Wednesday, April 7, 2010

Own the Fed, Part XVIII: The Great Recession

A number of economic downturns have been termed "the Great Recession." Usually this appears to be a derisive label assigned in view of the authorities' refusal to use the Dreaded D Word — "Depression." As the old joke has it, however, a recession is when you lose your job, a depression when I lose mine. The terminology used is pretty much a matter of personal preference.

Unfortunately, the current economic situation is no joking matter. Neither is it something that came from out of nowhere. On the contrary, the global financial crisis that the Federal Reserve claims began in the United States in August of 2007, and began to avalanche with a series of financial crises throughout the world, is the culmination of a series of events and the decisions made in reaction to those events by those in power for a full century.

Nor were these decisions made in isolation, but in obvious conformity to a specific orientation toward the role of the State and the place of the human person in society. This orientation is reflected most immediately in the understanding (or lack thereof) of the institutions of money, credit, and banking. Had the dignity of the human person instead of the demands of the State been at the center, the decisions would necessarily have been along completely different lines, and the outcome would have been substantially different.

Stated most simply, the understanding of money and credit (and, consequently, banking) that drove the decisions was responsible for their direction and orientation. Briefly, the common — and incorrect — understanding of money is that production is a derivative of money. That is, money must exist before there can be any production of marketable goods and services. This sets up an inherent contradiction, for in order to have an accumulation of money with which to finance capital formation so that marketable goods and services can be produced, it is necessary first to cut consumption of marketable goods and services. In other words, the common assumption is that you must first produce marketable goods and services before you can produce marketable goods and services.

Obviously, this is nonsense. Reality is exactly the opposite. Production is not a derivative of money. Instead, money is a derivative of production — the present value of existing or future marketable goods and services, to be exact. As Jean-Baptiste Say explained,
We do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for: to all those into whose hands this money afterwards passes, it is only the price of the productions which they have themselves created by means of their lands, capital, or industry. In selling these, they exchange first their productions for money; and they afterwards exchange this money for objects of consumption. It is then in strict reality with their productions that they make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands. (Jean-Baptiste Say, Letters to Mr. Malthus on Several Subjects of Political Economy and on the Cause of the Stagnation of Commerce. London: Sherwood, Neely & Jones, 1821, 2.)
The question then becomes understanding how we — and the Federal Reserve — ever got away from this common sense view of money and credit. The answer appears to lie in the attitude that developed at an accelerating rate in the 20th century, that the State is not only the guardian of the common good, but the provider of the common good as well as all individual goods.

There are, in general, two views of the role of the State. At one end of the spectrum is anarchy, in which there is effectively no State. Every human being is a law unto him- or herself, freely deciding which (if any) laws to obey as circumstances or personal preferences dictate. At the other end of the spectrum is collectivism, in which the individual is completely subsumed in an undifferentiated mass. In the former, there is no recognition of the human person as being in any way inherently social. In the latter, there is no recognition of human beings as "natural persons," that is, individuals with inherent or inalienable rights.

There is a third view of the role of the State. This is a position based on justice, a "Just Third Way." In germ, this was the understanding of Aristotle, best expressed (although not best understood by many people today) in the short observation, "Man is by nature a political animal." That is, human beings are both individuals with inherent rights, and social creatures who naturally come together to realize their fullest development as human beings within a social setting. Aristotle called this social setting the "polis," the city-state, hence the description of humanity as political animals.

Individuality implies inherent natural rights. On the other hand, our social nature implies the State. The former recognizes and protects our individual identity from unwarranted intrusion by other individuals, groups, or the State itself. The latter recognizes and protects the social order, within which we as moral beings acquire and develop virtue and so become more fully human.

What has this got to do with money and credit, and the role of the Federal Reserve? Everything. If we believe that responsibility for human development rests primarily with the human person, individually or in free association with others, then we necessarily hold that the State has a very limited role in both economic and (surprisingly) political life. The primary responsibility for both individual and general welfare rests with the human person. For individual welfare, the individual (as we might expect) is chiefly responsible, while for general welfare, the primary responsibility rests with the individual in free association with others.

