Does Establishment support Capitalism?
SUBHEAD: There is no economic solution to the mess we have created for ourselves. By Steve Ludlum on 10 October 2010 in Economic Undertow - (http://economic-undertow.blogspot.com/2010/10/does-establishment-support-capitalism.html) The country has been in an economic breakdown for the past three years but from a policy standpoint the Federal Reserve does not seem to know it. The Great Unwinding has had definite characteristics that have held consistent from the very beginning but from a policy standpoint the Federal Reserve does not seem to recognize them. 'Characteristic A' is the unraveling has been taking place at the bottom of the economic food chain; this has been true since the end of the 1970's as wage earnings have been stagnant over the entire interval. What has masked effects has been the rise of two-earner households and several asset price bubbles. In place of return-on-labor has been substituted expensive credit loaned to the same workers on collateral that has turned out to be illusory. Instead of wealth there has been the 'Wealth Effect'. Real wealth would allow workers to afford rising prices as these would be the consequence of an increase in business activity and rising wages. In a productive environment, wealth increases faster than costs. Finance seeks to have the activity increase while reducing wages so as to keep business returns for itself. Reducing wages cuts into business profits because workers are business' customers. This reality escapes participants in markets for goods essential to the physical economy such as food, metals and fuel. Last week's price action in commodities is both indicative and self-destructive. Here, finance acts as if it can get blood from a stone when it cannot. The Fed pretends that none of this matters. By attempting to regain relevance it has turned to being dangerous. By attempting to revive finance from the doom of its own follies it destroys sectors upon which the economy itself depends. This in turn adversely effects finance which cannot escape a blow directed toward any other. Prices for food products above a certain level are catastrophic for poor countries. Whether the prices are supported by supply fundamentals is irrelevant to finance. Countries hoard and essentials become unavailable at any price. Political disturbances follow which - in an international economy - increase overall costs. These costs rebound to finance as losses to businesses elsewhere. Meanwhile, futures traders make money trading 'blood wheat' and 'blood corn' both coming and going. One of the losses the system absorbs is loss of confidence in the both the judgment and fairness of the markets themselves. In this country, food cost increases aren't catastrophic (yet). Both food and fuel costs are small parts of the typical family budget. Allocation between purchases takes place instead. Priorities and funds are shifted from non-essentials to basics. People become thriftier, many have no choice. Food price increases are followed by restaurant closures, retail center failures, declines in purchases and consumer credit overall and more workers being laid off. This represents and accelerates declines in aggregate demand. The futures markets price in inflation when there is scant labor earnings to support it. The markets respond to presumed Fed monetization that may or may not take place. The establishment acknowledges the decline without understanding it. With personal balance sheets in need of repair and with an increase in savings necessary, price increases add to the universe of the insolvent rather than shrinking it. For those who inhabit this universe, the effects of rises in basic goods prices are little different from effects in countries with absolute shortages. The systemic consequence is that all costs are aggregated somewhere in finance which exists largely for this purpose. Those without wages tend to seek services from the public sector, This turn of support puts a larger strain on governments which sell the risk back to private finance. The risk that accompanies adverse market actions always rebounds back onto finance and the banks who have the most invested in these markets. These rebound effects can now be seen in the poor performance of finance companies and their stocks. Rises in commodity prices do not and will not 'save' finance. Price increases for basic goods erodes banks' 'retail' earnings - spending is allocated away from profitable retail bank services, away from the bank business itself. Banks are stores that 'sell' money. If they do not do so they go out of business. If the markets are truly blind rather than willfully self- deluded, the Fed needs to guide rather than goad them. Fuel prices reaching the level of 5% of GDP is the danger area. The US output is less than it was in 2008. The 2008 annual average oil price of $99 would certainly be unsupportable. The outcome is further declines in GDP in excess of what is current. If there is an intention on the part of Planet Bernanke to 'fix' the economy, the consequences of the Fed adding currency are opposite of that intention. The Fed risks triggering the deleveraging event it seeks to avoid. The Fed along with the other central banks has painted itself into a corner. A solution would be for the Fed to increase short- term interest rates and add yield to the economy. Higher yields would remunerate the prudent savers and would decrease capital costs at the same time. An economy cannot be supported entirely by debt capital yet ours is. The repayment and maturation risks inherent to debt carries costs that do not aggregate to savings- as- capital. The risks themselves are costs. Additionally, debt capital is expensive even in a nominal zero- interest rate environment because the real interest rate is strongly positive. Meanwhile, the economies of the world are saturated with debt. More debt cannot be taken on even at zero percent discount, there are few significant borrowers with the means to borrow who are willing to do so. Adding funds to 'encourage borrowing' is simply pushing on the proverbial string. At zero percent returns on carry trades diminish. Debt flows are what support modern economies! Internal and external carries are essential to maintain these flows. Witness the desperate race of various nations to devalue their currencies so as to fund carry trades or maintain goods- trade advantages; so many doing so simultaneously renders these trades valueless. With national rates near zero, there are fewer destinations for 'carried' funds: China, New Zealand, Australia, Canada, Switzerland. The risks increase that these destination countries are becoming currency/liquidity traps. Foreign exchange and interest rate volatility makes carry trades extremely risky. What the Fed sells is both inflation overseas to China alongside volatility. How can this be good for either country? The fact of the 'sale' itself invites volatility which is visible now in currencies, in commodities and gold. The steep rises in prices and blow- off tops in these goods is volatility to the bubble side to be exceeded by the steep price plunges as the bubbles deflate. How can anything about this represent responsible policy? The Fed cannot risk higher rates because massive legacy debt overhangs make interest costs unaffordable to governments that borrow as well as to banks. Impaired borrowers - including the Treasury - cannot afford the higher rates. This is the corner the Fed