The Crisis

Groundbreaking economist, Herman Daly, zeroes in on the root cause of our financial meltdown.

The Crisis

The turmoil affecting the world economy unleashed by the US sub-prime debt crisis isn’t really a crisis of “liquidity” as it is often called. A liquidity crisis would imply that the economy was in trouble because businesses could no longer obtain credit and loans to finance their investments. In fact, the crisis is the result of the overgrowth of financial assets relative to growth of real wealth— basically the opposite of too little liquidity. We need to take a step back and explore some of the fundamentals that growth-obsessed economists and commentators tend to neglect.

After winning the Nobel Prize for chemistry, Frederick Soddy decided he could do greater good for humanity by turning his talents to economics, a field he felt lacked a connection to biophysical reality. In his 1926 book Wealth, Virtual Wealth and Debt: The Solution of the Economic Paradox, (a book that presaged the market crash of 1929), Soddy pointed out the fundamental difference between real wealth – buildings, machinery, oil, pigs – and virtual wealth, in the form of money and debt.

Soddy wrote that real wealth was subject to the inescapable entropy law of thermodynamics and would rot, rust, or wear out with age, while money and debt – as accounting devices invented by humans – were subject only to the laws of mathematics.

Rather than decaying, virtual wealth, in the form of debt, compounding at the rate of interest, actually grows without bounds.

Soddy used concrete examples to demonstrate the flaw in economic thinking. A farmer who raises pigs faces biophysical limits on how many pigs he can take to market. But if that pig farmer took on debt – a promise to repay at a future date – he would in effect be issuing a claim or lien on his future production of pigs. If he borrowed the equivalent value of 100 pigs, he could represent the loan on his balance sheet as “-100 pigs.”

While debt as the farmer’s accounting entry is negative, negative pigs do not really exist. If the farmer should suffer a series of lean years and be unable to pay the interest, he might soon owe more pigs than could be raised on his farm. After a year, with interest looming, he’d show “-110 pigs”; in 5 years, “-161”; in 40 (assuming a patient bank), “-4526.” When the bank finally came to call on the pig farmer to collect repayment of its loan, it could well find that most of the virtual wealth that had grown so appealingly on its books had to be written off as a loss.

Soddy’s insights show us that the institutions of a growth economy lead to the type of crisis that hit the US economy in 2008. Real wealth is concrete. Financial assets are abstractions. Existing real wealth serves as a lien on future debt. For example, the 100 dollars of virtual wealth that I carry in my wallet are a lien on real wealth in that those dollars enable me to buy pork at the store.

The problem that we’re seeing in the US has arisen because the amount of real wealth is not a sufficient lien to guarantee the staggering outstanding debt which has exploded as a result of banks’ ability to create money, loans given out on shaky assets and the US government’s deficit, which has been stoked by financing the war and recent tax cuts. All of these factors are exacerbated by the compounding mechanism on debt. The debt is growing, and consequently, it is being devalued in terms of real wealth.

The conventional wisdom is that when faced with the threat of recession and business failure, the solution is to grow the economy so we can grow our way out of the crisis. But because the wrong diagnosis is made, namely that businesses are in trouble because access to credit has tightened, the wrong solution is proposed. Even if we could grow our way out of the crisis and delay the inevitable and painful reconciliation of virtual and real wealth, there is the question of whether this would be a wise thing to do. Marginal costs of additional growth in rich countries, such as global warming, biodiversity loss and roadways choked with cars, now likely exceed marginal benefits of a little extra consumption. The end result is that promoting further economic growth makes us poorer, not richer. The cost of feeding and caring for the extra pigs is greater than the benefit of eating extra pork.

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 growth of real wealth. That future growth is very doubtful, given the deferred real costs, while the debt continues to compound to absurd levels.

What allowed symbolic financial assets to become so disconnected from underlying real assets?

First, our economy is based on fiat money (paper money issued by governments) that has value by convention but isn’t backed by any physical wealth. 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 of the already multiplied money supply. In addition, the financial sector was very inventive in coming up with new financial instruments that were designed to circumvent government regulation of commercial banks to protect the public interest.

The agglomerating of mortgages of differing quality into opaque and shuffled bundles that led to the sub-prime mortgage crisis should be outlawed. The US balance of trade deficit has allowed us to consume as if our economy was growing real wealth instead of accumulating debt. So far, US trading partners have been willing to lend the dollars they earned from running a trade surplus back to us by buying treasury bills but these treasury bills are 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”).

How then do we clean up this mess?

