Leverage, Knowledge, and the Uncapitalizing of America
The most egregious falsehood regarding economic health that is nonetheless widely believed is surely that we ought to measure it by the magnitude of goods and services consumed. This is dangerous nonsense. Consumption is the result of a complex web of individual commitments of time and energy towards uncertain ends. The result is delayed, and the greater the complexity, the greater the uncertainty, the greater the delay, and the more plentiful the result is likely to be. To measure the health of such a mechanism only by its tangible output and not its internal workings is like measuring the health of a tree by its size. Small trees can be vibrant and large trees can be dead.
A better analogy — perhaps the perfect analogy — is a farm. A planted seed is foregone consumption. The farmer invests time and energy, made uncertain by the vagaries of pests and weather, in nurturing the delayed but more plentiful bounty of harvest. The wealth of the farmer is not the magnitude of the harvest, but the capacity of the land to produce harvests indefinitely. Indeed, this is the origin of the word “yield”. The farmer could always choose to maximize his consumption by eating his seed rather than planting it; by selling his soil rather than tending it. But, patently, this would decrease any sane conception of his wealth.
In, The Unsettling of America, Wendell Berry laments the gradual shift in attitudes to agriculture in the US from that of nurturers to exploiters:
“I conceive a strip-miner to be a model exploiter, and as a model nurturer I take the old-fashioned idea or ideal of a farmer. The exploiter is a specialist, an expert; the nurturer is not. The standard of the exploiter is efficiency; the standard of the nurturer is care. The exploiter’s goal is money, profit; the nurturer’s is health — his land’s health, his own, his family’s, his community’s, his country’s. Whereas the exploiter asks of a piece of land only how much and how quickly it can be made to produce, the nurturer asks a question that is much more complex and difficult: what is its carrying capacity? (That is: How much can be taken from it without diminishing it? what can it produce dependably for an indefinite time?) The exploiter wishes to earn as much as possible by as little work as possible; the nurturer expects, certainly to have a decent living from his work, but his characteristic wish is to work as well as possible.”
I contend an analogous transformation is happening to the capital stock as Berry bemoans of the agricultural stock; that this is driven by an obsession with immediate, quantifiable consumption rather than delayed, uncertain investment; and that this is fuelled by dysfunctional money that does not calibrate certainty and uncertainty as it should. In our ignorance, impatience, and arrogance, step by step we are turning the farm into a strip mine.
In Part One of this series, Wittgenstein’s Money, I explored the consequences of failing to appreciate the role of time, ignorance, and uncertainty in understanding the function of money, and how its function can change. I pushed the reasoning to an embrace of the role of capital: that the certainty provided by money allows for increasingly uncertain endeavors to create increasingly complicated tools and organizations, and the extent to which the creation of capital is successful sets the stage for further economic uncertainty still. The more capital we accumulate, the more specialized we are incentivized to become in our own economic contribution, which increases our vulnerability to unpredictable changes in all other supplies and demands. Also, the more surplus we are likely to be able to create, some portion of which can be diverted towards further experimentation, which makes changes in supply and demand more unpredictable still. This makes money that actually functions the way its users expect it to all the more valuable. Money emerges from uncertainty, capital emerges from money, and uncertainty emerges from capital.
In this essay, I will explore what we can expect to happen to this potentially virtuous cycle if we ignore the link between money and uncertainty; if we fail to grasp the importance of capital and suppose maximizing consumption to be our most important collective goal; and if we are indifferent to the money underpinning the cycle becoming highly uncertain and dysfunctional. The Semantic Theory of Money I satirically articulated in Part One has a spiritual counterpart here: that by all manner of semantic contortions we can convince ourselves that we can consume more than we produce, reap more than we sow, borrow more than we repay. As Wittgenstein said in Philosophical Investigations, “philosophy is a battle against the bewitchment of our intelligence by means of language.” Let us not be so bewitched, but cut through this nonsense and call a spade a spade.
In Part Three, Bitcoin Is Venice, I will get rather more excited about putting all this behind us. But for now, let’s get our hands dirty.
How to Increase Consumption
There are three ways to increase consumption. One is to commit more human time and energy to producing stuff to consume. Another is to consume existing capital rather than use it. Clearly, neither of these first two options is sustainable. There is a maximum of time and energy it is possible to commit, and a point well below the maximum beyond which committing any more is undesirable. And there is a finite stock of capital which, if consumed rather than used, will eventually be depleted.
