From the Bubble Economy to Debt Deflation and Privatization
by MICHAEL HUDSON
The Federal Reserve’s QE3 has flooded the stock and bond markets with low-interest liquidity that makes it profitable for speculators to borrow cheap and make arbitrage gains buying stocks and bonds yielding higher dividends or interest. In principle, one could borrow at 0.15 percent (one sixth of one percent) and buy up stocks, bonds and real estate throughout the world, collecting the yield differential as arbitrage. Nearly all the $800 billion of QE2 went abroad, mainly to the BRICS for high-yielding bonds (headed by Brazil’s 11% and Australia’s 5+%), with the currency inflow for this carry trade providing a foreign-exchange bonus as well.
This financial engineering is not your typical bubble. The key to the post-2000 bubble was real estate. It is true that the past year and a half has seen some recovery in property prices for residential and commercial property. But something remarkable has occurred. So in this new debt-strapped low-interest environment, Hedge funds and buyout funds are doing something that has not been seen in nearly a century: They are buying up property for all cash, starting with the inventory of foreclosed properties that banks are selling off at distress prices.
Ever since World War II, the operating principle of real estate investors is never to use their own money – or at least, to use as little of their own as possible. Debt leveraging leaves the rental income paid to the banks as interest. The absentee owner is after the capital gain at the end of the bubble’s rainbow. That is what a bubble economy is all about. But the only way that investors can obtain current returns above today’s miniscule rates is to buy assets directly for cash.
In a bubble economy, falling interest rates (e.g., from 1980 to today) almost guarantee capital gains. But today’s near-zero interest rates cannot fall any further. They can only rise, threatening capital losses.
That is what is panicking today’s bond and stock markets as the Fed talks about ending QE3’s near-zero interest rate regime. So there is little incentive for bond buying. Once interest rates rise, we are in an “anti-bubble” economy. Instead of capital gains driving “wealth creation” Alan Greenspan style, we have asset-price deflation.
In the bubble economy, families became convinced that the way to build up their wealth was to borrow as much as they could to buy the most expensive home they could, and ride the wave of asset-price inflation. But since 2008, consumers have paid down about $5 trillion of personal debt. This has meant using their wages and other income to pay down mortgages, student debt, auto debt, credit-card debt and other bank loans. This leaves only about a quarter of the typical family’s paychecks to spend on goods and services after paying the Finance, Insurance and Real Estate (FIRE) sector and the taxes shifted onto wage earners and consumers. The outlook looks dim for corporate sales and hence earnings. So instead of debt-leveraged inflation of asset prices, we have debt deflation of the overall economy.
To put this in perspective, from 1945 until interest rates rose to their peak in 1980, there was an almost steady 35-year downturn in bond prices. The Bubble Economy was fueled by interest rates being rolled back down to their 1945 levels and even lower. Credit flowed into the financial markets to buy stocks, peaking in the dot.com bubble in 2000, and then to inflate the 2001-2008 real estate bubble.
So we are now in is the Bubble Economy’s legacy. We can think of this as Phase 2: repayment time, along with foreclosure time. That is what happens in debt deflation. The Obama Administration has broken its 2008 campaign promises to Congress and to voters to write down mortgage debt to the ability to pay or to market prices reflecting realistic rental values. The debt legacy has been kept in place, not written down.
Carrying this debt overhead has caused a fiscal crisis. The financial and real estate bubble helped keep state and local finances solvent by providing capital gains taxes. These are now gone – and properties in default or foreclosure are not paying taxes. And whereas public pension funds assumed an 8+% rate of return, they now are making less than 1%. This has left pensions underfunded, and prompted some municipalities to engage in desperate gambles on derivatives. But the Wall Street casino always wins, and most cities have lost heavily to the investment banking sharpies advising them.
In place of a new bubble, financial elites are demanding privatization sell-offs from debt-strapped governments. Pressure is being brought to bear on Detroit to sell off its most valuable paintings and statues from its art museums. The idea is to sell their artworks for tycoons to buy as trophies, with the money being used to pay bondholders.
The same dynamic is occurring in Europe. The European Union and European Central Bank are demanding that Greece sell off its prime tourist land, ports, transport systems and other assets in the public domain – perhaps even the Parthenon. So we are seeing a neo-rentier grab for basic infrastructure as part of the overall asset stripping.
This is a different kind of inflation than one finds from strictly financial bubbles. It is creating a new neo-feudal rentier class eager to buy roads to turn into toll roads, to buy parking-meter rights (as in Chicago’s notorious deal), to buy prisons, schools and other basic infrastructure. The aim is to build financial charges and tollbooth rents into the prices charged for access to these essential, hitherto public services. Prices are rising not because costs and wages are rising, but because of monopoly rents and other rent-extraction activities.
This post-bubble environment of debt-strapped austerity is empowering the financial sector to become an oligarchy much like landlords in the 19th century. It is making its gains not by lending money – as the economy is now “loaned up” – but by direct ownership and charging economic rent. So we are in the “economic collapse” stage of the financialized bubble economy. Coping with this legacy and financial power grab will be the great political fight for the remainder of the 21st century.
NEW BOOK: This collection contains the most important interviews and speeches that Professor Michael Hudson, Distinguished Professor of Economics at the University of Missouri (Kansas City), and president of the Institute for the Study of Long-term Economic Trends (ISLET) has given over the past decade (2003-2012). They span the political spectrum from COUNTERPUNCH.COM and KPFK radio’s GUNS AND BUTTER to iTULIP.COM and SANKT GEORGE in Berlin. It also includes his now-famous Rlmini, Italy, speeches that were given at a packed sports arena in early 2012 on the topic of how finance capitalism is pushing the world, starting with Europe, into austerity and neo-feudalism.