The State's role in the Just Third Way is to safeguard the social order. That is, the State's job is to ensure that the system operates as it is structured in accordance with certain basic principles, of which justice is the most important. Except as a last resort in response to an emergency, and as a recognized expedient, the State is not to provide for individual welfare, whether of discrete individuals or individuals assembled in groups. The State's legitimate role must necessarily be limited to ensuring a "level playing field," policing abuses, and maintaining order.

If, however, we believe that responsibility for human development rests primarily with the State, a human creation (albeit in response to the social nature hard wired into us as human beings), then we necessarily hold that the State has the responsibility not only to protect and maintain the common good — the general welfare — but to structure the common good, and to ensure that all individual goods are provided to everyone. This orientation is loosely termed "equality of results," although true equality is often the last thing achieved.

Because equality of results (as opposed to equality of opportunity) is contrary to human nature, it requires an ever-increasing degree of State control and intrusion into the daily lives of the citizens to establish and maintain any degree of false equality. As Moulton commented in the 1930s in the wake of the virtual takeover of the financial systems by the State via the New Deal,
During the last twenty years central banks everywhere have become increasingly linked with government fiscal operations. In nearly every country there has been a decline in the proportion of credit granted to trade and industry as compared with that granted to the state. While the charters of most central banks contain restrictions with respect to state loans, such limitations have been impossible of enforcement in the face of the financial exigencies of recent times. Commercial banks are not only very large holders of government issues, but in the majority of cases they are under the practical necessity of underwriting huge current deficits. . . .

. . . with the coming of the world depression and the need of funds to support tottering banking institutions and relieve unemployment, control of government over the central banks once more increased everywhere. The extent of government control over the administration of banks varies considerably. In the case of state owned banks it is complete; in the case of the privately owned central banks the government commonly has representation on the Board. In most cases the presiding officer of the bank is appointed by, and is subject to removal by, the government. Thus the trend noted in the United States in preceding chapters is part of a universal phenomenon. (Financial Organization and the Economic System, op. cit., 429-430.)
What happened in the "Age of Deregulation" of the 1980s and 90s was that the financial services industry put immense pressure on the State to remove systemic, internal controls in the name of economic freedom. They especially targeted the Banking Act of 1933 — "Glass-Steagall" — and the Bank Holding Company Act of 1956 for repeal. The effective internal control measures of Glass-Steagall and the Bank Holding Company Act were replaced by ineffective "external" controls in the form of existing laws prohibiting conflict of interest — laws that were intended to function as backups to internal, systemic controls, not to provide the control. Conflict of interest is virtually impossible to avoid when it is built into the system by combining such incompatible elements as commercial banking, investment banking, and insurance.

A conflict of interest under the separation imposed by Glass-Stegall was painfully obvious, simply because it necessarily involved two or more discrete entities, and collusion between them was clear and apparent. After the full repeal of Glass-Steagall, whether or not a conflict of interest occurred became a matter of a judge's opinion. This became a very gray area, and not obvious at all. Whether a conflict of interest was deemed to have occurred sometimes depended on whether a financial services company was deemed "too big to fail," and thus immune from prosecution, or whether other political motives entered into the decision. The effect was to enable the financial services industry to enter into combinations that rivaled the power of the financial empire over which J. P. Morgan ruled in the early 20th century — and which caused the Panic of 1907.

Ironically, some very bad regulations were retained. These included such requirements as "equal opportunity" lending that lured financial institutions into lowering standards in order to comply with political directives not to discriminate in, e.g., housing loans or other consumer credit. This encouraged bad uses of credit and speculation, in preference to good uses of credit and productive investment.

