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: 2/3^rds of the economy is consumption. No one seems to notice the frightening absurdity of this statement. If 2/3^rds is in consumption, then no more than 1/3^rd 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.