Michael Hudson is Distinguished Research Professor of Economics at the University of Missouri, Kansas City and president of The Institute for the Study of Long-Term Economic Trends (ISLET). This is the first chapter of his book “Finance Capitalism and its Discontents,” published by ISLET in November 2012.
Suppose you were alive back in 1945 and were told about all the new technology that would be invented between then and now: the computers and internet, mobile phones and other consumer electronics, faster and cheaper air travel, super trains and even outer space exploration, higher gas mileage on the ground, plastics, medical breakthroughs and science in general. You would have imagined what nearly all futurists expected: that we would be living in a life of leisure society by this time. Rising productivity would raise wages and living standards, enabling people to work shorter hours under more relaxed and less pressured workplace conditions.
Why hasn’t this occurred in recent years? In light of the enormous productivity gains since the end of World War II – and especially since 1980 – why isn’t everyone rich and enjoying the leisure economy that was promised? If the 99% is not getting the fruits of higher productivity, who is? Where has it gone?
Under Stalinism the surplus went to the state, which used it to increase tangible capital investment – in factories, power production, transportation and other basic industry and infrastructure. But where is it going under today’s finance capitalism? Much of it has gone into industry, construction and infrastructure, as it would in any kind of political economy. And much also is consumed in military overhead, in luxury production for the wealthy, and invested abroad. But most of the gains have gone to the financial sector – higher loans for real estate, and purchases of stocks and bonds.
Loans need to be repaid, and stocks and bonds receive dividends and interest. For the economy at large, people are working longer just to maintain their living standards, which are being squeezed. Women have entered the labor force in unprecedented numbers over the past half-century – and of course, this has raised the status of women. Mechanization of housework and other tasks at home has freed them for professional life outside the home. But on balance, work has increased.
What also has increased has been debt. When World War II ended, John Maynard Keynes and other economists worried that as societies got richer, people would save more. For them, the problem was to keep market demand high enough to buy all the output that was being produced.
And indeed today, markets are shrinking in many countries. But not because people are saving out of prosperity. The jump in reported “saving” in the National Income and Product Accounts (NIPA) in recent years has resulted from repaying debts. It is a negation of a negation – and hence, a statistical “positive.”
Paying off a debt is not the same as building up liquid savings in a bank. It reflects something that only a very few economists have worried about over the past century: the prospect of debts rising faster than income, leading to financial crashes that transfer property from debtors to creditors, and indeed polarize society between what the Occupy Wall Street movement calls the 1% and the 99%.
What also was expected universally fifty years ago – indeed, until about 1980 – was that governments would play an increasingly important economic role, not only as forward planners but as direct investors in infrastructure. To Keynesians, government spending served to pump money into the economy, maintaining demand and employment in cyclical downturns. And for hundreds of years, governments have undertaken basic infrastructure spending so that private owners would not use monopoly privileges to charge economic rent.
Nearly all observers expected the fruits of technology to trickle down, not be siphoned up to the top, to the banking sector whose “financial engineering” played no directly technological role in the production process. Textbook models describe – or rather, assume – that rising productivity will be passed on to labor in the form of lower prices (reflecting falling costs of production, enabling wages to buy more) or, if prices are “sticky,” higher wages.
According to what the textbooks called Say’s Law, there is a circular flow between producers and consumers. Workers must be able to buy the results of what they produce. This correlation between output and consumption goes back to the Physiocrats prior to the French Revolution, who created economics and account keeping. Their founder, François Quesnay, was a medical doctor and a surgeon. He created the basic format of national income accounting on the analogy of the circulation of blood within the body. An increase in production had to find its counterpart in increased consumption, creating its market by paying workers who spent their wages on buying the products they produced.
Working harder, producing more, but going into debt to buy it
After World War II many women stayed home and raised families. But since the 1950s they have been forced increasingly into the labour force for what are called two-job families – and now, three-job families (with only two family members). If you project labor participation rates, by the year 2020 every woman will have to work 18 hours a day or economic trends will falter.
What was applauded as a post-industrial economy has turned into a financialized economy. The reason you have to work so much harder than before, even when wages rise, is to carry your debt overhead. You’re unable to buy the goods you produce because you need to pay your bankers. And the only way that you can barely maintain your living standards is to borrow even more. This means having to pay back even more in years to come.
That is the Eurozone plan in a nutshell for its economic future. It is a financial plan that is replacing industrial capitalism – with finance capitalism.
Industrial capitalism was based on increasing production and expanding markets. Industrialists were supposed to use their profits to build more factories, buy more machinery and hire more labor. But this is not what happens under finance capitalism. Banks lend out their receipt of interest, fees and penalties (which now yield credit card companies as much as interest) in new loans.
The problem is that income used to pay debts cannot simultaneously be used to buy the goods and services that labor produces. So when wages and living standards do not rise, how are producers to sell – unless they find new markets abroad? The gains have been siphoned off by finance. And the financial dynamic ends up in austerity.
And to make matters worse, it is not the fat that is cut. The fat is the financial sector. What is cut is the bone: the industrial sector. So when writers refer to a post-industrial economy led by the banks, they imply deindustrialization. And for you it means unemployment and lower wages.
Financial dynamics vs. industrial dynamics
The accumulation of payments on interest-bearing debt leads companies to search for new loan markets, just as industrialists seek out new markets for their expanding output. This search means looking for assets in place to be pledged as collateral. The largest asset in any economy is real estate – mainly the land’s site value. So about 80 percent of bank loans are mortgage loans. But by 1980 property prices had turned down as interest rates rose during the Vietnam War and the general Cold War buildup throughout the world. Overseas military spending obliged the Federal Reserve to raise interest rates to borrow abroad to prevent the dollar’s exchange rate from declining.
