Introduction by PCR: In this article economist Michael Hudson points out that in a financialized economy economic growth tends to slow to zero and then enter negative territory as debt service draws away from the purchase of goods and services more and more of consumers’ disposable income. As disposable income shrinks, so does consumer demand for the purchases of goods and services. Without aggregate demand to drive it, the economy stops. Hudson notes that the economics profession is blind to the austerity consequence, because the reigning neoliberal economics counts the cost of debt service as an increase in GDP. Hudson’s article is a response to the self-congratulatory celebration policymakers gave themselves for “saving the economy” on the 10th Anniversary of the collapse of Lehman Brothers.
Economic Policy Serves The Rich, Not The Economy
The Lehman 10th Anniversary spin as a Teachable Moment
Wall Street did not let the Lehman Brothers crisis go to waste. The banks that have paid the largest fines for financial fraud are now much bigger and more profitable. The victims of their junk mortgage loans are poorer, and the economy is facing debt deflation.
Was it worth it? What was not saved was the economy.
The malaise that pension funds, state and local budgets and economic growth are experiencing today is a result of the 2008 bailout, not the crash. What was saved was not only the banks – or more to the point, their bondholders – but the financial overhead that continues to burden today’s economy. This overhead takes the form not only of paying more interest, amortization, and penalty or service fees to carry the debt needed to buy a home or to live off a credit card, but also takes the form of higher housing prices inflated on bank credit, and even prices for goods and services that are pushed up by the debt overhead.
Also saved was the idea that the economy needs to keep the financial sector solvent by an exponential growth of new debt – and, when that does not suffice, by government purchase of stocks and bonds to support the balance sheets of the wealthiest layer of society. The internal contradiction in this policy is debt deflation: interest, amortization and late fees divert income away from being spent on goods and services. This diversion of income from consumer purchases to debt service has become so overbearing and dysfunctional that it prevents the economy from growing, thus undermining the economy’s ability to carry the debt burden.
Trying to maintain an excessive debt level by creating more debt, or by using monetary Quantitative Easing to re-inflate real estate, stock and bond prices, protects the asset prices of creditor One Percent class, not the disposable incomes of the 99 percent. Therefore, from the economy’s vantage point, instead of asking how the banks are to be saved “next time,” the question policymakers should be asking is how should we best let them go under – along with their stockholders, bondholders and uninsured depositors whose hubris imagined that their loans (other peoples’ debts) could go on rising without impoverishing society, thereby preventing creditors from being repaid – except from government by gaining control over it.
This basic principle should be the starting point of any macro analysis: The volume of interest-bearing debt tends to grow faster than the economy’s ability to pay. This tendency is inherent in the “magic of compound interest.” The exponential growth of debt expands by its own purely mathematical momentum, independently of the economy’s ability to pay – and faster than the non-financial economy grows.
The higher the debt to income ratio rises, the more interest, amortization payments and late fees are extracted from the economy. The resulting debt burden slows the economy, causing defaults. That is what happened in 2008, and is accelerating today as debt ratios are rising for corporate debt, state and local debt, and student debt.
Neither legislators, academics nor the public at large recognize a corollary Second Principle following from the first: An over-indebted economy cannot be saved unless the banks fail. That means writing down the financial claims of creditors to a level that debtors can service. Otherwise the economy will suffer debt deflation and austerity, like Greece.
“Recovery” since 2008 has been much slower than earlier recoveries because debt deflation is eating away personal and corporate income. To make matters worse, the bailout’s policy of Quantitative Easing to re-inflate asset prices has reduced interest rates on bonds and, therefore, investment income for pension funds, insurance companies and employee retirement savings. This means that more state and local government tax revenues must be diverted to meet retirement commitments and if not retirement pensions have to be cut, further shrinking aggregate demand.
As the economy at large is threatened with an exponentially expanding erosion of disposable income and, thereby, aggregate demand, a debt write-down is a precondition for today’s economy to recover from the rising debt/income and debt/GDP ratios that are burdening the United States, Europe and other regions.
The United States has been able to monetize its budget deficits and subsidize banks to carry its rising debt overhead with new debt. The Eurozone has banned budget deficits of over 3 percent of GDP, imposing austerity that leaves the only response to over-indebtedness to be Greek-style austerity: depopulation, shrinking living standards, wipeouts of retirement income and pensions, mortgage defaults, shortening lifespans, and mass selloffs of public infrastructure such as municipal water companies to foreign interests who repatriate the earnings outside the country, thus further draining income from the country.
None of this was spelled out in the September 15 weekend marking the tenth anniversary of Lehman Brothers’ failure and subsequent rescue of Wall Street. President Obama, Treasury Secretary Tim Geithner and their fellow financial lobbyists at the Federal Reserve and Justice Department are credited with saving “the economy,” as if their donor class on Wall Street constituted the economy. “Saving the economy from a meltdown” has become the euphemism for saving financial sector bondholders and other members of the One Percent from taking losses on bad bank loans. The “rescue” is Orwellian doublespeak for expropriating over nine million indebted Americans from their homes, while leaving surviving homeowners saddled with bubble-mortgage payments to the FIRE sector’s owners.
What has been put in place is not a restoration of traditional status quo, but a reversal of over a century of central bank policy. Failed banks were not taken into the public domain. Instead, they have been enriched beyond their former levels. The perpetrators of the collapse have been rewarded, not penalized, for lending more than could possibly be paid by NINJA (no income, no job or assets) borrowers and speculators whose mortgage applications were doctored by systemic fraud at Countrywide, Washington Mutual, Bank of America, Citigroup and their cohorts.