The absolutely only way to sustainably increase the economic output that is available for consumption is to grow the capital stock above its natural rate of depreciation. If we have more capital, the same amount of human time and energy will create a greater output available for consumption. Hence it ought to take less human time and energy to exchange for a given proportion of this output.
The tricky thing about growing the capital stock is that it is by nature an uncertain process. It cannot be automated, nor reduced to an algorithm. It is necessarily experimental. This is why money is so important to efforts to create capital: these efforts themselves take time and energy that might otherwise have gone towards more certain avenues of production. Only some small group may have the knowledge and skills to credibly experiment with creating a particular new tool or new organization, and they may not be willing to take the risks required. Some other group may have the willingness to take the risks but not the knowledge or skills to do so. Money provides a means for coordinating the risks of attempting to create capital such that those contributing to the risk-taking are not necessarily those bearing the risks.
By disconnecting the bearing of the risk from its execution, we incentivize those willing to bear risk to seek out those risks whose reward seems the greatest, unburdened by their own particular circumstances. We will collectively run not only more experiments that have the potential to increase our economic wellbeing, but we will also prioritize running the best experiments. Functional money facilitates all this parceling up and trading of risk. What we must try to understand next is that this process has reflexive effects on the functioning of money.
Accounting for Time and Risk
In pondering the flow of money around the creation of capital, I think it is helpful to be rigorous in keeping track of accounting identities and thinking about how they evolve across time. Trading certainty for uncertainty in the form of experiments in capital creation results in a very particular accounting transformation. It pulls forward potential value from the future and crystallizes it as value in the present, while we create a separate financial asset to reflect the future value we hope will one day be realized. We might call this financialization. We pay for production capital with financial capital.
For example, say we take $100 of savings and make an entrepreneurial investment. That is to say, we buy some capital goods, some raw materials, and hire some workers, and put them all to work over time to try to churn out a product we will attempt to sell for a profit. This $100 which was originally intended for future consumption will now very likely lead to present consumption, as our workers and suppliers will be $100 better off and may very well decide to consume. This will happen first. It will take time for us to make a profit, but we will have to make our payments upfront as we are the ones willing to bear these risks, not our employees and not our suppliers.
This $100 has become a $100 liability of equity finance and probably less than $100 of assets with the remainder as an expense. If we succeed in making a profit above these expenses, we will earn cash as an asset, which we balance with retained earnings as a liability. But we can’t know that until it happens. At the very start, we have simply spent $100 in exchange for a collection of assets and promises. We have swapped certainty for uncertainty. Our workers and suppliers have crystallized $100 in present value in exchange for future value, the risk of which we have decided to bear over the period of its attempted realization.
This could all be more complicated still. Rather than owning a stake in the uncertain output of an entrepreneurial venture, a provider of capital may prefer to be entitled to an agreed upon return, provided it is received first amongst the venture’s profits. This may be efficient all-round as such a provider of capital may willing to embrace some uncertainty, but not quite the level she thinks this entrepreneurial venture entails in its entirety, and would prefer to trade potential upside for surety and priority of repayment. The entrepreneur may agree to this as she may be unable to reach the required $100 of financing otherwise, or may be confident enough of the relative certainty of the return on the project that accepting the need to divert the first profits is worth it to boost her own returns on equity.
Of course, I have just described debt — hardy a revelation. But once again, let us track the accounting identities: the debt provider started with $50 of savings and gave it all to the entrepreneur. Now the debt provider has a liability of $50 equity finance and $50 of credit assets. There is some uncertainty surrounding the true value of this credit, but it will only become clear as the venture is carried out. Hopefully, it will lead to a profit such that retained earnings top up assets as cash. Possibly, the venture will fail so badly that even the $50 provided cannot be recovered from the remaining assets. The debtor and creditor weighing up these possibilities in their own minds, and comparing them to their respective other opportunities, will determine the level of interest — the cost of this capital.
The entrepreneur is in a similar accounting position to previously: $100 of assets of entirely uncertain value, but now $50 of equity liability and $50 of debt, with an additional cost going forward of interest on this debt. Once again, this total of $100 of savings has been crystalized as present value, transferred, and very possibly spent currently, while the future value for which it was traded remains as-yet-unrealized and uncertain.