A massive bailout – and having the US taxpayer take on billions in bad debt – is merely a way to keep the growth economy from failing a little longer while allowing it to continue degrading the planet. Propping up such a destructive system makes no sense. Instead, we need to redesign our laws and institutions to foster an economy that remains within biophysical limits.

I would not advocate a return to commodity money (such as gold), but would certainly advocate gradually increasing reserve requirements for banks. Commercial banks should act as financial intermediaries that lend other peoples’ money, not as engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved, we could restore the classical economists’ balance between investment and abstinence. Far fewer stupid or crooked investments would be tolerated if abstinence had to precede investment.

Of course the growth economists will howl that such measures would slow the growth of GDP. I say so be it – growth has become uneconomic, and we have limited time to bring the economy into line with the biosphere’s carrying capacity.

Were Soddy still around, I doubt he would be surprised by the havoc wreaked by all these two-legged Wall Street pigs, given that they were left free to raid whatever troughs they could poke their snouts into while drawing on conventional economic thinking to disguise their mess as innovations in finance. But I also think he would be disappointed that 80 years after the publication of his book, we still haven’t figured out a way tether the economy to reality – to ensure that the number of negative pigs can’t grow without limit.

102 comments on the article “The Crisis”

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Anonymous

Unionisation has not forced jobs overseas. Unionisation is the only refuge of the working classes against a predatory and greedy ruling class. It is utterly inevitable that the "3rd world countries" currently enjoying new found employment opportunities will become unionised because of the truth of the need for workers to stand together to prevent abuse and exploitation. Globalisation has caused jobs to go overseas. Because we didn't insist that the benefits of medicine and automation be spread equally to all men, but rather, fell into silly greed and competition and endless chasing after slightly upgraded machines and experiences. Because our governments failed to stand up to large companies, because we failed to see what the corporations would evolve into and because we're still too frightened to challenge them, still too addicted to endless new shiny toys to care. Whilst the minority own the means of production and distribution we will forever be at odds, forever be trapped in this nightmare of exploitation and poverty, forever be used to make another man rich and cast aside when we've fulfilled our purpose and this is NOT what human life was meant to be.

Anonymous

Unionisation has not forced jobs overseas. Unionisation is the only refuge of the working classes against a predatory and greedy ruling class. It is utterly inevitable that the "3rd world countries" currently enjoying new found employment opportunities will become unionised because of the truth of the need for workers to stand together to prevent abuse and exploitation. Globalisation has caused jobs to go overseas. Because we didn't insist that the benefits of medicine and automation be spread equally to all men, but rather, fell into silly greed and competition and endless chasing after slightly upgraded machines and experiences. Because our governments failed to stand up to large companies, because we failed to see what the corporations would evolve into and because we're still too frightened to challenge them, still too addicted to endless new shiny toys to care. Whilst the minority own the means of production and distribution we will forever be at odds, forever be trapped in this nightmare of exploitation and poverty, forever be used to make another man rich and cast aside when we've fulfilled our purpose and this is NOT what human life was meant to be.

Anonymous

Oh boy, this is going to be a doozy. The "we are one" philosophy is idealist. Suffering never ends, it can only be minimized. I love the whole "screwing the poor" mentality, it really cracks me up. It only seems like they're being screwed because there's wealth somewhere else. I like the bread machine analogy the best. A man makes a machine that helps people feed themselves cheaper than they could have previously. This man gets rich from his invention, and he keeps coming up with new products. What Adbuster's suggesting is that he's should be punished. I say, give him some credit, the people would be worse off without him! Adbusters loves to play the blame game, but can't seem to come up with any reasonable solutions. See true cost economics. All big corporations started small. Nike was started by a college graduate. Youtube was a similar case (two guys). Bill Gates was a drop out. All of them worked hard and turned over something people found useful. I don't understand why this is a problem now that the companies are very large. They have magical powers that make us want to consume? I just don't get it. Consumption is a person's choice, the people that are smart enough to cash in on people's consumption aren't to blame any more than the consumer. Suggesting that the producers are solely to blame is like saying that pornography is the sole reason for sexual promiscuity and infidelity. One could also argue that government intervention caused rampant consumption. With it's deficit spending and manipulation of interest rates, causing severe crowding out, it only makes sense than our consumption would change. But, nevermind, that's not important! It's the corporations, and that's it, right? Probably not. Unionization has lead to the near collapse of many of our currently running industries. With it's positives came negative consequences, like everything in the world. Globalization contributed as well, instead of illegally hiring labor within boarders, we legally shipped jobs over seas. Fair enough. Crystler, GM, are just a few CAR companies in trouble. The steel industry is also nearing it's end. All due to higher wages, limiting productivity, and regulations. Wages go up, regulations go up, and so do prices and unemployment. Works miracles on crippling an economy. Adbusters wants to liberate the world from oppression and exploitation. This is impossible without globalization in one shape or form. Saving people from oppression isn't a magic trick, it requires all people working together. Closed economies prevent this. Globalization is not only efficient, it's inevitable. Your life would be significantly more expensive and technologically hindered without it. You just take it for granted. Without globalization, we wouldn't have the servers Adbusters uses, the telecoms relaying the information, the computers we're using, and therefore this discussion. If you think closing boarders leads to efficiency and a better standard for everyone, you need to look more into comparative advantages. With the amount of people in this country, non globalized markets would cause rampant unemployment and/or emigration. You're suggesting you know the meaning and purpose of life? Explain what humans are meant to be on the planet for. Serving a higher power? Individual freedom? Prosperity of the species as a whole? From what I'm aware of, this is an unanswered question in philosophical circles. Leaning on your own idea of purpose does not change market efficiency or standards of living. It's all just a recycled form of the Marxist assumption of capital accumulation in capitalism. Even Keynesians laugh at his theories, let alone Austrian and Neo-classical economists! He was wrong, and so is your argument.

