WE CAN’T RESCUE FINANCE UNLESS WE RESCUE THE ECONOMY
As we enter an Autumn which many of us have all along expected to be ‘fraught with interest’, one question, above all others, dominates the economic and financial debate.
Are the authorities going to try to monetize their (meaning our) way out of the extreme difficulties exacerbated and catalyzed by the Wuhan coronavirus pandemic?
Or are they going to adhere to a form of monetary rectitude that was so conspicuously abandoned during the 2008 global financial crisis (GFC)?
The central conclusion reached here is that we have exhausted the scope for short-term, ‘band-aid’ fixes for a fundamental imbalance between (1) a growth-predicated financial system and (2) an underlying economy that is tipping over into “de-growth”. We simply cannot reconcile a ‘financial’ economy of money and credit that keeps getting bigger with a ‘real’ economy of goods and services that has reached the end of growth.
This has both near-term and longer-term implications. Longer-term, we need to find ways of rebalancing the economy towards quality rather than quantity, and shrinking the financial system back to a sustainable scale.
Why ‘2008 revisited’ won’t work
More immediately, we need to recognize that the stop-gap ‘fixes’ used during the GFC won’t work this time.
Back in 2008, it was just about possible for the authorities to bail out the financial system whilst leaving the economy to its fate, an approach lambasted by critics at the time as ‘rescuing Wall Street at the expense of Main Street’.
This time around, no such possibility exists. On the one hand, the process of financialization has advanced to the point where credit has been inserted into virtually all economic transactions. On the other, forward income streams have been incorporated into financial instruments to such an extent that the financial system could not withstand any significant and prolonged interruption to underlying economic activity. Large swathes of the financial system have become hostages to the continuity of interest, rent and earnings streams from households and from private non-financial corporations (PNFCs).
What this means is that, if it were ever really perceived that economic deterioration is going to undermine the ability of households and businesses to maintain such payment streams, the financial system would fall apart.
We cannot know, of course, whether the authorities actually understand that they can’t repeat the tactic of rescuing the financial system whilst leaving the ‘real’ economy to its fate. Some policymakers, at least, might labour under the delusion that the prices of securities, and the validity of collateral, can be shored up even if the underlying entities (businesses, borrowers, tenants) go to the wall. Delusions undoubtedly still exist at the policy level, as evidenced by the wholly fallacious faith that some still seem to place in the ability of negative interest rates to ‘stimulate’ the economy, and to ‘support’ financial valuations.
The view taken here, though, is that most policy-makers, if they don’t already understand this point, will very soon have its reality imposed upon them. This means that, even where propping up the financial system remains their first priority, they will come to recognize that the only way to do this is to support the underlying economy.
This in turn means that even those governments currently proclaiming fiscal rectitude are likely to be pushed into larger (and longer) support programmes, running ultra-large deficits whose additions to public debt will, in due course and to a very large extent, be monetized by central banks. This points to a scenario in which initial deflation (imposed by sagging economies) is likely to be followed by soaring inflation (as the authorities try to force a quart of monetary stimulus into a pint-pot of economic capability).
Under starter’s orders
On the question of “monetize or not?”, participants in capital markets have already placed their bets – if they thought for one moment that governments and central banks were not going to intervene, the prices of equities (and, very probably, the prices of property and of a very high proportion of bonds, too) would already have crashed.
The clear message from the markets is that, faced with a worsening economic and financial crisis, governments are going to turn to full-bore fiscal support, with the highly probable corollary that central banks will create (in an earlier idiom, ‘print’) enough new money to monetize the gargantuan debts thus created. If it’s objected that huge monetization might trigger high inflation, markets would doubtless retort that, if this were indeed to happen, investors would be better off holding almost any form of asset in preference to cash.
