Saturday, November 15, 2008

Economics: the Origin of Current Crisis

For the past generation, government has used inflation and debt to artificially stimulate the economy, because excess money leads producers to ramp up production. The Social Security Trust Fund, the excess money brought in by FICA taxes over what is paid out in SS benefits, was converted to debt. The federal budget was never balanced, but financed totally by borrowing. Common citizens have run up massive personal consumer debts.

The camel that finally broke the camel's back was the recent run up in mortgage debt. Home values shot through the roof based on a massive expansion of credit combined with an artificial expansion of population due to immigration, especially illegal immigration, ramped up even further through widespread speculation in the housing market. When home values peaked, short term mortgage rates could no longer be refinanced, starting a tsunami of foreclosures. The increased foreclosures undermined existing home prices, leading to a further fall in home prices, which then forced more people into foreclosure, since they could not sell their house at a price that would cover their mortgage, which then further undermined home prices, in an ever-widening housing death spiral.

Banks were put against the wall because so much of their book value was tied to the value of those home loans. Because they were heavily leveraged with outstanding debt, they could not afford to write down the value of the homes or resell them at lower market values because to do so would put the bank's asset level below their required capital reserve. Thus homes would sit unlived in, as the banks could not afford to sell them, which would realize a huge loss, potentially destroying the bank itself.

By refusing to sell at loss in foreclosure or restructure the loan with the original borrower, the banks temporary clung to life, an they began to hoard money to prop up their reserves to be able to withstand the inevitable write-offs. The solvency of the banking system itself came into question, as banks hoarded reserves to cover further losses, and refused to even lend to each other. Thus, banks abdicated their foundational economic purpose, which is to transfer wealth. By hoarding money to preserve their own institutional existence, banks are actually devastating the real productive economy, the exact opposite of what they are supposed to do.

Keep in mind, the banking problem is all an accounting mirage. The true wealth of the country was unaffected by the dollar-counted book value that sat on the account ledgers of the banks. Every bank in the whole country could close, and the true wealth of the country would be totally unaffected. However, our entire economy was now based on accounting illusions, propped up by debt, leveraged to the hilt because of the fractional reserve system and fictional financial instruments.

In a functional economy, spending proceeds from savings. Savings represents a real accumulation of wealth, based on an excess of production over consumption. In a dysfunctional economy, spending proceeds from debt. Debt spending represents a trick based on money, not a real source of wealth, a gimmick to get producers to create more. The gimmick can work as long as the money keeps flowing, although the downside is a chronic inflation of the money supply. The chronic inflation of the money supply discourages savings while at the same time subsidizing debt, as old money is always worth less and less. Thus savings, which represents a real accumulation of wealth, continued to decrease, while debt continued to increase.

In a major buzz kill for everybody, banking system liquidity dried up under the onslaught of the housing price collapse. Massive job losses in the financial industry ensued in the first phase of the system-wide collapse, as banks shed costs with massive layoffs. Paradoxically, we should keep in mind, these layoffs did not affect the overall wealth of the country, as financial services workers do not create wealth.

Bankers, and all variety of paper-pushing money managers, do not themselves create wealth. Their only economic utility comes from facilitating wealth-producing activity by others. In a functional economic system, excess wealth in the form of saving goes towards helping the up-and-coming producers, through the medium of the bank. Productive work is done elsewhere. If another way could be found for savings to meet productive need, banks would be obsolete. If another way for storing and transferring wealth could be found, money itself would be obsolete.

The financial balance of America in early 2008 is called a negative savings rate, meaning we had more debt than savings. The false idea of a negative savings rate is that we have a negative net worth, because debt is greater than assets. But remember, debt is fiction. Savings represent real wealth. Negative net worth is only a book value, a fiction based on money.

For example, think of a house. A house is a tangible asset, a real piece of wealth. The wealth value of that house exists whether or not a dollar value is associated with it. The money value of the house is determined by market forces like supply and demand, but even if every money dollar in the country disappeared, the house would still have wealth value. The house is real wealth, the money is just a means for exchanging the house on the market. The house is real wealth. The debt is fiction.

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