The proposition that the near death experience of world finances in 2008 came from excesses that can be regulated away incrementally while restoring and preserving growth is destined to become a cherished exhibit in the Museum of Historic Misunderstandings.
Mix the documented vulnerability of the banking system, commercial real estate, mounting doubts about the creditworthiness of extravagant sovereigns with half-crushed balance sheets across the entire corporate spectrum; add the fuzzy surge of the next 30 months’ record-breaking credit needs and you will get an ominous cocktail of possibilities. It does not even smell good; nay, it stinks — like a flat-liner duck — since recent revelations that not only the dollar but also the euro is subject to large-scale, hostile speculations by the evil twin of transnational financial services.
In the United States, where trillions of bailout money is suspected to have been sucked into a black hole, “greed” is seen as the fountainhead of distress. Only hope for revitalized prosperity, and a short-term call loan extended to reformative undertakings keep the body politic from leaving the lounge without paying the bill.
Greed!? What does that explain?
It has been a constant component of human nature ever since the New Stone Age squeezed out prehistoric collectivism, and constants without variables have no explanatory power. If curbing the share-out of haute finance in the common weal were the only hindrance that bars everlasting economic growth (“equilibrium,” according to a favorite neoclassical phantasmagoria), we could indeed look forward to “peace in our time.”
Reason for concern runs much deeper. To put it on the table all at once, the breeding of toxic assets has been as much an intrinsic characteristic of the prevalent texture of global economic interrelationships, which must fill out in order not to mangle and unravel, as environmental toxification and the exponential depletion of nonrenewable resources.
To turn up the wattage on the raw uncertainty and angst not experienced since the 1930s we need to step away from the closed circuitry of received economic and political economic wisdom.
Any analysis that aspires to be relevant ought to be integrative and historical.
The financial crisis and the explosive rise in oil prices must be seen as related. Fragmenting the two, as if they came from two independent phenomenal domains, despite their temporal coincidence in 2008, is a greater offense against the requirement of keeping assumptions to a minimum in economic model building than hypothesizing their “co-integration.”
Breaking the lock on a-historic confinement
The global system that has worked well since World War II is becoming weak and it is “going, going” because it no longer corresponds to the institutional demands of a “full world.”
No imagined universal harmony through self-tuning interest rate differentials and the divine blessings of untrammeled competition among rugged, devil-may-care independent businesses with planetary reach in the service of misconstrued and truncated consumer sovereignty (dubbed “rational”) can prevent the exfoliation of political and cultural layers covering this core truth.
Do yourself a favor and “x out” the screen on reports, stop reading printed material, flip the channel on commentaries (no matter how transfiguring the sheen on their originators may be or how scholarly guileless they may appear) that argue exclusively with predictable-pattern-suggestive market historical parallels. (If you are a college student and your economics professor starts to explain the state of the world by scribbling some version of the Cobb-Douglas function on the blackboard, you may justly consider the gesture a profane mockery of reason and reality.)
In this spirit, let us sketch out the argument that the growing clout of the financial estate is rooted in systemic design; and, that the unwieldy, labile mega-structure it helped create began to crumble when the “grow or perish” economy ran into modernity’s first binding material constraint — cheap oil.
The “Old Deal”
From its inception, the postwar international monetary/financial system contained a fundamental structural asymmetry; viz., a single nation’s fiat money became the global currency. A rising tide of offshore dollar balances provided the liquidity needed in the rest of the world and the concomitant, automatic credit entailed by being the issuer of the “global currency” benefited the “System Administrator.”
The “Deal,” which had always been implicit, became somewhat less so following the 1971, so-called “collapse of Bretton Woods.” The system, of course, did not collapse. Rather it experienced a relatively smooth phase transition that allowed the world economy to get out completely from the straightjacket of growth- and public policy-constraining gold supplies.
Since 1971, movements on currency markets have served as the backstop signal generator to communicate demand for the shared medium of exchange. A lack of liquidity would appreciate the dollar; increasing U.S. imports, decreasing exports. The rest of the world would have its currency and the U.S. its debt (in one form or another), given that under the post-1971 flexible exchange rate regime the equivalence of current account deficit and capital account surplus became an internationally applied accounting convention.