So in the 1980s banks found a new market: corporate raiders treated companies much like real estate, to be bought on credit and managed to create a capital gain. The rise in interest rates to 20 percent by 1980 forced most states to revoke their usury laws, and credit card companies played states against each other in a race to the bottom when it came to protecting consumer rights. So the high-interest junk bond was born, largely at the hands of Michael Milken’s gang at Drexel Burnham.
American industry began to be financialized (and in the process, criminalized). But running a company to make a financial gain is different from running an industrial firm to expand production. Cash flow that was not paid to bankers and bondholders for the credit to buy out stock holders was used for purposes other than direct capital investment – above all for stock buybacks to support their price, and for mergers and acquisitions to acquire yet more companies.
The aim was not to increase production but to increase balance-sheet wealth – while extracting revenue from companies much like landlords bleeding a building. That is the time frame of finance capital, in contrast to industrial capital. It is short-term, not long term. This is why it is extractive rather than productive. The revenue has no counterpart in new direct investment in output, but rather in overhead debt extracting a rising flow of interest from the economy.
“Wealth creation” by debt leveraging – that is, asset-price inflation – was celebrated as a post-industrial economy, as if this were a positive and natural evolution. But in reality it is a lapse back into a rentier economy, and even into a kind of neofeudalism. The post-2008 bailouts have vested a new rentier elite to lord it over the 21st century, thanks to the fact that most gains since 1980 have gone to the 1% – mainly the financial sector, not to the 99%.
In the end this shrinks the economy – and that means that more and more loans will go bad, until crisis levels are reached at the point where lenders realize that there is no more room to extract more, and stop lending. But in the absence of government budget deficits, bank lending is the only support for demand – so the financial rug is pulled out from under the economy. That is the point at which banks demand bailouts – giving them the money, rather than giving the economy the revenue to spend and pull itself out of depression. So government debt is increased by giveaways to the banks, not by spending into the “real” economy.
Economics textbooks teach supply and demand curves. Every marginal increase in supply lowers the price of what is being supplied. For the job market this means that the higher the unemployment rate, the lower wages will fall. Conversely, the more workers you hire, the more you have to pay to attract workers. Government officials and bankers are indoctrinated in these textbooks and conclude that the less employment there is, the more wages will fall – thereby presumably leaving a wider profit margin, assuming that the goods can still be sold at a steady price. So employers seek to earn more by keeping employment low enough to prevent wages from rising. This maximizes the power of wealth over labor.
Economists conclude that to make economies more competitive, they need to keep wages low so as to undersell other countries. So a race to the bottom develops. But what seems to help countries compete actually hurts their domestic market.
Back in the 19th century this was called the reserve army of the unemployed. Unemployment keeps labour down. And even more important, to the extent that incomes do rise, they are paid out as debt service. A dynamic is put in place in which debt keeps labor down – not only by eating up its wages in debt service, but in making workers suffer sharp increases in the interest rates they have to pay or even risk losing their homes if they miss a payment by going on strike or being fired. Alan Greenspan explained that unemployment was not needed to keep labor down these days. All that is needed is to traumatize and disable them politically by debt leverage. (Quote his Senate testimony)
This is why, despite the fact that productivity has risen so dramatically, the real economy and its wage levels have tapered off in an S curve. The magic of compound interest has increased debt (and the savings of the 1%) to more than absorb the productivity gains. And this financial overgrowth has accrued to the 1%, not to the 99%.
Finance is what makes today’s economy different from that of 1945. We are at the end of a long cycle. Back in 1945 the private sector in every country was relatively free of debt. There was little civilian output for consumers to buy during the wartime years. Companies had little reason to invest, except for the government’s military demand. So most families had little debt – and a lot of savings, and good job opportunities after the return to peace. But today the economy is in reverse. Savings have been run down and consumers, real estate and industry is left in debt.
Untaxing land rent and monopoly rent so that it can be paid to the bankers, not to government
???To stop this reversal, it is necessary to understand its causes. They are not only financial. The banking interests have gained sufficient power to distort tax policy, creating a dual fiscal-financial problem. Taxes have been shifted off the major bank customers – real estate and monopolies – onto labor and consumers. In the United States, two-thirds of state and local tax revenues in the 1930s came from the property tax. Today the proportion has fallen to only one-sixth. States and cities replaced property taxes with income and sales taxes. Europe and the post-Soviet economies have adopted the most anti-labour tax of all – the value added tax.
The rationale is that it is easy to collect. But it falls on consumers, not on the economy’s free lunch of economic rent as advocated by classical free market economists. The value added tax adds to consumer prices and shrinks the market, preventing labor from buying the goods it produces. This is done simply to free more land rent, natural resource rent and monopoly rent from taxation so that it can be paid to bankers as interest.
When voters threaten to elect politicians to pursue less bank-friendly policies, the EU announces that the country needs a technocrat to impose more taxes to bail out the banks for their bad loans. It is all in vain without changing the system, because today’s financial business plan cannot work for more than a short time. Being extractive rather than productive, it leaves a swath of bankruptcy in its wake. Yet it is the banks that the technocrats are saving, not labor and industry, the “real” economy’s employment, social spending and public wealth.
Changing Social Security from being paid out of progressive taxation to a regressive labor tax
In 1982, bank lobbyist Alan Greenspan was appointed to head a U.S. commission to shift Social Security out of the public budget (where it was funded largely by progressive taxation) and fund it by user fees that fall on employees and employers. The aim was to privatize it Chilean style. Wall Street’s dream is to turn wage set-asides over to money managers to buy stocks and create a stock market boom (and in the end, siphon off commissions and push contributors into high-risk bets on the losing side of the deal with large financial institutions, Goldman Sachs style). In effect, Mr. Greenspan’s position was that Social Security should not be a public service. It should be a user fee, so that prospective retirees would pay for it in advance. Their savings were to be lent to the government to enable the Treasury to slash taxes on the higher income and wealth brackets. So the effect was to reverse the long trend toward progressive taxation.
