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Herman Daly on the Credit Crisis, Financial Assets, and Real Wealth
Posted by Nate Hagens on October 13, 2008 - 9:08am
Topic: Economics/Finance
Tags: credit crisis, economics, herman daly, original, reserve requirements [list all tags]
Previously, Herman Daly wrote a guest post on the Steady State Economy, outlining core suggestions on how to overhaul our banking, financial (and value) systems. I encourage everyone to read it (if short on time, please read the conclusion). Professor Daly was Senior Economist at the World Bank before leaving to teach Ecological Economics at University of Maryland's School for Public Policy. He was also the catalyst for me to leave my own financial career and return to school to study the real economy (i.e. what we call the human economy is only a small part of a larger closed system). Below the fold are his thoughts on the current crisis (current being defined as last 30-40 years or so). (For comparison, here are links to what 'mainstream' economic icons George Soros, and Bill Gross are saying.)
The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth—pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy—paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt. The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.
Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two‐legged Wall Street pigs, but that is another matter.
Growth in US real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so‐called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.
What allowed symbolic financial assets to become so disconnected from underlying real assets? First, there is the fact that we have fiat money, not commodity money. For all its disadvantages, commodity money (gold) was at least tethered to reality by a real cost of production. Second, our fractional reserve banking system allows pyramiding of bank money (demand deposits) on top of the fiat government‐issued currency. Third, buying stocks and “derivatives” on margin allows a further pyramiding of financial assets on top the already multiplied money supply. In addition, credit card debt expands the supply of quasi‐money as do other financial “innovations” that were designed to circumvent the public‐interest regulation of commercial banks and the money supply. I would not advocate a return to commodity money, but would certainly advocate 100% reserve requirements for banks (approached gradually), as well as an end to the practice of buying stocks on the margin. All banks should be financial intermediaries that lend depositors’ money, not engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved we would restore the classical economists’ balance between investment and abstinence. Fewer stupid or crooked investments would be tolerated if abstinence had to precede investment. Of course the growth economists will howl that this would slow the growth of GDP. So be it—growth has become uneconomic at the present margin as we currently measure it.
The agglomerating of mortgages of differing quality into opaque and shuffled bundles should be outlawed. One of the basic assumptions of an efficient market with a meaningful price is a homogeneous product. For example, we have the market and corresponding price for number 2 corn—not a market and price for miscellaneous randomly aggregated grains. Only people who have no understanding of markets, or who are consciously perpetrating fraud, could have either sold or bought these negative pigs‐in‐a‐poke. Yet the aggregating mathematical wizards of Wall Street did it, and now seem surprised at their inability to correctly price these idiotic “assets”.
And very important in all this is our balance of trade deficit that has allowed us to consume as if we were really growing instead of accumulating debt. So far our surplus trading partners have been willing to lend the dollars they earned back to us by buying treasury bills—more debt “guaranteed” by liens on yet‐to‐exist wealth. Of course they also buy real assets and their future earning capacity. Our brilliant economic gurus meanwhile continue to preach deregulation of both the financial sector and of international commerce (i.e. "free trade"). Some of us have for a long time been saying that this behavior was unwise, unsustainable, unpatriotic, and probably criminal. Maybe we were right. The next shoe to drop will be repudiation of unredeemable debt either directly by bankruptcy and confiscation, or indirectly by inflation.
A superb piece, thanks.
I am glad to hear Prof. Daly's remarks on how the credit crisis should be handled. If we get rid of fractional reserving, derivatives, and structured securities, it seems like there will be vastly less credit. Also, the payback of loans plus interest in a slowly growing economy will take a big chunk out of company's (and individual's) cash flow. Unless the loans are used for only the occasional very productive project, they will be a big drain on the economy.
I wonder how Prof. Daly would handle the transition. It seems like there would be a huge drop in GDP at the time this change takes place. The lower GDP will make it even more difficult to balance the trade deficit.
Gail,
Doesn't your last statement imply we do one thing while the world does another? The best solution would seem to be for the world to do all the above.
I think trade imbalances will be primarily driven by the relative weighting of his last point -- how much bankruptcy versus how much inflation. This is really a critical question for each of us, as it affects where we should put our savings, whether into cash, commodities, or other equities.
I know food and tools, a house, and skills are always good bets, but beyond that it just isn't clear to me.
Anything in the financial sector seems like a very bad bet, in any case.