Plenty of head scratching on both sides
The iron-law like tendency to push the U.S. current account (trade, at its core) into negative territory and keep it there has severely damaged the country’s manufacturing sector and has led to unmanageable levels of individual, business and government debt. Foreign-owned assets in the United States exceed U.S.-owned assets abroad by a large margin and an increase in the imbalance appears irreversible. The American public may justly regard as unacceptable the logical end-state of this unidirectional process.
Relative order (a condition of “stable disequilibrium” or “unstable equilibrium”) lived on borrowed time and now there is trouble with the “Deal.”
Net offshore dollar balances that accumulated from the expanding volume of sales on U.S. markets called for placement opportunities, far beyond what U.S. Treasury papers, corporate stocks and bonds could provide.
Risks associated with the growing aggregate heap of payment obligations further spurred their growth, and the relentless rise in oil (energy) prices that started at the beginning of the past decade contributed to the spur.
Consequently, the secularly rising demand for financial instruments has been the primary cause of their mass production. (Greed, always present like hot air, only moved into cool-headedly pinpointed, cumulatively growing patches of vacuum.)
Inevitably, the rest of the world’s dollar-denominated portfolio has become too big not to fail.
Much like in a Ponzi game, the exponential increase in the obligations by less than 25 percent (and shrinking) portion of the global economy to the more than 75 percent (and expanding) is credible only as long as the scheme expands; that is, until output growth is not in doubt.
And when does an economy that must grow under the penalty of ruin fall into disorder through an unparalleled bloating of payment obligations? “When the price of the globally narrow resource constraint — i.e., conventional oil — damages the profitability of production” may be a good place to start. It not only allows us to understand the collapse of investment banking but it also helps to see why a tightening of the leash on financial activities, securities trading; reforming accounting practices and modalities of risk management, in general, would fail to restore ante-financial crisis/ante peak oil conditions.
The shortage of cheap energy is the disease. The inflation and deflation of credit and all that political sound and fury are only symptoms that expose the general weakness of a world economy that must increase its mass and measure to prevent it from going into a collapse mode — income, employment, social safety net, et al.
Rolling up shirtsleeves to rock the boat big time
Latter-day economic historians will doubtlessly dwell on the curious phenomenon that the “Deal,” as such, had never been explicitly recognized by business, government, and the public at large.
Had it been otherwise, efforts over half a century to restore the U.S. trade surplus, which appeared so firm and natural following the War, through “opening markets,” “energy independence,” and other alluring policies would have seemed rather futile and naive even before being reported out of a congressional committee or seeing the daylight in executive orders. As hindsight reliably testifies, these policies were no match for the forces that kept the “Deal” in place and going.
But now, in the era of a never-before-seen economic setback that refuses to float away in the sea of cheap money, something has changed.
The new export drive announced by the current U.S. administration, which aims to double the nation’s sales abroad in five years, while creating 2 million jobs, goes far beyond the innocent hope that marginal measures could spontaneously develop into a D-Day class invasion of foreign markets. The announced program surpasses all previous attempts and, if it shows meaningful results, it could be the proverbial straw grown into a fully-dressed Chevrolet compact that would break the back of the camel — it could be the “Deal- breaker.”
What’s wrong with the “National Export Initiative?” Everything — almost!
Its success would undermine the dollar’s role as the world’s chief reference currency and medium of exchange; it would endanger the rest of the world’s ability to finance the U.S. budget deficit; it would prompt accusations of unfair trade polices; and, since it amounts to a “Re-industrialization of America,” it could, by itself, push the price of the barrel back above the red line where economic growth self-disrupts.
The announced program violates “subsidiarity,” an important principle in economic policymaking that stipulates maximum alignment between target level and authoritative competence. It amounts to a local (i.e., national) approach to the global problem of the financial/monetary system’s growing distortions.
This violation, while proving, among other things, how anarchic conditions can make intelligent people believe that they have discovered a way out of Death Valley when, in reality, they are moving deeper and faster into it, represents an inadvertent, unconscious, experimental search to reverse another, in the long run untenable, historical development:
The shift of systemic power from real to financial capital
The trend, with its built-in inclination to intensify, is deeply rooted in laissez faire – based economic organization and development. Already Marx and Engels were well aware that the lender of capital picks the most successful producing firms among would- be borrowers, and while the fortunes of industry and commerce shift the good-borrower status from one set of firms to another, the lender’s fortune remains undiminished.