Ultimately, expecting the State to assume responsibility for ensuring that no conflicts of interest occurred means that something is wrong only if you get caught — and sometimes not even then, especially if you are "too big to fail." There is also the far more fundamental problem that expecting the State to do everything, rather than assist an organized citizenry in setting up and maintaining a self-regulating system, leads to functional overload of a very powerful (and thus very dangerous) tool. The State, despite what its worshipers claim or believe, cannot do everything. Paradoxically, expecting the State to do everything leads to its being unable to do anything either effectively, well, or (eventually) at all.

This, then, was the setting for the global financial crisis. Depending on your source(s), the current recession began in the United States either in August of 2007, or a few months later, in December of the same year. By September of 2008 the crisis began to worsen at an accelerating rate, affecting most of the industrialized countries of the world. Economic activity slowed tremendously, assisted in no small measure by a number of factors reminiscent of those that preceded the Crash of 1929.

Significantly, the global economic environment was — and remains — characterized by serious imbalances. The most obvious of these imbalances is the growing "wealth gap" not just between countries believed to be rich and those considered poor, but most dramatically between ordinary citizens in presumably wealthy countries and the "super rich." The paradox of an allegedly wealthy country in which most of the citizens qualify as poor relative to the immense accumulations of the top tenth of one percent has ceased to be regarded as anything unusual.

Under the influence of Keynesian economics, the wealth gap is regarded as necessary, even beneficial by those in power. The alarming incidence of riches in the midst of poverty has ceased to alarm; disparities in wealth, far from causing politicians and policymakers grave concern, is viewed as a desirable state, and the wealthy an endangered species that must be protected to encourage economic growth.

The problem with regarding any class of persons as special and insulating them from their own folly is a clear signal of a badly structured social order. It encourages, even subsidizes bad and counterproductive behavior on the part of individuals and groups so protected. The welfare system and affirmative action, while there are some exceptions, have — as Alexis de Tocqueville predicted in his Memoir on Pauperism (Memoir on Pauperism: Does Public Charity Produce an Idle and Dependent Class of Society? New York: Cosimo Classics, 2006) — by and large destroyed the culture and sense of family and community of African Americans. (cf. Star Parker, Uncle Sam's Plantation: How Big Government Enslaves America's Poor and What We Can Do About It. Nashville, Tennessee: Thomas Nelson Publishers, 2005.)

Obviously, dependency on the State is not just for the poor any more. Treating wealthy stock market speculators as a special class has had a similar effect. Repealing Glass-Steagall and similar legislation, and shielding the gamblers from the consequences of their own irresponsible behavior encouraged speculation and discouraged productive activity. The returns on successful speculation are always immensely higher than what can be realized by producing marketable goods and services.

When the gambler is assured of winning whether the speculation makes or loses money, gasoline is poured on the fire fueling the mania. The government bailout of the savings and loan industry in the 1980s and 90s was tantamount to a virtual guarantee that the State would ensure that the financial industry would sustain no unacceptable losses. The sheer size of the new combinations and the degree to which the financial and economic well-being seemed dependent on the existing accumulations of savings controlled by the financial services industry made certain that the new financial monopolies would be considered too big to fail.

The blindness of both government officials and academic economists to the fact that existing accumulations of savings are not essential for financing capital formation shackled the global economy firmly to what Kelso and Adler called "the slavery of savings." The inevitable consequence of dependency on savings is that owners of savings must be protected at all costs — even if the result is to destroy the value of those savings, and even if the savings are not used for productive purposes and reinvestment, but for gambling and speculation. Boys will be boys. What are you going to do?

Consequently, the financial services industry in what might be described as virtual collusion with government agencies — the former motivated by greed, the latter by political expedience — promoted what can only be described as very bad, almost colossally stupid expansion of credit. Money was created in massive amounts through what has been described as "reckless and unsustainable lending practices." This was made infinitely worse by increasing State interference in the financial system, promotion of greater and greater amounts of consumer credit (and thus unserviceable consumer debt), and what proved to be a very dangerous development, the securitization of residential real estate mortgages, especially in the United States.