I could see a lower GDP will make the budget deficit and overall debt look a LOT worse, but wouldn't trade imbalance (for the US) be improved by a focus on tangible wealth generation like manufacturing?
While you're plotting to get rid of fractional banking, here in the UK we're just about to pump another GBP50bn ($80bn) into the banking system, details will be announced tomorrow morning before the markets open.
300,000 savers here found their savings frozen today when the Icelandic bank Landsbanki went bust.
The shares of our ex-second largest bank (Royal Bank of Scotland) dropped 40% today. A few weeks ago they were the tenth largest bank in the world.
Will this be "the week the banks went away"?
Helicopter Ben, with one blade rusting apart and the other increasingly covered in bird doo-doo, to the rescue!!
Read all about the latest unprecedented action here. So maybe 'the week the banks went away' will be next week instead...
It seems like the lower level of debt will reduce natural gas production. We have already seen cutbacks in planned drilling from natural gas companies, related at least in part to the loss of available credit markets.
It may also interfere with oil production and distribution, because there are many smaller entities (oil and gas service companies, gas stations, various kind of subcontractors) involved in the distribution chain, and they rely heavily on debt financing. Utilities are similarly likely to be affected. They are likely to have a more difficult time buying fuel and trading for electricity over the grid.
All of this is likely to lead to disruptions of many types--loss of electrical power, shortages of gasoline and diesel, and probably some interference with agriculture.
At the same time, we no longer have factories for a lot of basic things we need--repair items for the electric grid; new nuclear reactors; fertilizer; clothing and shoes; items to repair the cars we drive. One can think of a lot more.
With the disruption to fuel supplies and utilities, we will most likely have a lot less that we can manufacture or produce from agriculture. At the same time, our needs for imports will be as high, or higher, then ever before. How do we bridge this gap?
A working capital market will arise again, with or without gov't help. It'll cost more, for sure.
Beyond that, I think there will be some cases of VC-funding (but small scale, family and friends) and shoe-string entrepreneurship to address observed manufacturing niches, and re-purposing of some existing businesses. For example, about half of my wife's employer's business was related to luxury toys like personal watercraft and high-end motorcycles, and the rest to things like generators and lawn equipment parts.
Boats are down, but generators are up. Expensive motorcycles are down, but they're looking at a growing scooter market. Interestingly, they'll go for some shared-risk development with new companies, but not much credit-risk for any customers.
I fear, though, that the primary solution for the nation will be the same as for individuals as credit runs out -- they'll sell assets to raise cash to live. For the nation that means we may take outside investment to get some oil and some capital. That will only work as long as SOMEBODY has capital to invest. A spiraling decline could wash out a round of investments and close that spigot as well.
Your incorrect axiom is that we NEED those imports. Incorrect. We WANT those imports.
I think he's saying that the Financial sector of the Service economy is way too big, employs way too many people and that may be true of the Service economy itself! What do you do with all these people when they are no longer needed to produce real things, which itself has been exported from the US?
If we are not getting many imports, we suddenly will need to produce real things. What do we do when we don't have the facilities to produce these things ourselves, and loans are very difficult to get?