Financiers have always had the added advantage of better information in search of capital gains — speculative profit in common parlance. Thus, from the get-go, banks held the commanding heights of the economic landscape. Of course, not all of them survived panics and general downturns. But the ruin of some benefited the strongest among them, establishing and maintaining the long-term trend of concentrating financial power.
The decline and fall of the gold standard that spanned three decades (from the early 1900s to the early 1930s) opened the door wide for transaction activities that have precious little to do with the effective allocation of resources.
How did Keynes, without doubt the clearest-eyed economist who ever walked into the Oval Office, say it in 1936?
“The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism.”
Then came the “Deal” and by the end of the 20th century, the political influence of the financial estate in American political life reached the point where it could break the leash of public control. The U.S. financial services industry’s share of corporate profits rose from a moderate one-tenth to a jaw-dropping 40 percent in the quarter century that ended with the dramatic fissure.
The growing might of the financial sector as an idiosyncratic side effect of entrepreneurial freedom has been part of the price society had to pay for the saturnian feats of capitalist economic development.
“Deal”-induced U.S. deindustrialization has been a major factor behind the financialization of the national economy.
When, as a result of losing export and domestic markets, the opportunity cost of activities associated with U.S.-based physical assets threatens to exceed the aggregate level of expected profits, corporations intensify portfolio management. They adjust capital structure, especially leverage (i.e., the debt/total asset ratio) in order to protect profits, stock values, and market shares.
Many industrial firms became financial service providers. General Motor’s involvement with such services far removed from facilitating car sales (e.g., mortgage financing, home insurance) is perhaps the most stunning and, in many ways, the saddest example in U.S. economic history.
The comprador intelligentsia got this one wrong too.
Mainstream economists have argued since the 1950s that market forces will reduce the importance of a firm’s financial structure. They prophesized, with remarkable doctrinal unity, that technical progress and entrepreneurial dynamism will diminish the relative significance of banco-financial activities.
The Modigliani-Miller, so-called “irrelevance theorem,” which claims that in a system of perfect markets corporate finances have little or no importance, laid the groundwork for a vast edifice of exegetic exploits. While Nobel Prizes and other academic distinctions were handed out, there seemed to be only one little problem: Mr. Perfect Market, whose address had always been unknown (presumably the same rabbit hole where it’s polar opposite — Mr. Real Socialism — resides), had never showed up.
Long suspected to be an elaborate plug for deregulating financial markets, the “irrelevance theorem” has finally lived up to its name.
“Whole lotta hucksterin’ goin’ on”
Based on data released by the U.S. Census Bureau, the dollar volume estimates of revenues earned from securities trading, commodity contracts and other financial investment activities (portfolio management and investment advice) grew steadily from $293 billion in 2002 to $464 billion in 2007 before dropping to $297 billion in 2008, owing largely to the recession that began in December 2007.
Taking these numbers as proxies for the cost of maintaining the functional integrity of a capital market deemed to be indispensable for the effective allocation of productive capital (structures, equipment, and software in nonresidential sectors, plus residential development) indicates a gross systems failure in the interaction between the economy’s tangible and intangible facets.
In 2007, at the height of the business cycle, following the previous recession early in the past decade, net private nonresidential investment amounted to $402 billion and net residential investment, to $332 billion. (Source: DOC/Bureau of Economic Analysis. The numbers are in volume-implying, chained 2005 dollars.)
The costs of letting the market guide the evolution of economic structure being comparable with the de facto allocation of productive capital? This is certainly not what Adam Smith had in mind when he argued way back in 1776 that society ought to trust its welfare to the unobstructed pursuit of self interest. Where are the times when decentralized decision making occurred on an economic proving ground that could be characterized by man’s innate propensity “to barter, truck, and exchange one thing for another”? Adam Smith and “too big to fail” panegyrists of free enterprise missed each other by well over two hundred years.
A highly suspicious “correlation of interest”
Change in revenues obtained from financial activities between 2002 and 2008 coincided with that in the price of oil.
The hypothesis that global oil production ran into a severe structural impediment midway through the past decade is consistent not only with the subsequently registered decline in economic growth but also with the intensification of financial activities. The murkier the business outlook, the more nonbanking firms become preoccupied with “risk management.” Future contracts and other derivatives (i.e., options and swaps), the vast and always expandable repertoire of investment banking and leveraged mortgage loans appear as solutions to stabilize earnings, cushion losses, and placate jumpy stockholders.
