The Economy: The Problem We FaceNews at Home
Our economic system has four principal characteristics. I will not give a name to that system as it tends to inflame the discussion. The four characteristics are: 1) it produces a great deal of wealth; 2) it distributes that wealth very unevenly (This is due to the differential value given to different kinds of labor and to the legal protection given to personal assets.); 3) it periodically produces wealth destruction -- euphemistically referred to as the “business cycle;” 4) there is very strong agreement among citizens that the system is legitimate. I realize that this simple model ignores the social, cultural, and psychological impact of economic change but I am not reaching for a Nobel Prize.
While the economic system is considered legitimate, it is not always considered fair. When the business cycle turns downward, revealing some of the more unfair ways in which wealth is created and distributed, it turns out that while victims are aplenty, those responsible cannot be found. Professors, pundits and regulators point to different culprits each of which is heavily camouflaged by a series of “causes” and “forces” and inexorable laws. As the system is legitimate, it cannot as a whole be responsible; but neither can any of the actors, all of whom seem to be in the grip of those inexorable laws.
One of these fruitless searches for culprits concerns the price of oil. While citizens shrink before the spinning numbers on the gas pump, they are told that: prices are not out of line with _______ (fill in another product or time period); that they represent only ___% of household income; which is __% less than in ____ (some other country). Or that greedy Arab oil moguls and instability in the Middle East push up oil prices. Or we have reached “Peak oil.” Or, simply, that it’s all a matter of supply and demand. None of this would matter if we could “kick our dependence on oil.” This could be accomplished if: we drove small cars, or if Detroit (or whoever makes cars these days) built them.
Again, none of this would matter if we invested in alternative sources of energy. Or if we gave the oil companies incentives to drill for more petroleum. Or if we would stop being hung up on the existence of species other than our own. Or if, like market cycles, we would just learn to live (more or less) with climate cycles. True, oil companies make obscene profits. But adjusted for _____ they are not that high. Anyway, that money is helping to bring petroleum to the market more efficiently. Anyway, it’s all the fault of the Chinese who want their own chance at petroleum dependence and air pollution. Amidst all of this finger pointing only the airlines have offered a constructive proposal: half-price tickets for air travelers who will book flights with no leg room -- seats only!
If we cannot pin down responsibility for the cost of petroleum, how can we ever explain the macro stuff like economic recession? Though we are taught that producers and consumers make reasonable decisions and that markets are large-scale reflections of the logic of those decisions, it turns out that producers and consumers (and as a result markets) are subject to “panics” and “bubbles.” Moreover, despite the logic of the market, beliefs about the state of the economy can affect the economy. That is, the use of the word “recession” can help produce one. The problem of naming the beast is compounded by the need of the media to appear informed. We are regularly told that we are “possibly heading for,” “unlikely to fall into,” or “technically in,” a recession. Tuesday’s headlines explain that “Dow rises 100 points as it shrugs off bad economic news.” Wednesday’s headlines tell us that “Dow drops by 100 points despite good economic news.” As befits a democracy, we can also rely on the “consumer confidence index” that registers the level of popular economic anxiety. Here we learn that many people are, well, anxious. Thus we are stuck within an economic system with neither clear victims nor beneficiaries; that while supposedly rational is subject to emotional breakdown as a result of causes unknown.
If we are “possibly heading for” a recession, consensus is forming around an unlikely culprit: the desire of Americans to own their own homes. This otherwise laudable goal is actually dangerous. American home buyers are not actually “settling down,” they are consumers making a purchase that reflects their life stage and their (hoped-for) life style. While a home is the most expensive purchase most people will ever make, it is not actually a purchase in the normal sense of the term. In the vast majority of cases, houses are not purchased they are borrowed. That is, a bank lends the home to the “owner” in return for a series of payments. Absent those payments, it becomes clear who actually “owns” the property. If Mary’s mortgage payment rises and her salary does not, she must hand over the keys.