Gail points to some consequences of Herman's ideas. It does seem obvious that there will be less credit but it will take VASTLY less credit and debt to bring the system back toward a steady state. It is the sheer huge size of our combined government, corporate and individual debt about $50+ trillion vs our GDP $13 or $14 trillion) that daunts me.That is a ratio of 3.5 to 1. At the nadir of the Great D that ratio had soared to only 2.5 to 1. Most TOD ers believe that cheap energy has allowed the kind of productivity that has converted that oil drum into a drum of something more valuable but if that cheap drum of oil isn't replaced with another cheap drum of a different energy, then where will the productivity emanate from? If growth slows or stops or becomes negative, that debt will never be repaid unless the currency is expanded, ie inflation. I think we have here not a problem but a "predicament" as JM Greer has pointed out in his latest book,"The Long Descent." Greer points out that problems may have solutions but predicaments do not.We know what expanded debt and credit did to the economy when the expansion was out of phase with real wealth creation and we fear what the consequences of pulling the plug on debt and credit might be, but what other choices are there? The huge majority of the nation opposed the banking bailout by a treasury secretary who was a Goldman Sachs former CEO. The problems were created and advanced by investment banks and bankers such as Paulson and his tribe so here we had the ludicrous spectacle of a banker bailing out himself paid by us using a hurry up offense. He promoted the banking bailout to prevent something worse.But he advanced no evidence to support his assertions that something worse might happen. Something worse may happen anyway but at least his former bank and his former tribal members are sleeping better.The morons and crooks who devised and promoted this debacle are not being punished but most of their employees are, as well as most of the country. The wall street banking industry owned the government and now the positions are reversed. They have the cash and we have the trash. As to How Prof Daly would handle a transition......well how can we transition from a situation of debt and credit created wealth to wealth? We can't. There is no easy way to erase wealth. Most of our wealth was chimera. It was never there anyway. Should we punish the banking axis of evil? Of course. Would it yield much money? of course not but sending a horde of these bankers and buffoons to the guillotine would send a message.This hurried and poorly thought out propping up of a failed financial system just delays the inevitable collapse. The investment banks should have been allowed to fail. There would have been huge financial harm to all manner of people and not just the investment banks who were leveraging and trading their own securities but innocents like the Norwegian Teacher's union and pensioners in Japan and Korea and other banks and insurance and pension funds and even governments worldwide. But they bought those securities. I didn't nor did 99% of my citizens. You choose. You lose. Will the world ever trust the US financial system again? Not in my lifetime, with or without a bailout. Daly points out the obvious that for wealth to be real, it has to be real. Real wealth is created by people doing real work not pushing paper oops! I mean hitting a keyboard to create a CDS to insure against a default which the bogus insurer can't pay anyway. GDP will fall and fall hard. There will be no way to balance a trade deficit that is 70% due to our purchase of imported oil any more than we can have energy independence by drilling off Virginia or California. YOYO folks. You're on your own. Hugh in Jackson Hole.
I am always fascinated by the term "real work". What does that mean? Did Beethoven do "real work"? After all, who really needs music? Yet millions of dollars (in every currency in the world) in concert tickets and more millions of dollars in records and CD's have been sold based on the "work" of this one man. Could Beethoven himself have ever believed that Japanese citizens would someday go to concerts of his music...or people in China and Brazil, and that they would buy recorded versions of his work to play in their cars (says Ludwig, what's a car? What's a recording?
This is just one small example of "work"..."real work"? Who knows. It is now easy to hate banks. I live in a rural area where many folks are not so trusting of banks. I once knew a man who remembered the great depression, and was scared to put his money in banks. They'll steal it or lose it he said, so he kept it in the floor of his house under some loose boards.
He was beaten to death and the money taken from him in his old age.
RC
Hi Gail,
What I got from Prof. Daley's presentation is that the damage has already occurred. The debts exist. There is no mechanism for their removal nor is there remotely sufficient real wealth to do so even if a globally agreed procedure was already in place.
Not only will the GDP fall, it is already falling and has been for a long time now. The decline was simply hidden by statistics that treated imaginary products as though they were real ones, as if bushels of wheat were somehow equivalent to 'credit default swaps of securitized tranches of tax incremented municipal surety bonds' (i.e. indecipherably absurd financial instruments.) As for the Trade Deficit, the arcane relationship between real and hallucinatory production makes it virtually impossible to even calculate what the deficit IS, much less balance it.
The situation is comparable to Peak Oil in a lot of ways. We might like to go on driving big cars on limitless fuels forever (just like we would like to have endless pay raises), but we're not going to because gone is gone. Another non-negotiable constraint imposed by an utterly non-abstract world.
I personally doubt that any government or combination thereof has the power to stop the chain reaction that is accelerating at such a rate as seen in the past few weeks. It would require what? The simultaneous elimination of fear in many millions of minds? The suspension of hundreds of laws controlling the honoring of debts and contracts? How could such an engendering of faith in the faithless even be transmitted to so many people so quickly? To make matters worse, those who need their heads put back on straight are the same people who created the problem in the first place. If we passed a hat for enough money to really bail out the world economy, does anyone believe Hank Paulson or any of his ilk would chip in their own ill gotten gains?
There might still be a miracle. It will require nothing less.
What we are doing now (in discussions like this on The Oil Drum) is not so much proposing realistic solutions to fix what's broke, as we are hashing out the details of better rules-of-play should we ever have the opportunity to rebuild a civilization from the ashes of this one.
I followed Daley's comments in the direction of placing value on the real biosphere assets of the natural world. That is the "subset" the "economy" is part of. Real wealth in the future might be if you can breathe in your part of the world or step out into the sun without fear of cancer. Safeguarding what we have now is the real work that must be done. Transferring work energy from war, competition, and useless accumulation of goods to building an infrastructure of green technologies is a clear way to go.