The rising tide of activities aimed at preserving the value of originally nonbanking, nonfinancial firms through adjusting the capital structure, current financing, and portfolio management, naturally lifts the demand for the services of the purely banking/financial establishment.
Eventually, the shrinkage of real production and the parallel acceleration of payment obligations had to result in calamity. It certainly did.
It’s already in the annals of economic history, but it is worth recalling, that cut-backs, defaults, and bankruptcies spread like an infection in an unaired room. Especially in the financial domain, our world of instant communications and speed-of-light transactions is ultra-repercussive and bent on amplifying initial disturbances in credit conditions and confidence into veritable tsunamis of storm and stress.
Peak oil and peak credit — inseparable but not equal
There is reciprocal causality between oil and credit.
Price signals obtained from oil markets and information (equivocal as it may be) about supplier inability to augment output prompt defensive measures that bloat the volume of financial transactions via commodity trading, hedging, betting, swapping bets, diversifying approaches to risk minimization. Venerable industrial firms become part-time financiers.
But as economic agents (including net oil-importing national governments) sense an increase in the implicit, crude ratio of the total value of monetary commitments to aggregate real output, they turn to commodities, with oil, the planet’s critical material resource, at the forefront of their attention. They bid up the barrel.
The process feeds on itself. Not only does a boost in the overall value of credit-debt pacts magnify the numerator, it also reduces the denominator by jacking up production costs. Not only does an increase in the price of oil prune the denominator, it also puffs up the numerator by luring economic agents to the “casino.”
The ascent of oil output towards its zenith and the descent of the utility of financial deals toward its nadir have been choreographed by the genesis of the prevalent global order. One of its defining attributes is that the quoted ratio can worsen even when all is quiet on the oil front. In particular, the unfolding disequilibrium inherent in the “Deal” may cause a spurt in promises to pay, leading to higher oil and other commodity prices.
Traditional economics does not see such a circular reference between oil and credit because its underlying credo prevents neurons from processing the possibility that material resources can stand in the way of everlasting economic growth. As is apparent from dominant analyses and daily commentaries, the conviction that the first grumblings of the financial firmament in 2008 heralded nothing more than the end of another credit cycle holds firmly in popular consciousness.
Primal matter holds sway.
Despite their stipulated organic unity, there is a hierarchical relationship between the real sector’s most binding material constraint (oil) and its most general financial constraint (credit).
Oil plays the leading part and credit the subordinate one for the simple reason that the marginal cost of the first is incomparably higher and its physical limits are decisively lower than those of the second.
A few touches on a computer keyboard can augment the sum of fiduciary bargains in a minute. If this act is based on information already collected, and is performed by a salaried employee in an office with set charges for overhead, the marginal cost is negligible. This is obviously not the case when it comes to increasing oil supplies upon which the expansion of industrial and agricultural output currently depends.
Mistakes will be made.
The world’s monetary-financial organization, sapped of its former resilience, is liable to undergo extreme changes. How these will occur and what they will bring cannot be predicted either by historical experience or via its disguised form, simultaneous differential equations. Nonetheless, scenarios in the evolution of profit-making opportunities through the multiplication of IOUs (or the many different names they are called) appear to fall into three categories of descending probability.
Contemplated measures to restrain over-exuberance in the credit-debit business falter on enumerated systemic obstacles in combination with the financial domain’s hypertrophied political influence to prevent any attempt to cramp its style. As U.S. external debt continues to build up and worldwide economic expansion pushes up oil prices, toxic assets, like a hydra’s million heads, grow back.
Harsh reforms over restrain transactions to the point where the dollar’s role as the main source of international liquidity is reduced. The ensuing adaptive scramble to draft other currencies to the global front runs into the issuing countries’ resistance to accept chronic trade/current account deficits. International trade and economic expansion suffer a setback.
The least likely scenario is that the revamped monetary-financial order finds a perfect balance between overfeeding and underfeeding the world with a goulash of IOU permutations. If such a miracle occurred, then medium-term fluctuation in the price of the critical natural resource would generate the global business cycle without interference from credit conditions. That is, high oil prices would disrupt growth; subsequent low oil prices would rekindle it.