If the markets are right, a large proportion of everything – from wages, debt service costs and rents to the purchasing of goods and services – will be propped up by government largesse. Taking equities as an example, high prices indicate, not only that capital isn’t expected to flow out of markets, but also that most of the businesses in which capital is invested will be kept viable – after all, no amount of market liquidity can attach much value to the stock of a company which has gone bust. So market thinking is certainly consistent – governments and central banks will prop up both the financial system and the economy itself.
The contrary argument begins with the observation that some governments seem already to have committed themselves to fiscal rectitude. More fundamentally, it’s argued that monetization could not, this time around, be ‘neutralized’ within the boundaries of capital markets, but would have to happen at such a scale, and in such a way, that faith in fiat currencies would be placed at grave risk.
There’s a strong body of opinion, then, to the effect that the authorities won’t take what could be existential risks with the monetary system. There’s a seldom-made argument, too, that no amount of monetary tinkering can save businesses, or indeed whole sectors, whose viability is gone, and which could continue to exist only, if at all, on the basis of perpetual financial life-support.
The view taken here – which is that the authorities are likely to succumb to calls for expanded fiscal support, much of which will then be monetized by central banks – is based on a reading of the fundamentals which is informed by the understanding that the economy is an energy system, and is not wholly (or even largely) a financial one.
From this perspective, how did we get ourselves into a situation in which a single crisis (admittedly a severe one, compounded by inept responses) could put the whole system at risk?
The Great Divergence
The background to the current crisis is that the ‘financial’ economy of money and credit has far out-grown the ‘real’ economy of goods and services.
The ‘claim for the defence’ in this situation is that the real economy, whilst it may lag the process of financial expansion, remains capable of pretty decent rates of “growth”.
This statement, though, is only true if you ignore the way in which we’ve been using the financial system to ‘buy’ growth, using $3 of new net debt (plus a lot of other deferred commitments) to create $1 of “growth”. Also, of course, conventional presentation ignores an escalating energy cost of energy (ECoE), and makes no effort to internalise the costs of environmental degradation.
For the purposes of this discussion, it’s going to be assumed that readers are familiar with the principles of Surplus Energy Economics (SEE), and know how this interpretation is put into practice using the SEEDS economic model.
Simply put, there are two ways in which the economy can be understood. One of these, favoured here but very much a minority view, is that the economy is an energy system, and that prosperity is a product of the economic value that we obtain from the use of energy.
The other – the established or ‘conventional’ orthodoxy – is that the economy is a financial system, a persuasion that has sometimes portrayed natural resources in general (and energy in particular) as little more than incidental contributors to economic activity.
The energy view of economics accepts – as conventional interpretation does not – that resources (which for this purpose include the environment) set limits to the scope for expansion in prosperity.
Though all of this sounds theoretical, it is in fact central to an appreciation of our current circumstances. Over time, the physical or ‘real’ economy of goods and services, and the immaterial or ‘financial’ economy of money and credit, have diverged relentlessly.
Between 1999 and 2019, the official (financial) calibration of World economic output (GDP) grew at an annual average rate of 3.6%, whereas SEEDS measurement indicates that underlying or ‘clean’ output (in SEEDS terminology, C-GDP) has grown at an annual average rate of only 1.8%. Because, of course, these are compounding rates, a huge gulf now divides GDP from C-GDP.
For practical purposes, what this means is that conventional statements, both of output (a measure of flow) and of wealth (a related measure of stock, but in reality linked to flow), are dramatically exaggerated in relation to the underlying reality of economic value.
One illustration of this is provided by the ‘values’ conventionally imputed to assets. Asset prices have come to represent not, as logic says they should, discounted forward streams of underlying income, but current and anticipated monetary conditions.
If, for instance, we multiply the average price of a house by a country’s total number of houses, we can arrive at a pretty impressive ‘valuation’ of the national housing stock. A moment’s reflection, however, tells us that this valuation could never be realised (monetized), because the only people to whom all of these houses could be sold are the same people to whom they already belong.