The final complexification possible is that financial capital and production capital are sufficiently decoupled such that it is possible to purely intermediate financial capital without ever directly investing. That is to say, to take savings from those seeking a debt-like return and to make credit investments — i.e. a bank. Once more, the accounting identities: that of the business will be the same, but now we introduce an intermediary with, let’s say $40 of debt financing, $10 of its own equity, and the $50 credit to the business, but now underlying savers who have $40 of equity and a $40 credit to the intermediary.
Again, this will hardly be a revelation. I run through these possibilities in such granular detail so as to make three points as clearly as possible. The first is to make plain the accounting balance: no matter how complex this gets, the same underlying uncertainty is still there. It cannot be escaped. It cannot be financialized away. We cannot use accounting to conjure up more time or energy. The capital structure financing the endeavor may be unboundedly complex, but there will always be $100 of expenditure of subsequently uncertain value that traces back to $100 of equity, somewhere.
The second is to make clear that while this underlying uncertainty cannot be removed by different financializations, the parceling up of risk can affect the experiment. This can be made clear in two ways: first of all, from the entrepreneur’s point of view, the more debt is used as finance, the more her potential equity returns are boosted, but the less room she allows for variability in the success of the venture. There are lower and closer bounds of the level of profitability that will be acceptable for the experiment to continue before her equity value is wiped out and the experiment ends with asset write-downs. Equivalently, at the macro level, we can see the proliferation of assets as we introduce more and more debt to the system. More and more (perceived) value is tied to the same underlying experiment. Debt gives greater perceived safety to the provider of financial capital by sucking safety from the rest of the system and making the real experiment more fragile. It is useful — but only to the extent this transfer of risk is what everybody really wants.
Financialization and Prices
The third, and most important, is what will happen to prices. Note that I am very deliberately not saying, what will happen to “inflation”, as this word has two distinct meanings that may be related to one another, but may not. We will shortly consider what happens if “the money supply” changes — call this “monetary inflation” — but in what follows, we assume it does not, and we face only “price inflation”.
It is instructive to think about why prices might increase as a result of decisions made by real people, rather than assuming this is a fact of life or some metaphysical constant (it is neither). Prices are set by sellers at the level they best judge will not be so high as to lead to customers going to competitors and leaving their own inventory unsold, but not so low that they can’t still make a desired profit and return. These decisions depend crucially on uncertainty and time. Profits, returns, and depletion of inventory cannot be known in advance and can only be judged and reacted to with respect to how they unfold over time.
Sellers will therefore decide to increase their prices for one of two reasons: i) their own costs have increased and they can no longer make the desired profit or return otherwise, or, ii) customers start to buy faster, such that inventory is depleted before it can be replaced, suggesting that more potential customers exist than can be serviced and unit profits can be risklessly increased. Likewise, sellers will decide to decrease prices if, i) costs have decreased and the increase in customers gained by lowering prices will more than offset the fall in unit profit, leading to an increase in aggregate profit and returns or, ii) customers start to buy slower, such that inventory is not being shipped as fast as it is being bought in.
The speed with which inventory can be moved is really a function of how much capital has been devoted to its production in the first place. Increasing or decreasing prices is the appropriate short-term response to positive or negative strains on inventory. But the appropriate long-term response may be more or less capital investment, such that real supply can be increased or decreased. The wisdom of such a decision will depend on whether the source of the faster or slower purchasing is fundamentally sustainable. Capital investment is essentially an experiment that must be financed and will take time, whereas prices can be changed on the spot.
This all raises a fascinating and more complex question: what will be the effect on prices of financialization to create capital? If we pull forward value from the future and crystallize it in the present, what will happen to prices? On the face of it, this turns savings that would not have been used to consume into income, some portion of which probably will. Therefore, goods will start to be bought faster.
But we must remember this $100 of present value only exists because it has been traded for an experiment of entirely uncertain value. What happens with this experiment is key. If the experiment fails: those who financed it will have $100 less than they had accounted for at the time of failure and therefore will be forced to consume less, meaning customers will buy slower. Recall, however, that capital naturally depletes, and so if it is not replaced, its ability to turn time and energy into a relatively increased output will diminish, meaning costs will steadily increase.
If the experiment succeeds: there will be no asset write-offs that destroy the ability to consume and so the $100 brought forward will not be perfectly balanced out. However, the financialization will have to be unwound, which will turn newly created income back into savings. Over the period this happens, consumption will once again be slower. But more importantly, the capital created by the experiment will then allow time and energy to produce more of some or other output, meaning goods and services can be created at relatively lower cost.