The upshot of the Greenspan tax increases (only on labor, not on wealthy earners) was to create a budget surplus for the Social Security Administration, enabling the government to cut taxes on real estate, on finance, and for the rich in general. Capital gains taxes in particular were cut in half. And real estate investors (absentee owners, not homeowners) were allowed to pretend that the value of their holdings were depreciating rather than rising in price, by junk accounting based on junk economics.
The end game came when the Bush and Obama administrations announced, in effect, “We’re broke. So now we have to balance the budget by cutting social spending and raising the Social Security tax further. We’ve cut taxes on the rich by so much that the workers have not paid enough to cover this give-away, not to mention fighting the Bush-Cheney war in Iraq and the Obama Administration’s war in Afghanistan – or for that matter, the class war against labour.
Under Pension Fund Capitalism, employees are encouraged to think of themselves as capitalists in miniature – and provide for their retirement by employee stock ownership programs rather than saving up their wages themselves or having pensions financed on a pay-as-you-go basis out of future production. The idea is to make money from money (M->M’), not by producing commodities (M-C-M’). In America, half the employee stock ownership plans (ESOPs) have gone bankrupt, mainly by being grabbed by the corporate employers. Corporate raiders borrow credit from bankers and bond investors to fund management buyouts. The plan is to buy out stockholders, pledging the earnings to pay out as interest. And not only earnings; they loot the employee pension plans. George Akerlof won the 20– Nobel Prize for describing this. But novelists have recognized it more than economists. It was Balzac who said that behind every great family fortune is a great theft, often long forgotten to be sure.
Today’s economy is based on theft under the euphemism of “free enterprise.” It’s sometimes called “socialism for the rich” because they receive most government subsidy. But it’s not the kind of socialism that people talked about a hundred years ago. It is a travesty of social democracy and socialism. In a word, it’s oligarchy. But we’re living in an Orwellian world. No party calls themselves fascist today, or even anti-labor. They call themselves social democracy. But it’s the opposite of what social democracy meant in the 19th and early 20th century.
Social Security has not yet been privatized, but education has – not only privatized, but financialized. Students no longer get free or low-priced education. In order to qualify for professional jobs in America, they have to take out loans that put them deeply in debt. Then, when it comes time to start a family, they have to take on a lifetime 30-year mortgage debt. They need to take out an auto loan to buy an automobile to drive to work, especially where public transportation has been dismantled as in Los Angeles. And when their paychecks are squeezed more, they can maintain their living standards and social status only by taking on credit card debt.
Paying the carrying charges on this debt diverts spending away from the goods and services that employees produce. The result is debt deflation. Employees have less and less ability to buy what they produce – except by taking on even more debt. That’s why banks and bondholders have ended up with the increase in productivity – almost synonymous with the 1%. They are the core of the Finance, Insurance, and Real Estate (FIRE) sector that now absorbs most of the economic surplus in the form of various types of economic rent: land and natural resource rent, monopoly privilege and financial overhead.
The inversion of classical free market reform to its diametric opposite
Classical political economy sought to mobilize democratic government to tax the rentiers: landlord, monopolists and bankers. The objective was to create an industrial surplus and, in the process, raise productivity, wage levels and living standards. To keep prices low and hence national economies competitive, governments were to undertake society’s largest spending programs: basic infrastructure such as transportation, power production, communications – all of which happen to be natural monopolies as well. So the aim was not only to provide basic infrastructure needs freely or at subsidized prices, but to prevent private owners from erecting tollbooths on roads and charging monopoly prices for power, phone systems (as in Telmex in Mexico or similar phone monopolies in the post-Soviet kleptocracies).
Post-classical economics (deceptively called neoclassical) seeks to untax the rentiers, and shift the costs of government onto labor and even onto industry. To achieve this, democracy is rolled back to oligarchies. But this time they are controlled not by landlords as in the case of Europe’s landed aristocracies, but bankers and financiers. And their aim is to privatize the public domain with its monopolies. Bankers advance the credit to buyers, who install tollbooths and raise prices for basic needs. By paying out their revenue in a tax-exempt form, as interest, they keep their income out of the hands of government – forcing national treasuries to tax labor and industry, consumers and producers rather than finance, insurance and real estate. Governments thus become the protectors of monopoly and its financing.
It is a short-term policy. By raising domestic price levels, financialized economies price themselves out of global markets – unless than can create a world order in which all economies are symmetrically debt-burdened. This is where the International Monetary Fund, World Bank and World Trade Organization are brought into play – to financialize globalization, excluding countries as pariahs if they do not join this self-destructive and self-terminating system.
An object lesson of the shift from classical democracy to post-classical oligarchy is a country that is held out to you as a success story: Latvia, where neoliberals had a completely free hand, as they did in Russia. What they call a neoliberal paradise turned out to be debt-ridden kleptocracy. The country has a set of flat taxes on employment of 59 percent – and only a 1 percent real estate tax.
You can imagine what happened with real estate taxed so low and labor taxed so high. Employment was high-cost – but there was a real estate bubble. When I was Research Director at the Riga Graduate School of Law, I visited the government agency in charge of property assessments, and asked how they got the 1 percent. I was told that they based it on the most recent real estate appraisal they had. This turned out to be back in 1917, before the Russian Revolution. (The lead assessor had written her doctoral dissertation on this survey.) Whatever the tax collector gives up and relinquishes in taxes, is available to be paid to the banks as interest. So housing prices are bid up in price – on credit – while the tax collector has to turn to labor and industry for the revenue that has been given up. Instead of paying taxes, new homebuyers pay interest to the bankers. The upshot is that the banks end up with the rent that used to accrue to the landed aristocracies of Europe. This is making bankers the new aristocracy.