This process – which uses marginal transaction prices to value the aggregate of an asset category – applies just as much to stocks and bonds as to property. When we read, for instance, that billions have been “wiped off” (or added to) the value of the stock market, it’s easy to forget that all of this is purely notional, because the market as a whole couldn’t have been turned into cash at any point in this process.
What this in turn means is that we’ve become accustomed to believing in aggregate valuations which are, in fact, purely notional. Just as we couldn’t turn the whole of the national housing stock, or the entirety of the equity market, into cash, the same applies individually to large corporations, and to the housing stock of, say, a town or a city.
The distorting effects of ‘notional value’
This concept of notional valuation extends in very important ways into everyday economic activity. Here’s an example.
If interest rates are 5%, a person who can afford $10,000 a year in mortgage payments can buy a house for $200,000 but, if rates now fall to 2%, his or her affordability rises to $500,000. Because the same applies to every other potential buyer, properties in general are re-priced accordingly. Because they can be pushed out almost indefinitely into the future, capital repayment considerations play an almost negligible role in such calculations.
A real estate agent, charging an unchanged rate of commission of 2%, earns $4,000 on the first transaction, but $10,000 on the second, even though the work done, or the real value added by that work, haven’t changed.
Meanwhile, the homeowner who bought at the earlier price-point has seen a big (though a paper) increase in his or her equity, making him relaxed about borrowing to finance a holiday, or the purchase of a new car. Unless he or she intends to cash out (monetize) the supporting equity – which is possible for some by trading down, but isn’t possible for everyone – then these debts, ultimately, remain tied to the future incomes of the borrowers.
This monetary inflation of asset prices – a process excluded, by the way, from conventional statements of inflation – needs to be considered in tandem with the broader financialization of the economy, a topic on which Charles Hugh Smith is particularly perceptive.
Historically, a car would have been made by a vehicle manufacturer and its employees, and bought by a motorist using his or her savings, which are in turn the product of his or her labour. Now, though, financial institutions have routinely been inserted into this transaction in a way which, from a purist point of view, might be regarded as unnecessary. The car is bought on the basis, not on saved income from the past, but of assumed income in the future.
The packaging and sale of forward payment streams (as exemplified by mortgage-backed securities, but in reality a very widespread, almost universal practice) dominates the financialized system. This has had the adverse effect of driving a wedge between risk (offloaded onto the purchaser of the security) and return (of which a significant part is retained by the initiator of the transaction). This is an example of quite how distorted the relationship between the financial and the real economies has been allowed to become.
Critically, this entire financialized process is wholly dependent on continuity, which in this sense is coterminous with growth. If the earnings of a mortgage-payer or a car-purchaser fall, he or she may not be able to keep up with committed payments, just as a business whose income deteriorates may no longer be able to afford scheduled debt payments. The same applies to rent (whether household or commercial), because the assumed forward stream of these payments is likely to have been packaged and sold on, often to somebody who, in turn, relies upon this income to service the debt that he used to finance the purchase.
Before turning to practicalities, let’s state what this means in the starkest possible terms. The real economy, and the people who comprise it, can tolerate stagnation, or a modest decline in output – but the financial economy relies absolutely on continuity and growth.
Most ordinary people, if they were unencumbered by debt, could certainly cope if their real (inflation-adjusted) incomes stopped growing, and could probably manage reasonably well if that income dropped by a relatively modest amount. By extension, if we imagined a debt-free economy, it, too, could probably adjust to, say, a 5% or a 10% fall in income, which in this context means a decrease in the quantity of goods and services that are produced. Its citizens wouldn’t like this, of course – but they could survive it.
All of this changes when you introduce the futurity of leverage into the equation. Whether it’s a household, a business or an economy, a significant part of future income is now earmarked for debt service. In this way, financialization of the economy takes away resilience. A person or a business with debt to service loses the ability to cope with static or declining income, primarily because the financial system discounts a future wholly predicated on the assumption of perpetual expansion.