Of course, we must aggregate all such behavior as no single experiment will impact all prices (or probably even any prices), hence in the above three paragraphs I referred only to costs of production and speed of purchasing, not to prices. But it is straightforward enough to realize that the timing of all experiments is all that really matters in determining to what extent the impact of a single experiment can be generalized. Let us look in turn at the immediate effect of crystallizing future value, then the delayed effect of changing the capital stock.
Financialization will always lead to immediate faster consumption, but later slower consumption as the financialization is unwound. If the unwinding follows from a successful experiment, the slower later consumption will be somewhat transient as the capital will likely be recycled; if a failed experiment, the slower later consumption will be permanent as the capital allowing for this consumption has been destroyed. But there will be slower later consumption of some variety due to this financialization alone in either case.
We must then look across all financializations: if the experiments are conducted in perfect synchrony, we can be fairly certain prices will rise dramatically in the short term. If they are perfectly desynchronized, then the unwinding of completed financializations will tend to cancel out the setting up of new financializations. Hence it is fair to say that the effect of financialization alone on price will reflect the rate at which aggregate financialization is increasing or decreasing.
Changing the capital stock will have a simpler and more fundamental effect: the capital stock naturally depletes, causing costs to rise and hence prices to rise. Hence the successful creation of new capital will cause costs to fall and prices to fall. We might summarise by observing that, in the short run, prices will respond to accelerating or decelerating financialization, but in the long run will respond to the inverse of the change in productive capital. In the medium run, it seems unlikely these processes will be perfectly synchronized or perfectly desynchronized, and hence prices may well be volatile as per accelerating and decelerating financialization, but following a trend as per net capital accumulation.
The desire to create capital at the level of individual such experiments will probably always follow, in one way or another, from the entrepreneur’s assessment of the sustainability of the movements in price she is seeing. There will never be a right answer — it will depend on knowledge, judgment, and appetite for risk. We must recognize that these decisions to create capital will affect prices in turn. If financial capital and production capital are adequately decoupled, the relationship in aggregate can quickly become complex and the feedback profound. A farmer may well be able to fashion a plow with time he consciously decides not to devote to tilling. But pledging some portion of a hoped-to-be-more-plentiful harvest against the tractor that will provide it — and which in no amount of time could he have possibly built himself — is another matter altogether. As is the possibility this pledge could then be traded on. Judgment pertaining to prices will affect decisions to experimentally create capital, but so too will decisions to experimentally create capital affect prices. We must bear all this in mind in charting the health of the capital stock.
The more we financialize, the more experiments we are able to run. The incremental experiment will probably be the next riskiest, and the more its financialization is steered towards debt, the greater the risk becomes still. As we need some level of experimentation to avoid the entropic decay of the capital stock and the collapse of civilization, there emerges an ever-important question of, how much risk do we want to take? and, derivatively, who is deciding to take these risks, and who is bearing them?
So far, the assumed answers to these questions have been something like, we take as many risks as individuals desire to and whoever decides to take the risks bears the risks. We haven’t assumed anybody is taking risks they don’t want to or that they aren’t bearing, and we certainly haven’t assumed that the aggregate magnitude of consumption features in anybody’s calculations. Unfortunately, to make the analysis more applicable to our sordid reality — to make clear why we might be incentivized not to create capital but to consume it; not to cultivate the land but to strip mine it — we will have to explore both.
What if we foolishly do not think that economic health rests on growing the capital stock, but rather on the instantaneous magnitude of consumption? If we grow weary of the hard work of farming and think the path to happiness lies instead in feasting on our seeds? How will our analysis differ?
First, we will see financialization as unequivocally good and be totally indifferent to the risks and the fragility it creates. When prices naturally increase as present value is crystallized and exchanged, we will have little choice but to conceive of this inevitability as an intrinsically good thing, since increased consumption is a good thing, and increased prices can’t help but follow.
In particular, we will encourage entrepreneurs to assume any increase in purchasing is fundamentally sustainable, regardless of what their judgment and their knowledge tells them, because this will motivate capital investment in increasing the production of whatever is being purchased. If more such investment can be financialized, all the better, because that starts the loop all over again. Financialization is good. Pumping out more stuff is good. Number go up is good.