The $4.3 trillion that could have been used to save debtors was given to the banks and Wall Street firms whose recklessness and outright fraud caused the crisis. The Federal Reserve “cash for trash” swaps with insolvent banks did not restore normalcy or the status quo ante. What occurred was a financial revolution by stealth, reversing the traditional responsibility of creditors to make prudent loans in order to avoid write-downs on bad ones.
Quantitative Easing saved creditors and the largest stockholders and bondholders by lowering the interest rates by enough to raise the price of financial assets on the banks’ books. This revived the value of the collateral backing bank loans and bondholdings. “Saving” the economy in this way actually sacrificed it by leaving the debt-deflation mechanism in place.
Among Democrats, Paul Krugman displayed the most extreme tunnel vision when he claimed that jobs, not debt, was the real problem. Krugman misses the point that 2009 was the beginning of the foreclosure and eviction of 9 million homeowners. Consumers found themselves with less income “freely disposable” after paying their monthly FIRE (finance, insurance, real estate) sector bill off the top of their paycheck – housing charges, credit card charges, medical insurance, student debt, FICA withholding and tax withholding. Krugman says that he would have solved the problem by more deficit spending to pump enough money into the economy to enable debtors to keep paying the banks their growing claim on consumer incomes.
We are still living in the destabilized, debt-ridden aftermath of such pro-bank advocacy. In the New Yorker, John Cassidy celebrates a book by Columbia professor Adam Tooze who promotes the idea that the economy cannot exist without the credit (that is, debt) provided by the financial sector. True enough, but it does not follow that rescuing the economy must involve rescuing Wall Street and enriching the banks at the expense of the rest of the economy. That conflation is an Orwellian rhetoric of deception that has been introduced to the discussion of how the economy was “rescued” by locking in debt deflation.
At the neoliberal/neocon Brookings Institution, Treasury secretaries Hank Paulson and Tim Geithner joined with the Federal Reserve’s Ben Bernanke to explain that the public simply didn’t understand how successful they all were in saving not only the banks, but non-bank financial institutions. Unlike Sheila Bair, they did not point out that behind these institutions were the bondholders, the One Percent of savers who held the rest of the economy in debt. Bernanke wrote a Financial Times piece using junk statistics to show that there was no underlying debt or financial problem at all, merely a “panic.” To paraphrase, he said: “The crisis was all in the mind folks. Nothing to see here. Keep moving on.”
Can a bailout without debt writedowns really bring prosperity? Can economies achieve growth by “borrowing their way out of debt,” by creating enough new credit to cover the interest charges out of capital gains from the asset-price inflation fueled by new bank credit? This is the logic that has guided the Federal Reserve’s net $4.3 trillion in Quantitative Easing, and the parallel credit creation by the European Central Bank under Mario “Whatever it takes” Draghi. Ellen Brown recently published a review, “Central Banks Have Gone Rogue, Putting Us All at Risk,” noting that the ECB has become a major stock buyer. The beneficiaries are the stockholders who are concentrated in the wealthiest percentiles of the population. Governments are not underwriting homeownership or the solvency of labor’s pension plans, but are underwriting the value of collateral backing the savings of the narrow financial class.
The GDP accounts treat debt service as “financial services income.” This overstates GDP by treating a cost as an income and shows the extent to which Wall Street lobbyists have captured economic statistics. The National Income and Product Accounts (NIPA) have been turned into a vehicle for deception. What is celebrated as growth of the GDP since 2008 has been mainly the growth in financial extraction (and the health-insurance sector’s profits from Obamacare).
Glenn Hubbard, chairman of the Council of Economic Advisors under George W. Bush, uses Orwellian doublethink to pretend that “Debt is Wealth.” He concludes a Wall Street Journal op-ed: “An ability to recapitalize banks remains crucial and must be explained to a skeptical Congress and public,” so that wealthy bondholders and speculators will not suffer losses.
The aim of the Lehman 10th Anniversary self-congratulation is to head off debt write downs. The ancients fought civil wars for land redistribution and debt cancellation. Today the demand should be for mortgage writedowns to bring their carrying charges in line with reasonable rent charges, limited to 25 percent of homeowner income.
Today’s financial administrators at the Treasury, Federal Reserve and regulatory agencies are no more inclined to halt the economy-destroying debt deflation mechanism than they are to enforce laws against criminal financial fraud and punish individuals rather than institutions.
The key financial point is that the expansion of interest-bearing debt absorbs more and more of disposable income until consumer incomes are exhausted with nothing left to purchase goods and services produced by the economy. Economic growth comes to a halt. The solution therefore requires debt write-downs. That is what is supposed to result from an economic crash, but it was not done in 2008. That is why the status quo was not restored. Instead, a vast giveaway to the financial elites occurred, setting the rest of the economy on a road to debt peonage.
It would have been encouraging if Sheila Bair had used the Lehman 10th Anniversary to lay out the procedures that the FDIC had put in place ready to take over insolvent banks in the future. It would have been encouraging to hear from Hank Paulson and Barney Frank that it is necessary to write down bad mortgages whose carrying charges are far above the debtor’s ability to pay and the going rental value for similar properties. It would have been encouraging to hear Obama apologize for representing the interest of his campaign donors instead of his voters. Perhaps also an expression of guilt from Tim Geithner and Eric Holder for the high-paying jobs they got for rescuing the banks from their bad loans.
What is needed now is the perception that today’s financially dysfunctional economy cannot be saved without a bank crash that rolls back the enormous gains that the FIRE sector has made at the expense of the “real” economy. Banks have ceased to be an “engine of growth.” They are not making loans to create new means of production. They are lending to asset strippers, not asset creators. It is not hard to show this statistically.
At stake is whether the U.S. and Western European economies are going to end up looking like those of Greece, Latvia and Argentina – or imperial Rome for that matter. Neoliberals applaud finance capitalism as the “end of history.” The end of history will be different from what they think as debt deflation brings back the austerity of the Dark Age.