A dangerous asymmetry
What this interpretation also tells us is that, whilst the ‘real’ and the ‘financial’ economies are interdependent, this dependency is asymmetric. The economy of goods and services, though it would be greatly disrupted, might well survive a slump in the financial economy, but the reverse proposition is not the case. For the financial system to survive at all, the real economy must carry on growing, and the absolute, irreducible minimum is that it must not contract, other than by a very small extent, and for a very limited period.
The more financialized an economy (or a household, or a business) becomes, the more its resilience is undermined.
From where we are now, the critical point is that the financial economy, though it might just about weather another modest recession, would be destroyed by “de-growth”. Moreover, the advance of financialization suggests that even something well short of de-growth – for instance, a severe and prolonged recession, well short of what was experienced in the 1930s – would bring down the financial system.
For policymakers, this means, as mentioned earlier, that a “Wall Street versus Main Street?” choice no longer exists. If they were to intervene to rescue the financial system, whilst leaving the ‘real’ economy to its own devices, the financial system would collapse anyway.
We need to be absolutely clear that the Wuhan coronavirus pandemic, though it has appeared to many to be a ‘bolt from the blue’, has in reality catalysed and accelerated trends that were going to happen anyway. Since 2008 – and, arguably, for a lot longer than that – a reversal of growth has been inevitable. It has already started in the advanced economies of the West, and was always going to pose an existential threat to a financialized money and credit system wholly predicated on perpetual growth.
Let’s look at what this means at the present juncture. Long before the pandemic, people in the West were already getting poorer, and a similar climacteric was imminent for the EM (emerging market) countries. Worldwide, growth in aggregate prosperity has now fallen to levels which are lower than rates of increase in population numbers. Thus far, we’ve blinded ourselves to this by using credit to sustain consumption in excess of real value output. As well as encouraging consumers to do this, the corporate sector has added top-spin to this process by using debt to buy back stock, essentially replacing shock-absorbing equity with inflexible debt (which is another example of how financialization takes away resilience). Critically, buy-backs add debt without adding to productive capacity.
Whether we borrow as individuals to increase our consumption, or as corporations to boost stock prices through repurchases, the common result is that we mortgage the future in order to inflate apparent prosperity and value in the present. Because we’ve used debt to try to mask the trend towards deteriorating prosperity (a trend that we can neither stop nor reverse), the imbalances between the real and the financial economies have grown steadily more extreme.
Our situation has become one in which monetary manipulation has created value which only really ‘exists’ if we can carry on sustaining illusory levels of output. The only comfort that can be offered to those who’ve mishandled the coronavirus crisis is that this crunch point, if it hadn’t been precipitated now, would in due course have happened anyway – indeed, SEEDS has long identified 2020-22 as the period in which equilibrium would bite back.
At the end of gimmickry and denial
The immediate conclusion has to be that the authorities can no longer sustain a semblance of sustainability through monetary manipulation (though they are highly likely to try).
If they decide to prop up the financial system whilst leaving the economy itself to its own devices, the financial system could not escape the consequences of slumps in ‘real-world’ income streams (which would show up in bankruptcies and defaults).
If, recognizing this, they decided to prop up the real economy as well, using fiscal and monetary intervention, this, too would fail, both because the ability to ‘stimulate’ the real economy is circumscribed, and because action on the required scale would undermine monetary credibility.
This leaves us with the question of whether fundamental reform is possible. In purely practical terms, it probably is, but the likelihood of it actually happening – let alone of it happening in time – seems remote.
In the economy itself, we could adapt to the implications of worsening imbalances between energy ECoEs, labour availability and the environment, opting for what might best be termed “craft” solutions for our profligacy with energy and broader resources.
Financially, shrinking the system back into a sustainable relationship with the real economy is by no means an impossibility.
But the processes of decision-making, the myriad self-interests in play, and sheer ignorance about financial, economic and environmental realities, makes the voluntary adoption of such courses of action look depressingly unlikely.