Interestingly enough, the bank has not purchased the house either, though it is, for the record, the legal owner. The bank’s view is that it has created a product – a mortgage – that it can sell to investors who buy such “securitized debt instruments.” (In the old days, respected main street firms like Glass & Steagall would not have considered such a purchase.) Though it would seem that the housing “problem” is a result of Mary’s failure to make timely debt payments, it is actually the failure of the bank to find buyers for its debt instruments. At a higher level, the problem takes the form of the declining value of such debt instruments in the portfolios of financial institutions that hold great amounts of them. Now the major players (as the result of the rational decisions that they and Mary have made) face a collapse of the credit market. Though wealth is supposed to consist of tangible goods and services, it is debt that in recent years has been the real engine of the economy. While the demand for debt was high (so to speak) it had more value. This is why Mary’s friendly banker was so eager to “sell” her a house despite the fact that as a widget maker her economic future was murky.
Now that we understand the problem, what is the solution? Clearly Mary needs more money so that she can continue to pay the bank. This will make her loan a “performing” one and thus help raise the value of “securitized debt instruments” so that the big financial houses can add the amount of her debt to their assets. This solution would seem to make everybody happy. Hard working people like Mary are given (back) some of their hard earned money so that they can finance the indebtedness that buoys up the economy. However, the big bucks are offered to the investment banks. To understand this fact, we must examine the issue of “confidence.” If Mary becomes very worried about losing her home, the worst outcome is that she will. If the investment banks become very worried about the declining value of their assets, they will call in their IOUs, which will cause those in debt to them to call in theirs and so forth. In this case the outcome is the collapse of credit markets.
To keep the credit dominoes from falling, Mary and millions of other tax payers generously tell the Fed that it is ok to use their money to give confidence to the investment bankers. But while Mary perked up as soon as “stimulated,” the investment houses look warily at the billions put on their plate. The Fed money is to be used to underwrite new mortgage lending and the buying of debt instruments. But the bankers are less easy than Mary to brighten up. If they lend, will the loan be repaid; if they buy will the value of the “securitized debt” decline? The Fed is pushing on a string; it can tempt the bankers but it cannot make them re-enter the market place.
Though it may seem to violate fundamental economic laws, this mortgage based recession while it leaves us with mountains of debt (especially in the U.S.) leaves standing even larger piles of private and “sovereign” money. While highly leveraged investment houses must write off billions of paper profits, other wealth holders that were less exposed to the U.S. sub-prime virus now sit around with vaults overflowing with cash moved to higher ground above the red ink flood plain. What will these lucky money managers do?
Well, they are unlikely to buy Mary’s mortgage. Instead they may become attracted to investments in sectors unharmed by Mary’s reach for middle class bliss. These can now be bought on favorable terms.
The flight from bad paper leads refugee assets to find a home in markets for “real” goods such as tangible corporate assets, solid currencies and raw materials. If consumers stop feeding their plastic into the digital readers, these money managers will increase their positions in global markets for durable goods such as metals, minerals and, humble as it may seems, food. Mary does not need to be encouraged to eat.
Some of the new speculative cash helps to push up the price of oil. (Why was this one overlooked while the gas pumps whirled?) U.S. legislators now make grand populist promises: windfall profits taxes; alternative energy subsidies; tax holidays, rebates; oil from the strategic petroleum reserve, etc.
Such threats only lead oil companies and assorted Sheiks to find useful places to empty out their overflowing baskets of currencies. While much of this oil wealth builds artificial islands in the Persian Gulf and office towers in East Asia, investment also flows to the lowly bean and corn kernel.
This process raises the price of food stuffs. While Mary waits to discover the terms of her new “securitized instrument,” more than a thousand miles away, Maria is being priced out of the tortilla market. In desperation, she and her husband Juan say goodbye to their village way of life (of a mere eon’s duration) and head for factory work in the city. They arrive in time to see the sewing machines and mother boards on semis heading for a nearby Pacific port. Most cruelly, at just the time that globalization orients them northward; earlier victims across the border are building a wall to keep them out. They retrace their steps and join the mass demonstrations against the rising price of corn. (Their act of rebellion is actually a contribution to the global economy; in this instance as an uptick in tear gas sales.) In some inexplicable manner, Mary has added to Maria’s misery.
