The Wealth Delusion

Often in these pages we have attempted to hammer home the difference between investment and speculation. The former creates wealth, the latter consumes it. The former is based on work, the latter is based on rents. Investment increases the wealth of society; speculation appropriates wealth created by others. It is a distinction that has been lost in the last 30 years, and with disastrous consequences. Just how much the line between investment and speculation has been blurred is documented by Tom Streithorst in the pages of The American Conservative. Tom points out that,

In the past four years, America’s 500 largest corporations made a profit of $2.4 trillion, more than 4 percent of GDP. Did they use it to increase productive capacity, improve quality, or strengthen their balance sheets? No, $1.7 trillion went for stock buybacks and $900 billion for dividends. Of the $2.4 trillion they made, they passed on $2.6 trillion to their shareholders. They gave away more than they made and invested nothing.
Investment, as defined by Adam Smith, Max Weber, and most economics textbooks, is the use of deferred consumption for the purchase of capital goods, which create a cash flow in the future. For the past generation, however, when most of us used the word “investment,” it meant that a greater fool could be found to buy our house or share of a derivatives contract for more than we paid.

A society that does not invest does not grow. It may appear to grow for a time, but this will turn out to be a delusion. The delusion is based on rising asset prices, which make people feel wealthier, even when they are actually poorer. So when a person rejoices that the price of his home has doubled, he does not think that so has the price of replacing it, so have the taxes, the insurance, and everything he puts in the home. He thinks that his home is his best investment, and that he doesn't really need to save; rising home prices will see him through retirement.

And yet, when his three-bedroom home doubles in price, does it magically become a six-bedroom home? Does its utility increase in any way? There may be some actual increase in value, due to population growth in the area, but the house in general is no more useful than it was at half the price.

The history of the real growth of the economy indicates why the recent asset inflation was not growth at all:

Barry Eichengreen, perhaps the leading economic historian of the Golden Age, tells us that much of the growth in Europe after World War II was due to a social pact. Labor agreed to restrain its wage demands, and in return, capital agreed to reinvest most profits into the business. As productive investment rose, so did worker productivity, and between 1950 and 1970 real wages more than doubled. Investment in productive capacity works: it makes the entire society richer—entrepreneurs, bankers, and workers alike.
That compact has broken down. As finance has grown to dominate the rest of the economy, with interest payments as a share of GDP rising from under 1 percent to over 16 percent, real productive investment has declined. If you build a factory or invent a new product using borrowed money, you create a cash flow that allows interest payments to be paid no matter what happens in the financial markets. But when “investment” creates no new productive capacity, when the link between financial investment and the real productive economy is broken, finance becomes a faith-based enterprise in perpetual asset-price increases. When that faith begins to crumble, the debt structure has no foundation to hold it up.

To those who understand the distinction between investment and speculation, the current crises comes as no surprise. But it also points to the way out of our dilemma, a way that is, alas, not being taken by the Obama administration:

The current crisis gives us an opportunity to rethink the link between the financial and real economies. For too long, those working in the productive economy of goods and services have subsidized bankers and traders who have done little to make the rest of us richer or more productive. Since we are bailing out their stupid bets, let us insist that from now on their investments serve our common future. We can no longer afford paper “investments” that merely represent a hope that since asset prices have gone up in the past, they will continue to do so forever.

6 comments:

JimB Wednesday, April 8, 2009 at 7:04:00 PM CDT  

The finance sector is only one part of an unholy trinity - the other two are the enviro”mental” movement and globalization or "free trade". All three have teamed up with one goal in mind - to bankrupt the West and establish a fascist "New World Order" of international finance and global governance.

Obama performed like a trained seal at the G20 to please the Malthusian population controlling corporate and banking oligarchs behind it all. He's the best President George Soros' money could buy, with the most pro-death, Harvard Yard/Wall Street cabinet ever assembled under one West Wing roof.

Thus more and more "wealth" will continue to be concentrated in fewer and fewer hands while the US assumes it's rightful place among the other Banana Republics in the New World Order, apologizing to the world for having had the audacity of daring to strive for a higher standard of living, and Obama will continue globetrotting as “Apologist in Chief” offering mea culpa’s and assuring the world that we WILL feel your pain as a penance for our past environmental sins.

So we will continue to dismantle our productive capacity, padlock our coal fired plants and pay triple for energy while we "invest" in "green" jobs and dutifully pay our "cap and trade" taxes to the WTO and IMF (which is really just the newest form of financial alchemy), trash the Constitution, and “harmonize” our laws with the “global community”, and hire 50,000 government workers to process the foreclosure notices the Chinese send to the Fed for all those empty subdivisions they financed. You can mail your rent payments to Hutchinson Wampoa c/o Timothy Geithner at the Treasury Dept. All while Al Gore and Prince Phillip laugh all the way to the bank.

Madoff and AIG bonuses (which amount to peanuts) make the headline news daily - while not one of the pinstriped bandits on Wall Street has done a "perp walk".

Obama, Geithner, “W” Bush, Paulson, Clinton (both), Larry Summers, Robert Rubin, Bush 41, Pelosi, Dodd, Bawney Fwank, Greenspan, Bernanke (and about half of congress) should be tried for treason.

I’m mad as hell and I’m not going to take it anymore.