Anonymous

Oh boy, this is going to be a doozy. The "we are one" philosophy is idealist. Suffering never ends, it can only be minimized. I love the whole "screwing the poor" mentality, it really cracks me up. It only seems like they're being screwed because there's wealth somewhere else. I like the bread machine analogy the best. A man makes a machine that helps people feed themselves cheaper than they could have previously. This man gets rich from his invention, and he keeps coming up with new products. What Adbuster's suggesting is that he's should be punished. I say, give him some credit, the people would be worse off without him! Adbusters loves to play the blame game, but can't seem to come up with any reasonable solutions. See true cost economics. All big corporations started small. Nike was started by a college graduate. Youtube was a similar case (two guys). Bill Gates was a drop out. All of them worked hard and turned over something people found useful. I don't understand why this is a problem now that the companies are very large. They have magical powers that make us want to consume? I just don't get it. Consumption is a person's choice, the people that are smart enough to cash in on people's consumption aren't to blame any more than the consumer. Suggesting that the producers are solely to blame is like saying that pornography is the sole reason for sexual promiscuity and infidelity. One could also argue that government intervention caused rampant consumption. With it's deficit spending and manipulation of interest rates, causing severe crowding out, it only makes sense than our consumption would change. But, nevermind, that's not important! It's the corporations, and that's it, right? Probably not. Unionization has lead to the near collapse of many of our currently running industries. With it's positives came negative consequences, like everything in the world. Globalization contributed as well, instead of illegally hiring labor within boarders, we legally shipped jobs over seas. Fair enough. Crystler, GM, are just a few CAR companies in trouble. The steel industry is also nearing it's end. All due to higher wages, limiting productivity, and regulations. Wages go up, regulations go up, and so do prices and unemployment. Works miracles on crippling an economy. Adbusters wants to liberate the world from oppression and exploitation. This is impossible without globalization in one shape or form. Saving people from oppression isn't a magic trick, it requires all people working together. Closed economies prevent this. Globalization is not only efficient, it's inevitable. Your life would be significantly more expensive and technologically hindered without it. You just take it for granted. Without globalization, we wouldn't have the servers Adbusters uses, the telecoms relaying the information, the computers we're using, and therefore this discussion. If you think closing boarders leads to efficiency and a better standard for everyone, you need to look more into comparative advantages. With the amount of people in this country, non globalized markets would cause rampant unemployment and/or emigration. You're suggesting you know the meaning and purpose of life? Explain what humans are meant to be on the planet for. Serving a higher power? Individual freedom? Prosperity of the species as a whole? From what I'm aware of, this is an unanswered question in philosophical circles. Leaning on your own idea of purpose does not change market efficiency or standards of living. It's all just a recycled form of the Marxist assumption of capital accumulation in capitalism. Even Keynesians laugh at his theories, let alone Austrian and Neo-classical economists! He was wrong, and so is your argument.

Jeremy

"Suffering never ends, it can only be minimized." That is a complete falsehood. Suffering is a purely human construct; it is simply the space between what is and what we *think* things should be. The larger the gap the greater the suffering. Until you change that belief there is no solution.

Jeremy

"Suffering never ends, it can only be minimized." That is a complete falsehood. Suffering is a purely human construct; it is simply the space between what is and what we *think* things should be. The larger the gap the greater the suffering. Until you change that belief there is no solution.

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