When I headed an international investigative economic team in 2010, we visited Latvia’s bank insurance agency and were told that they had anticipated a collapse of the bubble. Their response was to advise banks to back their mortgage loans not only with the property as collateral, but to get as many family members as possible to co-sign the loan. That way, if and when default occurred, the parents, siblings or other relatives would be personally liable.?? The bank regulators did not urge the government to tax real estate more. That would have squeezed homeowners on their bank loans – and left less new rental income to be capitalized into new bank loans. But it would have enabled the government to reduce its heavy taxes on employment. This was not the bank regulators’ concern – and bankers themselves saw their main business in lending to fuel real estate, not industry, given what the neoliberals did to Latvia’s economy and that of the other Baltic states!
Unfair? Economically polarizing and destructive? Of course. But the bank insurers said that their task was to protect bank solvency, not create an optimum economic structure.
One result is that a recent EU survey found that one-third of Latvia’s population between the age of 20 and 35 either had emigrated or was planning to do so. As of 2012 the country’s population recently has shrunk by 15 percent. Marriage and birth rates are falling off, as they are throughout the post-Soviet economies. After all, who can marry and buy a house when your wages are taxed at 59 percent and you have to take on a debt?
Iceland provides another object lesson. Even more than Latvia, it became a rogue banker’s paradise – and also one for vulture banks. Their loans are indexed to the consumer price index – which means in practice to the foreign exchange rate. The krónur plunged after the banks crashed in 2008. The result a 1,000 krónur debt has become perhaps 1,800 – against property that has fallen from the equivalent of 1000 krónur down to perhaps 400 krónur. This leaves many families in negative equity. And they are personally liable.
When the crooked banks of Iceland went under (and they’ve only recently begun to arrest some of the crooks) the government took them over and, on European advice, sold them to vulture investors, for around ten cents on the dollar. Despite the fact that Iceland’s constitution said that they were not allowed to increase debts by indexing, this is just what the banks did. If the government had taken over, it could have written down the debts to the ability to pay. But the new vulture banks have not done this. And the Social Democratic government backed their rights to make as much as they can, rather than giving priority to the welfare of the Icelandic people.
What I find so striking is how far to the right wing of the political spectrum the Social Democratic and Labour parties have moved. Iceland’s Social Democratic leadership explained that it wanted to be part of Europe. But this meant acting on behalf of the British and Dutch bankers, not democratically on behalf of Icelanders. They acted on behalf of the emerging financial oligarchy.
I’ve known many of the social democratic leaders of America and the world since I was a young boy. My father was a socialist labor leader and political prisoner from Minneapolis, which was the high point of American labor history as a result of its great General Strike in the 1930s. I was told by a Socialist Party leader (Terence McCarthy) in the early 1960s that the travel and hotel expenses of nearly every member of the Socialist International (the Second International, of which Dmitri Papandreou of Greece is President as of autumn 2011) was paid for by the CIA or its front organizations. I watched the Socialist Party in America come to support the Vietnam War, and Michael Harrington ban criticism of the war in its youth magazine – driving it to quickly lose most of its members.
Harrington and his mentor, Max Shachtman, took this position because they believed that the West could not be persuaded to be Marxist until the world was freed from the Stalinist travesty that claimed to be Marxist. So the Social Democratic Party of America joined the Cold War effort. Politics was turned upside down by the triangulation of socialism, Stalinism and the ability of the United States to back and finance European social democrats to support the banks and “centrists.” This became the tragedy of the old non-Stalinist left in America and other countries. So the Social Democratic leadership imagined (or simply sold out to pretend to believe) that “free financial markets” would lead the world into economic progress.
This was just the opposite from the Progressive Era and indeed, what industrial capitalism promised. The Social Democratic parties of Iceland, Britain, Greece, Scandinavia and other European countries have adopted the position that the way to re-employ labor is to impose austerity. Budgets are to be balanced by lowering wages by 30 percent, and shifting taxes off the finance, insurance and real estate sector onto consumers.
Taxes on labor add to its cost. So competitive power would be maximized by untaxing labor and consumer goods, by getting rid of the value-added tax. But not all taxes are bad. The classical free market economists endorsed taxes on unearned income: land rent and natural resources, monopoly rent and financial privilege. These categories of income have no counterpart in a cost of production undertaken by the rent recipient. The more that governments can shift the tax burden onto land and property, the lower housing prices will be – and the less governments will need to tax labor by income and sales taxes.
Bankers back anti-government ideology because they want to obtain all of the untaxed rental revenue as interest. So taxes that otherwise would be paid to the government will be paid to the bankers. The result – what you’re seeing today in Europe and North America – is an economic grab that is in many ways like that which gave birth to European feudalism. But this time around it is financial, not military.
Michael Hudson’s new book The Bubble & Beyond is vital for those vying to make sense of the economic quicksand global policy makers find themselves in. Buy it now. He ties a thread between the big issues of our times – underwater housing, money market manipulations and lifetime debt – concerns that appear too difficult for the world’s big name economists.
Hudson does this by looking at the systemic causes of inequality, complexity and economic despair.
The book traces how industrial capitalism has turned into finance capitalism. The finance, insurance and real estate (FIRE) sector has emerged to create “balance sheet wealth” not by new tangible investment and employment, but financially in the form of debt leveraging and rent-extraction.
Decision making is clouded by an economic system that favors natural monopolies. Michael’s reading of policy implications for the geo-political future is compelling.
“There are few people alive who have taught me more than Michael Hudson. The incisive and brilliant essays in this book should really be assigned to every first-year student of economics. The fact they never will be is the ultimate testimony to the fact economics has betrayed its own most noble tradition – one that Hudson here so magnificently embodies – to become a sheer instrument of power.”
– David Graeber, author of Debt: The First 5,000 Years and co-organizer of Occupy Wall Street
“Michael Hudson has consistently been an eloquent, erudite, accurate analyst of the strengths and failings of modern capitalism. He is one of the prescient few who anticipated today’s never-ending economic crisis, and one of a smaller number still whose advice about how to end the crisis would actually work. His simple mantra “debts that can’t be repaid, won’t be repaid” will echo down the ages. Buy this book and acquire real wisdom, with a breadth of vision from the origins of human society till today that no one else can match – and I include myself in that judgment.”
– Steve Keen, author of Debunking Economics and editor of debtdeflation.com
“Among the contemporary voices crying in the wilderness of the world’s financial trouble, I know of none more forceful or prescient than Michael Hudson’s. He sets the crooked straight and makes the rough places plain.”
– Lewis Lapham, editor of Lapham’s Quarterly and editor emeritus of Harper’s magazine
Hudson has peppered the online community with cutting commentary of contemporary issues over recent years. This is his first full book in over 20 years.
For students of the big picture, The Bubble and Beyond provides a compelling road map into our empty wallets and onto a future rich in opportunity. Support Michael’s work.
Note: If you get a note saying “Temporarily out of stock,” it simply means that the print-on-demand is not printed yet. However, you can buy it on the Amazon shopping cart, to be sent soon. Thankyou for your support.
Table of Contents
The Bubble and Beyond:
The Road from Industrial Capitalism to Finance Capitalism and Debt Peonage
Essays on Fictitious Capital, Debt Deflation and the Global Crisis
Preface
Summary and Analytic Table of Contents
Introduction: Today’s Financial Crisis and Economic Theory
I. Fictitious Capital and Economic Fictions
1. Two Traditions of Financial Doctrine
2. The Magic of Compound Interest: Mathematics at the Root of the Crisis
3. How Ricardo’s Value Theory Ignored the Role of Debt
4. The Industrialization of Finance and the Financialization of Industry
5. The Use and Abuse of Mathematical Economics
6. The Road to Debt Deflation, Debt Peonage and Neofeudalism II. From Inflated Debts to Debt Deflation
7. Property is Worth Whatever a Bank Will Lend Against It
8. The Real Estate Bubble at the Core of Today’s Debt-leveraged Economy
9. Junk-Bonding Industry
10. Privatizing Social Security to Rescue Wall Street
11. Saving, Asset-Price Inflation, and Debt Deflation
12. Saving our Way into Debt Peonage
III: The Global Crisis
13. Trade and Payments in a Financialized Economy
14. U.S. Quantitative Easing fractures the Global Economy
15. America’s Monetary Imperialism: Dollar Debt Reserves without Constraint
16. The Dollar Glut Finances America’s Military Build-up
17. De-dollarizing the Global Economy
18. Incorporating the Rentier Sectors into a Financial Model
IV: The Political Dimension/The Need for a Clean Slate
19. From Democracy to Oligarchy: National Economies at the Crossroads
This summary of my economic theory traces how industrial capitalism has turned into finance capitalism. The finance, insurance and real estate (FIRE) sector has emerged to create “balance sheet wealth” not by new tangible investment and employment, but financially in the form of debt leveraging and rent-extraction. This rentier overhead is overpowering the economy’s ability to produce a large enough surplus to carry its debts. As in a radioactive decay process, we are passing through a short-lived and unstable phase of “casino capitalism,” which now threatens to settle into leaden austerity and debt deflation.
This situation confronts society with a choice either to write down debts to a level that can be paid (or indeed, to write them off altogether with a Clean Slate), or to permit creditors to foreclose, concentrating property in their own hands (including whatever assets are in the public domain to be privatized) and imposing a combination of financial and fiscal austerity on the population. This scenario will produce a shrinking debt-ridden and tax-ridden economy.
The latter is the path on which the Western nations are pursuing today. It is the opposite path that classical economists advocated and which Progressive Era writers expected to occur, given the inherent optimism of focusing on technological potential rather than on the political stratagems of the vested rentier interests fighting back against the classical idea of free markets and economic reforms to free industrial capitalism from the surviving carry-overs of medieval and even ancient privileges and essentially corrosive, anti-social behavior.
Today’s post-industrial strategy of “wealth creation” is to use debt leveraging to bid up asset prices. From corporate raiders to arbitrageurs and computerized trading programs, this “casino capitalist” strategy works as long as asset prices rise at a faster rate than the interest that has to be paid. But it contains the seeds of its own destruction, because it builds up financial claims on the assets pledged as collateral – without creating new means of production. Instead of steering credit into tangible capital formation, banks find it easier to make money by lending to real estate and monopolies (and to other financial institutions). Their plan is to capitalize land rent, natural resource rent and monopoly privileges into loans, stocks and bonds.
This leads the banks to act as lobbyist for their rentier clients, to free them from taxes so that they will have more available to pay interest. The resulting tax shift onto labor and industry adds a fiscal burden to the debt overhead.
This is not a natural and even inevitable form of evolution. It is a detour from the kind of economy and indeed free market that classical writers sought to create. With roots in the 13th-century Schoolmen discussing Just Price, the labor theory of value was refined as a tool to isolate economic rent as that element of price that had no counterpart in actual or necessary costs of production. Banking charges, monopoly rent and land rent were the three types of economic rent analyzed in this long classical tradition. These rentier charges were seen as unnecessary and exploitative special privileges carried over from the military conquests that shaped medieval Europe. A free market was defined as one free of such overhead charges.
This classical view of free markets as being free of an unearned “free lunch” was embodied in the Progressive Era’s financial and tax reforms. But the rentiers have fought back. The financial sector seeks to justify today’s deepening indebtedness on the ground that it “creates wealth” by debt leveraging. Yet the banks’ product is a debt overhead, leaving debt deflation in its wake as debtors try to pay debts that can’t be paid without drastically reducing consumption and investment. A shrinking economy falls further into arrears in a debt spiral.
The question today is whether a new wave of reform will arise to restore and indeed complete the vision of classical political economy that seemed to be shaping evolution a century ago on the eve of World War I, or whether the epoch of industrial capitalism will be rolled back toward a neofeudal reaction defending rentier interests against reform. What is up for grabs is how society will resolve the legacy of debts that can’t be paid. Will it let the financial sector foreclose, and even force governments to privatize the public domain under distress conditions? Or will debts be written down to what can be paid without polarizing wealth and income, dismantling government, and turning tax policy over to financial lobbyists pretending to be objective technocrats?
To provide a perspective on the financial sector’s rise to dominance over the industrial economy, Part I reviews how classical economists developed the tools to measure how finance now plays role that landlords did in Physiocratic and Ricardian theory: as beneficiaries of feudal privileges that oblige society to pay them for access to credit as well as land. As land ownership has been democratized, new buyers obtain credit to purchase homes and office buildings by pledging the rental income to bankers. About 80 percent of bank loans in the United States, Britain and other English-speaking countries are real estate mortgages, making land the major bank collateral. The result is that mortgage bankers receive the rents formerly taken by a hereditary aristocracy in post-feudal Europe and the colonies it conquered.
Whatever the tax collector relinquishes is available for this end. This has led the financial sector to subsidize popular opposition to taxing property – reversing the ideology of free markets held by the classical economic reformers. And with the financialization of real estate providing the postindustrial model, corporate raiders since the 1980s have adopted the speculator’s motto, “Rent is for paying interest,” using corporate cash flow to make a deal with their backers to obtain loans to take over companies already in place – and bleed them.
This phenomenon is called financialization, and Part II of this book describes how it has transformed the economics of real estate, industry and pension fund saving into a Bubble Economy based on debt-leveraged asset-price inflation – leaving debt deflation in its wake. The banker’s business plan, after all, is to turn as much of the economic surplus as possible into a flow of interest payments. But this must be self-defeating. Paying debt service diverts revenue away from being spent on consumption and tangible capital investment. This causes debt deflation and imposes financial austerity. Capital and infrastructure are bled to squeeze out the revenue to pay bankers and other creditors, depleting the economy’s reproductive powers.
What is unique to the post-1980 Bubble Economy is the tactic by which austerity has been averted, by new credit creation to inflate asset prices in what is rightly termed a Ponzi scheme. (The appendix at the end of this volume defines the terms and concepts by which I describe this process.) Instead of interest rates rising to reflect the increasing risks of the debt-ridden economy, banks kept the financialization process going by easing credit terms: lowering interest rates and the amortization rate (culminating in “interest only loans), and also lowering down payments (for zero down payment loans) and credit standards (appropriately called “liars’ loans”).
The direct effect of collateral-based lending is to bid up prices for the real estate, stocks and bonds pledged as collateral for larger and larger loans. An asset is worth whatever a bank will lend against it, and easier credit terms serve to preserve the market price of assets pledged for debt. This is the case even as the economy diverts more of its income – and transfers more of its capital and future income – to the financial sector, which concentrates wealth in its own hands.
Federal Reserve Chairman Alan Greenspan encouraged mortgage borrowers to think of themselves as getting richer as the market price of their homes rose in the early 2000s. But the “wealth creation” was debt-leveraged, and easy credit obliged new buyers to take on a lifetime of debt to afford housing. After 2008 their mortgages had to paid even as a quarter of U.S. residential real estate fell into negative equity when market prices plunged below the level of the mortgages attached to it.
A similar phenomenon has occurred as education has been financialized. Students must take on decades of student-loan obligations and pay them regardless of whether the education enables them to get jobs in an economy shrinking from debt deflation. The magnitude of these loans now exceeds $1 trillion – larger even than credit-card debt. Instead of being treated as a public utility to prepare the population for gainful work, the educational system has been turned into an opportunity for banks to profiteer from a debt market guaranteed by the government.
The economy’s circular flow becomes a vicious circle as paying debt service leads to smaller market demand for goods. Investment and employment are cut back, government budgets move into deficit, forcing cutbacks in revenue sharing with localities and subsidies for education. Schools raise their tuition levels, obliging students and families to take on more debt, creating yet more debt deflation.
Other public infrastructure is sold off to pay down debts, and the buyers raise access prices and tolls on roads and other privatized transportation – and so on throughout the economy. Debts mount up increasingly as a result of arrears in making payments, losing all relationship with the realistic ability to pay.
What has gone relatively unremarked by economists is how financialization of the economy has transformed the idea of saving. In times past, saving was non-spending on goods and services – in the form of liquid assets. Typically on a national scale, between one-sixth and one-fifth of income would be saved – and invested in capital on the other side of the balance sheet. But since the 1980s, as banks loosened lending standards on real estate and made and the financial sector in general turned increasingly to financing corporate raiders, mergers and acquisitions, the way to create future wealth was not to save, but was to go into debt. The aim was capital gains more than current income. Indeed, after 2001 many families “made more” on the rising market price of their homes than they made in salary (not to speak of being able to save out of their salary).
Under financialization, the strategy was to seek capital gains, riding the wave of asset-price inflation being fueled by Alan Greenspan at the Federal Reserve Board. Investment performance was measured in terms of “total returns,” defined as income yield plus capital gains. And the way to maximize these gains was to borrow at a relatively low interest rate, to buy assets whose price was rising at a higher rate. For the first time in recorded history, large numbers of people went into debt not out of need, not involuntarily and as a result of running arrears as a result of inability to pay, but voluntarily, believing that debt leveraging was the quickest and easiest way to get rich!
The national income accounts were not designed to trace this process. Using debt leveraging to obtain capital gains meant that bank loans found their counterpart in debt on the other side of the balance sheet, not new tangible investment. The result was a wash. So the nominal savings rate declined – to zero by 2008. Yet people thought of themselves as saving, as long as their net worth was rising. That is supposed to be the aim of saving, after all: to increase one’s net worth. The result was a financial “balance sheet boom,” not the kind of expansion or business cycle that industrial capitalism generated.
As this process unfolded “on the way up,” financial lobbyists applauded the asset-price inflation for real estate, stocks and bonds as “wealth creation”. But it was making the economy less competitive, as seen most clearly in the de-industrialization of the United States. Debt-leveraged real estate required families to pay higher prices for housing – in the form of mortgage interest – and pension funds to pay higher prices for the stocks and bonds they buy to pay retirement incomes. That is the problem with the Bubble Economy. It is debt-driven. This debt is the “product” of the banking and financial sector.
When asset prices finally collapse to reflect the debtor’s ability to pay (and the falling market price of collateral bought on credit), these debts remain in place. The “final stage” of the Bubble Economy occurs when foreclosure time arrives and debt-ridden economies shrink into Negative Equity. That is the stage in which the U.S. and European economies are mired today. Economic jargon has called it a “balance sheet recession” – the counterpart to the “balance sheet boom” that was the essence of the preceding Bubble Economy.
The process became political quite quickly. Banks and high finance sought to shift their losses onto the economy at large. As debts went bad in 2008, Wall Street turned to the government for bailouts, and demanded that the Federal Reserve and Treasury take their bad loans onto the public balance sheet. This has occurred from the United States to Ireland. The effect was to increase U.S. federal debt by over $13 trillion – without running a deficit of this magnitude, but simply by taking Fannie Mae and Freddie Mac onto the public balance sheet ($5.3 trillion), by the Federal Reserve swapping $2 trillion in newly created deposit liabilities in a “cash for trash” swap with Citibank, Bank of America and other banks that were the worst offenders in making junk mortgages, and with other policies confined to the balance sheet, not current spending.
This vast increase in money and credit was not inflationary. At least, it did not increase consumer prices, commodity prices or wages. The aim was indeed to increase asset prices, but the banks were not lending, given the fact that debt deflation was engulfing the entire economy. So the traditional monetary formula MV=PT became irrelevant. Asset prices were the key, not prices for goods and services – and asset prices could not rise as long as so many assets were in negative equity. So money creation became a pure giveaway to the financial sector – a “transfer payment,” not a payment for the purchase or sale of a consumer good or investment good.
Part III discusses the global dimension of “socializing” (or more to the point, oligarch-izing) unpayably high debts. The world’s money supply now rests ultimately on government debt – and the government’s acceptance of this debt as money in payment of taxes and public services. Yet there is something fictitious about all this: the debts can’t be paid!
The most obviously unpayable are those of the U.S. Government. This makes these debts “fictitious,” inasmuch as dollar holders are unable to convert their savings into tangible assets, goods or services. Gold convertibility was ended in 1971 in response to the Vietnam War’s drain on the U.S. balance of payments. Yet the dollar has remained the foundation of most central bank reserves even as the U.S. trade deficit deepened as the economy was post-industrialized while overseas military spending has escalated. This military dimension grounds the global financial system in U.S. military hegemony.
This has prompted the BRIC countries (Brazil, Russia, India and China) to seek an alternative payments and debt-settlement system so as not to base their international savings on a system that finances their military encirclement. As it stands the dollar standard provides a free lunch for the U.S. economy (“debt imperialism”), above all for its government to create money without regard for the ability (not to mention the will) to pay.
If the dollar deficit were used to promote peaceful economic development in an atmosphere of global disarmament, the rest of the world would be more willing to see the U.S. Treasury act as global money creator on its electronic computer keyboards. But when this is done for national self-interest that other countries see as being at odds with their own aspirations, the system becomes politically as well as financially unstable. That is the position in which the world economy finds itself today.
It became even less stable when the Federal Reserve provided $800 billion in credit to U.S. banks in 2011 under the Quantitative Easing (QE2), which the banks used to make easy money on international interest-rate and foreign currency arbitrage. Given the refusal of Congress to permit China or other countries to buy major American industrial assets (e.g., as when CNOOK was blocked from buying Unocal), and financial deregulation leading to decriminalization of financial frauds (as in the “toxic waste” of subprime mortgage packages), the world’s monetary system is in the process of fracturing into regional blocks.
What is not clear is what kind of regulatory, financial and tax philosophy will guide these blocs. At best, the world will return to the debates that marked economic discussion a century ago on the eve of World War I. At issue is whether the financial sector will translate its recent gains into the political power to take debt and financial policy out of the hands of elected government representatives and agencies and shift economic planning and tax policy into the hands of a super-national central bank authority controlled by bank lobbyists.
The lesson of history is that this would be a disaster of historic proportions, because the financial time frame is short-term and its business strategy is extractive, not productive. I hope the papers in this volume will serve as an antidote to the head start that financial lobbyists have achieved in sacrificing economies to austerity in what must be a vain attempt to pay debts under adverse financial conditions that make them less and less payable. By distinguishing tangible wealth creation from debt overhead and other rentier overhead – the task of classical political economy, after all – the policy debate can be cast in a manner that reverses the financial sector’s attempt to replace realistic analysis with euphemistic lobbying efforts and what best can be characterized as junk economics rather than empirical science.
Michael Hudson spoke with Max Keiser about what he calls “fictitious capital” which is essentially lending backed by inadequate capital, such as collateral that has fallen in value. This is an idea he has explored in his previous papers, such as “From Marx to Goldman Sachs” and now in his new book, The Bubble and Beyond. For German readers, Hudson was also interviewed in FAZ.