Charlie Roy Wednesday, April 8, 2009 at 7:41:00 PM CDT  

The majority of my income is derived from trading agricultural futures options on the CBOT. I wonder daily about whatever role I play in the financial world and my impact. I am a professional speculator. I suppose my willingness to take on individual risk would be frowned upon by some. I've read "Small is Beautiful" and am an ardent believer in the Church's social teachings. I want to understand the Church's position on what I do every day. I'm told and I believe my willingness to take on risk by trading agricultural options allows hedgers, producers and consumers the ability to transfer risk and leads to greater price stability for the bulk of humanity. I'm quite talented at what I do. I want to leave the world better than I found it. I've thought about using my skills primarily to help Catholic institutions better position their endowments and savings in non-equity tied derivatives to avoid what has happened to many recently.

Any advice from one who knows and understands what I do and Catholic teaching thoroughly would be appreciated. It is always easy to write off the unscrupulous speculators as the cause of all evil but scapegoating one group never really works in the end. We can play the game of semantics with investing and speculating and in the end it is what it is.

John Médaille Wednesday, April 8, 2009 at 8:20:00 PM CDT  

Charlie, thanks for commenting. This is a good opportunity to address the issue in a specific case. As to your work on the CBOT, I don't know precisely what you do, but I can address the issue of futures contracts. This is to the limits of my knowledge, so correct me if I am wrong.

A futures contract is normally a contract to buy or sell a given commodity at a fixed price on a certain date. In itself, it is socially useful. The farmer gets a known price before he plants or otherwise sells. Therefore, he can plan and remove some of the risk from his operation. Note here that the contract is related to the underlying thing. This would be, in Aristotle's terminology, a natural exchange, one well related to the underlying commodity.

Now take the case of a pure bet on the market in, say, wheat. You offer a bet that it goes up and I take the bet. Neither of us has any wheat or any intention of acquiring any. Aside from our morning muffin and our evening pasta, we have no intention of going anywhere near real wheat. Further, your gains are measured by my losses, or vice-versa. There is no net gain to the social order, no real wealth produced.

As I understand things, this secondary market can greatly affect the primary market, and usually for the worse. But there is nothing wrong with the primary market, and much in its favor.

To take another example, hedges (insurance policies) were written on various securities. There is nothing wrong with a person who owns the security hedging his bet. But what happened is that people who did not own the security bought insurance on it nevertheless. Trillions of the stuff. It is analogous to the situation that would obtain if everybody in your neighborhood bought a fire insurance policy on your house. There is nothing wrong (and everything right) about you buying the policy, because you really own the house and would suffer real loss. But when everybody buys the policy, then one fire brings down the system, even though the policy holders suffered no actual loss. This is unnatural exchange; its only point is money, not the insurance of real assets.

Now, you can instruct me as to how this applies to the work of the CBOT. I suspect that both kinds of trading goes on there, especially since they added derivatives to their pure commodities trading.

JimB Wednesday, April 8, 2009 at 8:23:00 PM CDT  

Charlie a CSA (Community Supported Agriculture) is basically a "future". It's not so much what is being done that is the problem, it's the SCALE and proportion to the rest of the economy. It's totally out of whack to the point that we now have an inverted pyramid of financial alchemy that is expected to be supported by an ever shrinking “real” economy. It’s no longer sustainable.

As I see it all boils down to a centralization / de-centralization issue. Is the system going to be controlled from the bottom up (subsidiarity) or top down (fascism)?

With regards to what you do - my only comment / question would be how much of the product you trade is a result of corporate factory farms by companies like Monsanto who have monopoly patents on life itself (seeds & animal genetics which they use to bully small farms with lawsuits) vs. organic family farms.

Small may be beautiful - but "that dog don't hunt" in the global markets. With regards to social justice the former is unjust - the latter isn't.

JimB Wednesday, April 8, 2009 at 8:34:00 PM CDT  

Here's a real eye opening chart titled "Paper vs. Real Things"
from Catherine Austin Fitt's blog.(Click on the image for full size)

http://solari.com/blog/?p=2429

Charlie Roy Wednesday, April 8, 2009 at 8:49:00 PM CDT  

@ John
Essentially I am the one willing to take the risk from the farmer, grain elevator, or other speculator. I really am unable to know who is on the other side of my order. It may be Bunge, Cargill, or some other agribusiness firm but then again it may be some rich European speculator. I usually immediately hedge my bits by spreading my options via diagonal calendar spreads or directly in the futures market itself.

The futures markets are tied to primary goods- the real wheat, corn, and beans that are about to be planted etc.

I truly appreciate your fire analogy. I've never quite heard it explained that well. The CBOT does set position limits to alleviate this from happening. Unfortunately large hedge funds have used loop holes in the law to exceed these limits through non regulated OTC trades. The concern in the industry is the futures markets may lose all correlation to the actual underlying crop in which case they turn into a casino instead of a hedging mechanism.

The credit crisis has done much to harm the cash flows of elevators and their ability to hedge due to increased margin requirements and the joys of bankers freezing credit.

@JimB
I would have to say the majority of #2 yellow soybeans and corn are probably produced on large corporate farms. My family still owns farm land and I suppose because we cash rent to a large farming group our own land is used for these purposes. I've began to read a great deal lately on the issue and the importance of sustainability. I'll look forward to reading the link you've posted.

Be well and thanks for the feedback

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