We have spent enough time building the oil/chemical/pollution-based economy which is killing us and our biological support system. It is time to develop bio-technologies that actually co-exist with nature and mimic nature.
So maybe it sounds crazy, and I am no expert, but eventually we have to learn to live in harmony with nature or turn ourselves into cyborgs.
Read John Todd and the development of eco-machines and eco-cities. Restructuring our productivity based on natural systems, restoring our depleted soils, recreating our wetlands, supporting rather than limiting bio-diversity. There is a way to move into the future, just not the way the American Dream has been promoted.
Gail,
I'm a financial newbie, trying to learn fast.
As I understand it, derivatives are unsecured, or undersecured side bets. Credit default swaps are on the books for approximately 50 trillion, and total derivatives represent about 500 trillion.
CDS were often acquired as a hedge against paper such as sub-prime mortgages and a large amount of them have already defaulted. If the majority of derivatives are smoke, why hasn't the derivative casino started to unravel? Is this the 1000 lb rhino in the room that everyone ignores?
As Professor Daly has appropriately suggested, this practice should be ended.
That's all well and good, but if mortgages of various qualities have been bundled into securities and unraveling individual mortgages seems nigh impossible, I don't understand how derivatives could be unwound in any sort of organized fashion. This means that it all has to fall down, and then we start again with a new rule book that has some basis in reality.
As I said, I don't understand how the lie is sustained, but what event would be necessary for derivatives to implode?
This all sound pretty scary to me, so I invite anyone to point out the error of my ways.
Cheers,
Gail,
I think the profits in the financial industry are counted as part of GDP. If so, there should really be a huge drop. And if there were not, we wouldn't be fixing the problem. Or am I seriously missing the point? Of course some of the financial industry is legitimate useful work, and should be counted, but mostly it is toxic fluff.
Great post. You've nailed the real reasons for the crisis.
Another piece that is missing from mainstream discussion on the implosion of these "asset" bubbles is this: where has the money gone? People talk about the wealth that has "vanished overnight", but of course it was never really there (or at least not yet, until the growth fairy delivers it). But real money (OK, as real as it gets...) has been surely transferred -- from the people who bought on the way up to those who sold. A novel but rather impractical idea would be to get the money back from those rubes who benefited from this scam. What have they done with that money anyway?
Similarly, on the downside of the bubble, the media talks of investors abandoning equities for the safety of T-bills etc. But somebody is buying those forlorn equities; what are they abandoning? The staidness of T-bills?
A novel but rather impractical idea would be to get the money back from those rubes who benefited from this scam.
Why is getting the money back impractical? We have trading records (these are securities). We have financial auditors.
We could deploy lots-o-lawyers for a modest recovery percentage.
Getting the money back is much easier/cheaper than waging war in Iraq and Afghanistan. We didn't shrink from those patriotic challenges.
Sending the repo man to cart off the bonus Lamborghinis sends a powerful message.
Won't help much, I imagine, and in most cases nothing illegal was done. It's not crime for you to buy an inflated stock or me to sell it, if the inflation was due to a overgrown bubble driven by loose credit and 401K shilling. Sure, there may be a few billion in financiers' pockets, but not enough.
I think most of the derivatives money was borrowed from the Fed, and exists in T-bills. The game now is to rotate out of fiat-value equities and money and into hard assets, I assume. Then the value of the dollar will fall, and T-bills with it.
I'm no economist, but if I were playing the big-money game that's what I'd want to do.
I cannot see any way for this to end except badly or worse.
Of course nothing illegal was done. This is the American Way at its finest. Buy low, sell high. The myth is that those who buy high will, if they wait long enough, get to sell higher.
In the meanwhile, the cavalry rushes in to rescue the besieged townsfolk by inventing new money. Everybody wins!
(Everybody loses!)
This is why we need a simplified legal system. Don't have much time now, so just these two:
1. A minimum of laws. Say, ten.
2. Leave it to the jury to decide if intent existed and harm done.
Bank: Here is a loan. Here is a teaser rate. Here are your assets. They are insufficient. Here's the loan.
Mortgagee: Thanks!
Later....