It would appear that a failing economy is just as uneven in its distribution of sacrifice as a booming one is in its distribution of gain.
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David Harold Chester - 6/11/2008
Professor Benjamin is sadly mistaken in his somewhat detailed description as to why the U.S. economy is in such a poor state. It is true that some of the distortions of the economy are associated with the interest being paid on deficit budgetting. But since nobody is going to let this result be the real driver, and for the amount of interest to dominate the whole economy, it is with concern that I wish to offer a better explanation.
Firstly I wish to clear-up the concept that debt and fecundatory currency are the problem. Nobody wants to accumulate money because it brings in no interest and is likely to be of smaller purchasing power with time. So the aim is to buy for consumption or to invest and not to hoard. This attitude keeps the economy going until a stage is reached in the process where the prices of ordinary things are allowed to rise, due to the creation of their deliberate scarcity. Even then the same rate of flow of money is passing but the amount of produce that it exchanges with becomes less. It doesn't matter if the cash is real money backed by gold, or fecunditary paper, printed by a bank or government. As long as people take it seriously and use it for the exchange of consumer or capital goods, services or other valuable legal documents, then there is nothing to spoil the business activity in which it will continue to circulate. But when there is a blockage in the process of the supply of a certain kind of goods or services, then there will be some kind of slow-down in the production and distribution of the goods, services or tools which otherwise we regard as wealth.
The three factors of production land labor and capital are exchanged in this way for rent wages and interest or yield on capital. In our free-market economy where there is competition to sell, the price of the goods or services is controlled by the existance of an alternative route for achieving the same end-result. However as soon as the supply of one of these kinds of services, availability of labor, tools or place to work being limited, then a monopoly develops and there is nothing to keep the price down.
Normally the problem is not with unwillingness to work, and if the capital investment in the right kind of tools is unavailable, it is possible to go somewhere else. However and consequently, the greatest and most easily restrictable kind of factor of production is in the land. As a cynic remarked, "they don't make it any more". Land is inelastic in supply. It is owned and its use controlled and its productive capacity depends very strongly on where it is located. This puts the landlord and the bank from where he gets the money to buy it, in a very strong position compared to the rest of the economy. In addition there is a strong trend to speculate in the land since its value is always rising. As towns grow, the banks are more than willing to help the landlords to speculate in its value. Due to the lack of competition possible in land, the landlord can control and raise the rent in a manner that is the same as a monopolist in any other kind of capital good, it rises until at last it becomes worthwhile to sell, and that is at a comparatively high price. Then the cost of the produce becomes greater due to the amount of return on it that is taken by the landlords (and of course less directly by the banks). It is this action that is slowing down our macroeconomy along with the wastage associated with having to invest it in almost any kind of durable capital, at home or abroard rather than accumulate it.
The answer is not to continue to allow the ownership of land to dominate the business activities of our society. Its vaule is mostly due to population density; where the most valuable and productive sites are in the middles of towns, the places where the people as tax-payers have made (via the local government) the biggest investments. However it is the land owner who reaps the benefit of this high productivity and the money that he makes is actually what would be the interest on the tax-payers investment, were he accute enought to demand and recieve what is due to him in this respect. This money return is really the rent which is otherwise mostly lost.
To get it back and to use it for the public purse is the answer, but this means that the laws regarding land tenure will need to be changed so that this interest on investment is for national use instead of the income and purchases taxes that replace it. Should even a small amout of the rent be collected in this way speculation in land would cease and the cost of production fall due to the competitive lowering of rents. Thus instead of being distorted by our present kind of tax and over-paying of the banks and landlords, there would be a more level "playing field" with greater opportunities for employment. The change in the choice for consumption and investment by the larger numbers of people that would become involved would also tend to reduce the degree of capitalist monopoly due to too few ways of doing certain activities by too small a number of outletting manufacturers.