is painted into: it must reduce real interest rates by any and every possible means even as the costs rise elsewhere to unaffordable levels. Deflationary valuable dollars and high real interest rates are fatal to a government sweating trillion$ of debts alongside further tens of trillion$ of unfunded liabilities. These higher 'system costs' are seeking a home, first in one market then another. They are currently being directed at a sector of the economy whose inability to support higher finance costs triggered the crisis in the first place! The Fed cannot see any way to support the productive economy without bankrupting client banks. The legacy debt is the hangover from previous Fed-supported asset price bubbles. The banks are already feeling pain because of their inability to process the immense default backlog which jeopardizes flows of funds through the banks to investors. Where these various and increasing liabilities will rest is hard to tell but the banks cannot survive for long without cash flow. What has taken place since the beginning of September in foreclosure processing institutionalizes debt repudiation. There is currently no mechanism to enforce mortgage debt repayment. The banks' PR departments present this as a trivial problem, it is not. It is the beginning of the end for a large number of banks. Keep in mind, if crude oil cost $20 a barrel, no bank would be in difficulty, no consumer would be facing destitution, no sovereign would face default. Crude oil derivatives such as corn and wheat would be cheap. Expensive fuel enforces income allocation. Fuel rationing by price rations business incomes at the same time. Squeezing the price balloon at the fuel end has it swelling at the business income end. With unemployment rising and worker earnings declining the price increases in primary goods is unsustainable. This does not mean that they will immediately decline, rather the actions of the establishment will spread more and more pain to more people and toward unintended sectors before the prices inevitably fall again. Pain Has Consequences. If goods allocation cannot accomplished by market action that is perceived to be fair, the markets themselves suffer. This is taking place on the stock market now as retail investors abandon it as being manipulated by hedge funds and investment banks. The stock market has lost much of its ability to discover value. Rationing by price is acceptable if prices do not increase above levels that constrain the business activities that markets measure. If rises become unacceptable then confidence falters. Failure is laid at the doorsteps of the markets themselves rather than with the goods that are traded on them. The markets are considered to be contaminated by manipulation. When this happens, controls follow along with real rationing. Market distrust is a vicious cycle that feeds on itself. An outcome is a flight from the market and a 'run'. When a run takes place because of a market breakdown there are few if any tools able to address it. This lessens the positive effect of liquidity which is perceived to be just another garden-variety asset being traded on an unresponsive market. Credit mispricing leading to systemic failure has been taking place in mortgage markets with the just this outcome: the markets themselves turn sclerotic because debts cannot be cleared transparently. The knock- on effect is for credit to vanish with the market becoming illiquid. The logjam eventually causes the participants to lose confidence. When the market is perceived to be unfair or 'inefficient' it is unfair and inefficient. The outcome is stabbing blows to free market capitalism by the institutions that claim to rely on it! Activities of the past three years and more are a direct consequence of the Establishment's unwillingness to face reality and take necessary and painful actions. The reflex has been to avoid the truth and to let finance go its own way and have 'Daddy Fed' clean up the mess afterward (by printing more money). One has to question whether the Establishment supports markets or simply gives lip service? What appears rather is cronyism and the sort of bulbous state-supported enterprises that fastened themselves on the USSR. Markets in this context are another form of fraud along with the participants who use them to offload costs on the unwary. The simplest explanation of why that empire collapsed is that after three generations of living with the parasitic apparatchiks, the Soviet public learned how to insulate themselves from the costs that the government intended to saddle them with. The state strangled on its own stranded costs. The same thing is now taking place across the developed world along with the development wannabees. Can the citizens of developed countries learn enough in the short time remaining to insulate themselves from the flood of liabilities being emitted from their government-run economies? Watch and see the Chinese autocrats submerge their naive citizenry with the stranding costs of that country's over-development and excess capacity. China's government has successfully looted its citizens before and will certainly do so again. Market capitalism would have banks take their lumps along with banks' investors. The finance enterprise would indeed fail. Out of the ashes of a ruined finance system would rise a new one. Our government would keep bank depositors whole, close insolvent banks, write off non- collectible debts and rearrange bank ownership structures. This is how markets are supposed to work: they reward success with wealth - and failure with bankruptcy. By allowing markets to function properly the Establishment would submit to a 'higher authority'. Both markets and the Establishment would regain the credibility both have squandered over the decades. The related form of willful ignorance is denying peak liquid fuels and the issues that accompany it. This is the consensus conclusion of the ASPO world conference participants. Establishment economics renders inputs as being easily substituted for. This 'brand' of economic theorizing has fallen on its face. Substitution is a sham. Inputs have been mispriced under false assumptions with the consequences being felt now across all markets. The inevitable repricing is taking place when the effects are greatest and carry the most adverse consequences. The effects of the repricing amplify dislocations and reduce both time and resources available to take mitigating steps. Instead of taking these steps and by doing so support the sectors that actually create real wealth, the Establishment does nothing and our productive citizens go begging in the streets. While this takes place futures traders profitably buy and sell 'blood corn' and 'blood oats'. Good grief! If the Establishment cannot find a way to resolve its finance mess it at least can acknowledge its failures and its own blindness. While this is no cure it would at least be a step in the right direction. Is this austerity or Keynesianism? does it matter? At bottom there is no economic solution to the mess we have created for ourselves. Only tender concern for all of our citizens, that they have food to eat and a dry, warm place to sleep, some security, some money in their pockets and something useful to do; this is the job of the government(s). This an be done while all else that makes up 'modernity' seeks its own level. That would represent a good second step. See also: The Telegraph: Currency wars are necessary 10/10/10 .