Jury: You knew they would be screwed when it reset. You knew you most likely wouldn't let them refinance as you make more money from fees than from the mortgage. Taking it back and selling again makes you more money. You know markets don't go up for ever and that only so many homes can be re-sold at any given time, anyway.
Guilty of fraud.
And you: You knew you couldn't afford it and lied about your assets.
Guilty of fraud.
-------------
Cheers
"... in most cases nothing illegal was done."
Nothing illegal?
Fraudulently overstating value (via mark to model strategies) enabled billions of fees and bonus money.
We're due for the return of mis-allocated compensation. Letting thieves keep the loot is simply foolish.
What is most shocking is that the widespread rating agency fraud continues to be tolerated. Without the rating agencies on board a lot of these fraudulent schemes would never have gotten off the ground.
When the issuer pays the ratings agency there is a fundamental flaw. Another flaw is where the auditors of giant companies are selected from only four companies and those companies provide much more lucrative consultancy.
i will be interested to see if anything comes out of the AIG enquiry. IMHO for an insurance company to write Credit Default Swaps without the means to pay up is criminal, certainly to try and hide the extent of losses must be criminal??
It's not going to change meaningfully. After, this all got plowed through during the dot.com bust and then again with Enron.
I learned long ago that rating agencies reflect the inverse of the desire of the institution, but mostly as a lagging indicator. It changes from "neutral" to "buy" right after the raters bought in, and goes from "buy" or "hold" to "sell" right after they get out, or it crashes, whichever comes last.
.. during the dot.com slide, all the money made on the way down got locked in real estate. Bill Clinton said this when he was on Letterman the other week.
AIG isn't very popular right now... I mean, spending 440,000$ for an executive getaway with spa treatments just a week after being bailed out.. that's normal right?
Aren't some, maybe most, of these rubes non Americans. China, Russia, etc..?
We'll kill the lawyers first.
In a fractional reserve banking system, when a dollar is created -- through the issuing of a loan, say -- it isn't necessarily passed from hand to hand forever in the financial system. It can be destroyed.
When a bank lends against it's own reserves, it creates money. When the principle is paid off, money is destroyed.
Say a loan has to be written off because the borrower defaults and the price of the asset used as collateral has fallen drastically..... well, that means the banks reserves decline and it's money-creating powers decline also.
Now, say the guy from whom the borrower bought the asset in turn paid off a loan (using the proceeds from the sale) from a bank that, because of current conditions, is not really anxious to lend again. In that case, the amount of the principle was effectively destroyed. The money vanished overnight.
If you and I (or two banks) lend each other the same amount, has "money" been created? I suspect that a lot of the financial house of cards is built with debt that goes around in circles. (Thus the absurd "total" of the derivatives being in the hundreds-of-trillions raneg.) Thus I am not convinced that "deleveraging" will necessarily reduce the amount of money available for actual purchase of real goods such as oil - as opposed to the gambling in futures and such, with no intention to ever receive the physical asset.
Thank you.
But that money has an active life before it goes away in the paying off of a loan at some point. It's just a presumption on my part, but I would think that the sellers enjoying the windfall spend that money on expensive cars, boats, second houses. And the people that didn't sell but came to realize that their asset was worth more felt flush as well, spending more freely and possibly taking a second mortgage to buy even more. The bubble and deflate cycle would seem to promote a lot more mindless consumption.
Indeed. And some of the money supply isn't created by loans in the normal sense. So that money can float around in the economy for a long time.
But the sad thing is that it's just not possible to cover the damage by going after the scammers who benefited. Though, dear jesus, I hope it's attempted! With some corporal punishment to make up for the unrecoverable balance! :-)
The US has pushed the idea of fractional reserves much farther than in other countries:
LOAN TO DEPOSIT RATIO
3.5 to 1: United States
1.8 to 1: Russia
1.2 to 1: Germany
1.0 to 1: South Africa, Brazil, Japan, UK
0.8 to 1: China, India
See graphic at "How it got this bad"
http://money.cnn.com/2008/09/26/news/leverage.fortune/index.htm?postvers...
I hadn't seen that. That is really scary, though it leaves off hundreds of other countries so COULD be data mining - I will email Merril Lynch and see if I can get the report. It is quite possible that the United States DOES have the highest leverage...
Here is the graph you linked to:
When I first saw this chart on the sidebar of some article I was reading, I came at it from the bottom. It took me a while to find the US as I was scrolled down and didn't realize there was more chart above the whitespace above 2:1. Talk about an outlier.