9:53:00 PM CDT  

Anon says If a company will lose money by making loans, then they won't make the loan in the first place.

But they don't know that the loans will go bad, do they? They thought they had a perfect model with CDS's.

Have you taken a look at commodity prices?

Yes, I have looked at them. They are deflating. BTW, deflation is far more damaging to an economy than inflation.

Government bonds also yield an interest rate above zero.

Banks buy gov't bonds when they have no other use for the money, but they would go broke if all their money was in gov't bonds.

Services can bring in plenty of wealth.

They can, IF they have something to service. I don't know what countries you are talking about, but a "service economy" needs something to service, by definition. Without some source of original wealth from field, factory, forest, fishery, or mine, there is no service economy; all other professions depend on the wealth produced by these professions.

The Guild Master Tuesday, October 7, 2008 at 7:14:00 AM CDT  

Anon says If a company will lose money by making loans, then they won't make the loan in the first place.

But they don't know that the loans will go bad, do they? They thought they had a perfect model with CDS's.


I don't think Anon has been looking very closely at how the banks have been making loans in recent years, and what that tells us about the assumptions they have made.

Let's look at the property (real estate) market here in the UK. Now not so long ago, banks would insist on a 5 percent deposit from anyone wanting a mortgage - it was a sign that if the borrower had got together that sum he/she would have a better chance of keeping up the repayments - it showed good form. In the last 10 years many mortgages have been given by banks with a zero percent deposit, i.e. to people with no financial track record, a much higher risk bet. Secondly, until recently mortgage-lenders have only given a mortgage 3 times the annual salary of the borrower - a reasonable ratio if he is to pay it back over 20 years. Recently, banks have been giving mortgages at 5 and 6 times annual salary. In other words there was not a snowball in hell's chance of the repayments being kept up. So why did the banks start making these loans? Simple. They believed, as the government and their own "experts" had been telling them over and over, that real estate prices would
continue to rise ad infinitum. The "boom", we were told, was different from all previous booms in that this one was "sustainable". The banks depended entirely on house-price inflation outstripping the value of the mortgage repayments and that the housing boom would drive the rest of the economy leading to higher salaries, etc., etc. Now that kind of economic model is complete fairy tale stuff. It's up there with "perpetual motion" and other fancies. But the banks believed it and lent to some pretty desperate cases. The trouble was greed blinded them. The banker's dream had gone on for too many years for them to believe it could ever end. Remember, bankers are just as stupid as the rest of us. They make business mistakes just like the rest of us.

Anonymous,  Tuesday, October 7, 2008 at 7:32:00 AM CDT  


You need to get your stuff syndicated.

John & everyone else:

My wife and I recently attended a "Town Hall" meeting organized by the Ron Paul folks as they walked across Wisconsin to the Repubilican Convention...were they were snubbed.

The meeting was great in terms of organization. They had good speakers, music and a very nice slide presentation. Unfortuantely it led to the "free market" nonsense Ron equates with Liberty.

We should discuss similar organizing around the ProLife principles put forth by John.


Tom Laney

Athanasius Wednesday, October 8, 2008 at 3:17:00 AM CDT  

anon's response is a perfect example of why economic liberalism (free market nonsense) fails wherever it is tried. Economics is not reduceable to laws and math. There are no such things as "market forces" and the market does not "work", there are people who make decisions and manipulate trade to achieve affects. People do these things not markets! And as Guild master put it, bankers are just as imperfect as the rest of us. The fact that a common sense person would not lend money to a bad creditor does not mean that in no case would this happen. For one it did happen. Only the delusional would deny this. Loans are not determined by the market, they are determined by men who make the loans.

Consequently, just as I might make a loan expecting a return to my neighbor and then discover down the road that he can't pay and take a loss, so too the banks may make a loan expecting that money and necessarily take a loss when the creditor fails to pay up. This can happen under any economic system. The difference under a Distributist system vs. a Capitalistic one, is that if I make a loan and lose money, this does not cause the man who makes a loan across town to become insolvent, because by the principle of subsidiarity the smallest unit possible performs the action. In a market exposed to the predatory nature of free market thinking the bigger unit necessarily has advantages that it exploits, and consequently to make more loans must take on more clients and tie up its affairs with others. The existence of a unit "too big to fail" becomes paramount. This is not only the case with economic liberalism, but with any form of Capitalism which refuses to follow the principle of subsidiarity.

Then of course anon. scorns production, because every economic liberal hopes to make money by doing nothing (satire). The fact is that all economies are dependent on production, the problem for western free market elites is the production merely happens somewhere else. This has both the benefit of fueling the myths of their theories by exporting the prima facie evidence that they are false, and allowing them to overlook the gross social evils of their doctrine all with one fell swoop.

If the conditions experienced by workers in China for example, or Vietnam or Malaysia were experienced by Americans producing for a foreign power, there would be outrage! Yet it is production under the same detestable conditions which runs Walmart, which provides hardware and software for Circuit City, or pre-designed, carbon copy "do it yourself" equipment at Lowes. To modify a 90's expression, it is production stupid! The producing is merely done elsewhere.

If America were made up of small producers who individually produced their own livelihood, or else in partnership or co-ownership, this problem would not be happening. Production is superior to services (the latter of course must exist, but not as the dominant trade) and ownership is superior to indebtedness.

navkat Monday, March 2, 2009 at 5:18:00 PM CST  

What an excellent alternative to both Capitalism AND Socialism. I appreciate all of your readers' comments as well.

I went ahead and looked up Distributism and I must say: it makes a lot of sense. A system where society all takes ownership in production means that it behooves us all to BE productive and be good stewards of our collective future.

I have a lot of questions now and will be searching and seeking more essays like this to answer them.

Thumbs up on Stumbleupon and thank you.

Don Sabatini Friday, April 24, 2009 at 9:22:00 AM CDT  

Very good article Sir. And very true.

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