Through Fannie Mae and Freddie Mac the federal government had made home ownership a seemingly viable goal for the majority of Americans, especially those in the lower income brackets. Home ownership was touted not only as the best means of securing a roof over one's head, but as an important feature of retirement planning and thus an "investment." From regarding one's ownership of a home as a way of saving for retirement (which begs the question as to where one is supposed to live once the home is sold), to viewing it as a means of generating current income through speculation is a very short leap.

In the current financial environment that has confused speculation with true investment for generations, such a shift was inevitable. People who clearly could not afford what they were buying even at the true value were lured into purchasing homes far beyond their means. Making the situation worse was that this was in a market in which massive money creation was inflating prices far beyond the real value of the houses.

So-called "sub-prime mortgages," the chief means of financing purchases by unqualified buyers, had hidden, even unexpected triggers built into them. If the real estate market continued to rise without limit (much as speculators had been assured the stock market would continue to go up before October 1929), buyers could presumably refinance based on the increased value of the house. If they could not refinance, or preferred to make even more money, they could sell and pocket a substantial profit, which could then be used to leverage the purchase of another, even more expensive house.

To confuse matters even more, the sub-prime mortgages were bundled together with prime mortgages in a process called "securitization." This made the risks associated with such mortgage-backed securities extremely difficult to assess. Influenced by the financial euphoria, the U.S. mortgage-backed securities were marketed throughout the world. At the same time, massive money creation was also fueling global speculation in real estate and equity issues, driving stock markets to record highs. (The Florida land bubble that burst in 1925 as well as the 1929 Crash come forcibly to mind.) At the same time, in a series of events recalling the stagflation of the 1970s, oil and food prices began increasing rapidly.

The bubble was unsustainable, and it began to deflate rapidly in mid-2007. Losses on speculation in sub-prime mortgages revealed an entire superstructure of risky loans and grossly inflated asset values. When the venerable investment banking firm of Lehman Brothers filed for Chapter 11 reorganization on September 15, 2008, the inter-bank loan market went into a panic. Housing prices and values of equity shares on the secondary market plunged. Other financial services companies in the U.S. and Europe were hit with enormous losses as a result of speculative lending and money creation.

Many of these firms were faced with bankruptcy, only being rescued by massive State bailouts, the effect of which was to throw good money after bad. In September and October of 2008, for example, the Federal Reserve created money to purchase distressed assets, more than doubling the total factors supplying reserve funds, from $936 billion in August of 2008 to more than $1.9 trillion by the end of October of that year. ( The massive infusion of cash offset the deflation that would otherwise have occurred as securities and other assets settled to their proper values. This resulted in a type of "hidden inflation" by maintaining an artificially high price level for speculative assets.

With the emphasis on rescuing the speculators and gamblers, productive activity and new capital investment suffered. Just as in 1929, there was a sharp drop in international trade, commodity prices fell, and unemployment rose rapidly. Although the official line of the government has been that commercial banks are refusing to lend, the fact of the matter is that borrowers who seek to finance new capital formation are "refusing" to qualify. The productive sector does not enjoy the protections afforded to speculators and gamblers, and (just as in the Great Depression) lacks access to adequate or secure collateral. Government bailouts and guarantees have been reserved for the unproductive, not for the productive.

Although the end of the recession has been announced several times since mid-2009, this appears to be more wishful thinking on the part of economists, policymakers, and politicians than anything else. The underlying problems remain, and are even becoming worse as governments reinforce, even reward bad economic and financial behavior. The present Keynesian framework, although constantly touted as the only possible solution to the crisis, has only succeeded in making the inevitable crash much worse than otherwise would have been the case.

Nevertheless, there is a way out. It is still not too late to reverse course and implement a sound and rational program of economic recovery. The Capital Homesteading proposal developed by the Center for Economic and Social Justice ("CESJ") has the potential to reorient the global economy to comply with a more rational understanding of money, credit, and banking, and to establish and maintain an economically just future for all. Capital Homesteading includes a reform of the commercial and central banking systems of the world as an integral part of the program.


No comments: