Sunday, October 11, 2009

In the Land of the Cannibals, the Ponzi Economy Rules

We are not used to thinking about our own political economy as one that cannibalizes its basic supporting subsystems in order to generate the greatest short-term profits possible for a wealthy elite. I know that some environmentalists would disagree. They would respond that they have been engaged in a struggle for decades against a political class that would expand economic production until every tree was logged, every lake and river left polluted, an atmosphere rendered unbreathable, and our topsoil turned into dust.

Tree huggers, what do they know? Well, they were bang on in identifying the self destructive nature of free market capitalism. They just didn’t predict that the insatiable appetite for profits would begin to feed off of the very means of production that generated the initial capital that the Lords of Wall Street successfully looted, multiplied, and subsequently ran off with, ravaging the US economy so that if it were a landscape, it would resemble the remains of a clear cut forest.

Presently, we are led to believe that the economy is this large, somewhat incomprehensible, singular entity. Most of our politicians try to pass themselves off as competent stewards of THE ECONOMY. In fact, we would do much better to think of THE ECONOMY as being composed of three mutually interdependent economies: the primary economy, which consists of the natural resources and the freely given human labour that sustains human society; the real economy, which is the sector of THE ECONOMY devoted to the production of goods and services with real added value; and the speculative economy in which money multiplies as a result of a series of financial transactions.

Essentially, the primary economy gives birth to the real economy, which in turn gives birth to the speculative economy. It should be obvious that if the quality of the primary economy is led to degrade sufficiently, continued activity in the other two economies will cease. This is, in a nutshell, the economic argument for addressing climate change former World Bank chief economist Lord Nicholas Stern makes in the Stern Review. If we don’t begin to act immediately, the economic costs resulting from not acting or an undue delay taking action will far outweigh the cost of the investments. Some would say it is already too late, and we will scorch the earth and leave the planet inhospitable for humans for hundreds of thousands of years.

What is relatively new is that with the near collapse of the global financial system and the Great Global Recession that ensued, it has become evident that the unfettered activities in the speculative economy have been catastrophic for the activities in the real economy. In the United States alone 8 million jobs have disappeared since December 2007, and the US government has been forced to assume trillions of dollars in debt to ward off being plunged into another Great Depression. What the stewards of the free market failed to realize is that those who were raking in billions as a result of their trades in the speculative economy were more than willing to sacrifice the well-being of those who toiled in the real economy because the scale of the profits were exponentially greater than what could be made by making money the old fashion way, earning it.

To understand how the Great Global Recession came into being, we must give proper consideration to key developments concerning economic policy during the Clinton–Bush years. In particular, there was a significant shift in the importance accorded to the speculative economy, and a decision made not to regulate the exchange of financial derivatives.

During the nineties, a seminal article, Securities: The New World Wealth Machine, appeared in the periodical Foreign Policy, which effectively explained how financial markets could become the most powerful generator of wealth. In what appears to be a classic example of putting the cart before the horse, the author articulates what would become the dominant economic strategy in the U.S:

Historically, manufacturing, exporting, and direct investment produced prosperity through income creation. Wealth was created when a portion of income was diverted from consumption into investment in buildings, machinery and technological change. Societies accumulated wealth slowly over generations. Now, many societies, and indeed the entire world, have learned how to create wealth directly. The new approach requires that a state find ways to increase the market value of its stock of productive assets. Several countries have successfully directed their economic policies toward that goal, achieving and sustaining faster growth rates than were once thought possible...

an economic policy that aims to achieve growth by wealth creation therefore does not attempt to increase the production of goods and services, except as a secondary objective.

This represents a historical shift in thinking about the economy. Evidently, there is a reversal of economic priorities in regard to the creation of wealth, in particular, a shift away from the production of tangible goods and services in the real economy to the manipulation of financial assets in the speculative economy. In other words, why go through the painfully slow way of creating wealth through the real economy when unimagined riches (for the few) can be obtained by shuffling financial securities.

Importantly, not only is there a big disconnect between a sustainable future and the desire for immediate reward, but, as well, between the well being of a political and financial elite and the rest of the population. At least, within the real economy even though the benefits are distributed disproportionally, there exists a common interest between capital and labor in that direct investment leads to the creation of jobs. In the speculative economy, however, the so called creation of wealth is little more than a transfer of wealth from those who toil outside of the financial sector to those who work within it and the clients that they serve.

In order to bring about the realization of the New World Wealth Machine, an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000 needed to be introduced. It not only removed derivatives and credit default swaps from the purview of federal regulation, it gave Wall Street immunity from state gambling laws and legalizing activity that had been banned for most of the 20th century.