My message is thus to TAX TAKINGS AND NOT MAKINGS. It is only by a move in this direction that there is any hope for reducing the distortions and unnatural directions and separations by which the macroeconomy is being led.
Lawrence Brooks Hughes - 6/10/2008
An essay finding faults with the American economic system, as this one does, should be prefaced with a note to the effect it has produced more wealth and human progress (by far) than any other economic system in history--and continues to do so.
Also, I think it is incorrect to say "we are taught that producers and consumers make reasonable decisions and that markets are large-scale reflections of the logic of those decisions." Where is that taught, other than in Adam Smith's road map of 1776? Possibly in Ulan Bator.
We certainly do like the "legal protection given to our personal assets," and you are at your best when you report there is a strong agreement among citizens that the capitalist system is legitimate.
Edward Joseph Dodson - 6/9/2008
Professor Benjamin provides us with a thoughtful commentary on the nature of our economic system. Historians are often better at describing the complex relationships at work than economists trapped by their theoretical training and so-called "value free" analytical constructs.
Perhaps Professor Benjamin's most important observaton is this: "Though wealth is supposed to consist of tangible goods and services, it is debt that in recent years has been the real engine of the economy."
The enormous accumulation of debt indicates that neither individuals, businesses nor governments have sufficient cash flows to pay for desired (or, in many cases, necessary) goods or services. A significant percentage of households in the U.S. -- and in other countries as well -- calculate affordability based on their capacity to carry debt out of monthly income. When this income declines for any reason, delinquencies quickly accumulate. The result for an increasing number of households in the current recessionary downturn is foreclosure on their primary residence and personal bankruptcy.
For governments, a major reason for an escalating national debt is the lack of political will to raise revenue from those with the greatest ability to pay but who also exert the greatest political influence. Professor Benjamin will concur, I am sure, that wars are never paid for by the wealthy in a society. Governments issue bonds at interest, in which those with disposable income invest. Government then taxes others (and/or simply prints more currency into circulation) in order to service the rising debt. This is the case in the U.S. going back to the Reagan administration and his flirtation with "supply-side" economics.
Another major shortcoming of our systems of law and taxation is the failure to distinguish between income flows that are earned and yield additional creation of material goods versus those that merely transfer claims on goods produced by others. The so-called "capital gains" tax is a primary example of tax policy that actually adds stress to our economic system by rewarding non-producing investment activity with low effective rates of taxation.
Actual capital goods (e.g., buildings and machinery) are seldom sold for a gain over their depreciated market value. During their useful life they require ongoing investment of labor and additional capital goods just to maintain functional utility. Thus, we allow such assets to be expensed over their life, at the end of which the asset has only a nominal market value. When a old building is sold, what the purchaser is paying for is the capitalized economic rental value of the location. Absent availability of historic tax credits to maintain the exterior or facade, the building may be demolished and fully replaced.
What we instinctively understood for centuries is that the highest rates of return are gained not from the creation of goods or providing services but from what John Locke termed "licences." Governments issue licenses that limit competition. When these licenses are transferrable under law, they yield "rent" to the seller much as the deed to land is a form of license that yields rent to its holder. Market forces capitalize rent into a selling price for land. And, unlike markets for labor, capital goods or even credit, the supply of locations during a period of rising prices will contract rather than increase. The reason is simple. Locations do not depreciate and require minimal carrying costs to hold idle for speculative gain.
Governments ought to look to rent as a primary source of public revenue given the fact that rent is societally- rather than individually-created. But, we are a people addicted to land and resource speculation. As homeowners, we are more modest rent-seekers; yet, capitalized rent may be the difference between enjoying financial stability in retirement and poverty.
As members of our local community, we feel burdened by heavy taxation. We look to the state and federal governments to revenue share to pay for public goods and services. The states can borrow but they cannot issue currency. So, we arrive full circle back at the federal government and the dysfunctional manner in which our elected representatives spend without economically-rational or morally just principles considered. There, we find the origins of the boom-to-bust "business cycle." There, we could find the solutions if we could somehow get our representatives to consider the common good above that of vested interests.
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