Interestingly enough, the legislation was never debated in either the Senate or Congress and was adopted unanimously on the last vote of the last day of the lame duck 106th Congress, between the election and inauguration of George W. Bush.

Once the legal impediments had been removed, Wall Street began to put into practice the irrational belief that great wealth could be created by convincing those with limited means to assume levels of debt they could not possibly service, transferring the fiscal responsibility of the debt to third parties and then betting on the outcomes. Indeed, this is the unregulated world of subprime mortgages, collateralized debt obligations and credit default swaps, which has turned out to be perhaps the greatest Ponzi scheme ever undertaken.

This is the way the scam worked. During the recent real estate bubble in the United States, people were lured into buying houses with surreal financial terms (the subprime mortgage): little or no down payment and a mortgage with a low initial interest rate which would readjust to a higher rate at a later date. Imbued with the expectation that real estate values would continue to rise, people were led to believe that they could simply sell their house at a tidy profit if they were subsequently unable to meet their financial obligations when the higher interest rate kicked in. Knowing full well that many of these mortgages would be subject to default if the American real estate market began to level off (more so, if values began to fall) the financial securities industry buried these suspicious debt obligations within larger and more complex securities (collateralized debt obligation) and sold them as AAA financial products on the global financial markets. To make matters worse, one could take out an apparent insurance policy (credit default swap) on the likelihood that a party would default on its debt obligations, and even worse, such a policy could be bought without even being party to the debt, in other words, a side bet, which explains why it was necessary to gain immunity from state gambling laws. Moreover, the marketing of these derivates as a type of insurance was fraudulent since no monies were set aside from which payments could be made in case of default on a debt obligation.

It doesn’t take much to realize that this set up is nothing less than an elaborate house of cards that will begin to collapse once the subprime mortgages surpass the accepted default rate. Once this occurs, a domino effect takes over, where one default triggers another and where no one wants to be holding the toxic assets. As should be expected, the one ultimately holding the bag is the tax payer because, after all that is said and done, it’s his job or his pension that is eventually imperiled once the decline in asset prices impacts upon the real economy, and it will be his tax dollars that is called upon in order to prop up the financial system.

Without question there was an absence of effective regulation of the financial markets. In the worst case, the Securities and Exchange Commission failed to intervene in the New York financier Bernard Madoff’s elaborate scheme that bilked friends, clients and charitable foundations of approximately $50 billion despite having been informed of the gross irregularities concerning his affairs. The failure to do so has been often cited as the reluctance of regulatory officials to investigate suspected criminal behavior by those with whom they might do business after their stint at the regulatory agency is over. After all, time spent working for the government can often be parlayed into future career gains in the private sector as a result of increased familiarity with the regulatory mechanisms.

With regard to a much more disturbing phenomenon, the bond rating agencies decision to award AAA status to collateral debt obligations tainted with subprime mortgages seems to be a case of the refusal to kill the goose which lays the golden eggs. There is a flagrant conflict of interest when financial institutions have their quality of their financial products evaluated by agencies that are funded by the said institutions. Moreover, there was simply too much money to be made to take the time necessary to evaluate the risk. For example, in 2007 the top fifty individual hedge fund managers earned $29 billion. Their average income was twelve thousand times the income of the typical American family.

Finally, the investment climate allowed private equity firms to engage in leveraged buyouts of successful companies that operate in the real economy in which the real wealth of the company was sucked out and replaced with mountains of debt, often forcing the cannibalized company into bankruptcy, leaving the bondholders not holding the appropriate credit default swaps, creditors, and of course the workers in the lurch.

In the most telling example, the iconic manufacturer the Simmons Bedding Company was flipped from one private equity firm to another, generating millions of dollars of profit in the process and leaving behind an accumulated debt that grew from $164 million in 1991 to $1.3 billion in 2009. According to analysts at Standard & Poor’s, more than half of the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms.

With respect to how the financiers of the speculative economy have behaved towards those who gain their livelihood from the real economy, it is similar in kind to the way the proponents of wealth creation through the real economy behaved to those whose livelihood depended on the health of the primary economy. In both instances, there was a pathological fixation on wealth extraction with little thought and no remorse for the damage left behind.

If we are to have a sustainable future and be stewards of THE ECONOMY, we will need to reverse the direction of the cash flow. Monies gained from the speculative economy need to flow back into the real economy in such a way as to re-establish the health of the primary economy. Faced with the possibility of catastrophic climate change, this is the biggest and most important challenge facing humanity today.

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