Because we don’t care about the risks of these experiments failing — only that they are attempted — we will be in a curious position when they do fail. What we will see will be asset write-downs that mean purchasing power evaporates and consumption slows. This slowing down will force sellers to lower prices, at least for the period over which capital can be re-allocated to reflect this change. Hence, we will have little choice but to conceive of decreasing prices as an intrinsically bad thing, since decreased consumption is a bad thing, and decreased prices can’t help but follow.
The solution, naturally, will be financialization. We replace the uncertain value that has since proven to be certainly valueless with more crystallized value traded for future uncertainty and go back to step one. Financialization is good. Pumping out more stuff is good. Number go up is good. All the while the natural depletion of the capital stock is not offset, and the price increases that follow from real costs increasing is mistaken as a sign of health.
Depressing as this would be, this is actually a much rosier picture than reality because there is still an alignment between those taking and bearing the risks. What we are effectively assuming is that willing contributors of capital waste it on ill-advised experiments over and over and over again until they have none left. This is still unideal because the ability to increase output for the same input of time and energy is universally positive. But it is only indirectly bad for those that do not contribute to such financialization and simply save instead. The output they can purchase may have fallen, but at least they will retain entitlement to a given share of it.
This also shows why it is unlikely: it relies on capital providers and entrepreneurs being neverendingly stupid. They must make poor judgments about the sustainability of their investments over and over and over again, and take more and more risk with less and less realistic likelihood of the risks paying off. They suffer by far the most from their own folly. To understand why reality is far worse than this, we must return to the question of the supply of money.
What If Money Were Debt? No, Seriously …
We must be clear on how money is created in real life. My sense is many have the impression that fiat money is created by central banks. This is partly true, but is not an exhaustive explanation, and is actually misleading in isolation. It is true that “quantitative easing” involves creating new central bank reserves for member banks, but this is not the only way, nor the most common way. The majority of “new money” is created by banks making loans. Contrary to popular belief, modern banks do not “intermediate between depositors and lenders”. As is nicely explained in this Quarterly Bulletin from the Bank of England, when a bank makes a loan, it wills into existence a deposit that is the debtor’s asset and its own liability. In fact, it is more accurate to say that loans create deposits than it is to say that deposits create loans.
This might seem bizarre, but the explanation requires being clear on what fiat money even really is: it is a fungible pan-bank liability. Other than the tiny minority of modern money that exists as cash, there is simply no such thing as a dollar, a pound, or a euro, that is not a right to claim that amount of cash from a bank — which of course nobody does because it is far, far safer to keep cash in a bank, and far, far easier to make almost all payments by instructing your bank to just change the title on that amount of its liabilities. If the payee has liabilities with bank B, then bank A must transfer that value of its central bank reserve assets to bank B, so bank B can create a matching liability. Banks tend to have accounts with one another so they don’t have to resort to this so often, but it is central bank reserves that are the ultimate mechanism for value settlement.
There are two peculiarities with all this. First, there will almost certainly be far more debt than there is any real appetite for because it is not possible to save outside of financialization. The only way to save is to accumulate the residual of credit that has already been issued completely outside your consent or approval. You might think that holding others’ debt can still be worthwhile if it is paid back. But the situation here is far more perverse: your asset with the bank is the bank’s liability, matched by a loan somewhere else. That loan is that person’s liability. That person may accumulate their own assets in the form of bank liabilities, which means the bank has been transferred reserves assets to balance these liabilities. This person may then pay off the loan, at which point the bank cancels the two. But you get nothing. All that happens then is that the bank uses the new reserve cushion to justify making more loans. Your credit might exist because the bank made a loan, but it is not in that loan; it is in the never-ending recycling of one loan into another into another …
The second peculiarity is that those signing off on the risks are not those bearing the risks. In fact, the reader will be forgiven for having completely lost track of the real risk here because it is so well obscured. If enough loans go bad that the bank’s equity cushion is wiped out then the central bank will be forced to create reserves to ensure the bank’s liabilities can still be met (i.e. money can still function). But the original liability will now never be netted off, meaning there are permanently more such liabilities, which means there is permanently more money, which means everybody’s money is worth less. This will be true in both senses of “inflation”: it is true by definition in terms of share of the total, but it will be true for prices as well, as the local slowing in consumption that would have paired the initial quickening due to financialization just never happens. Don’t let any nasty Bitcoiners tell you that the dollar isn’t backed by anything, when we know full well it is backed by self-referentially mispriced toxic loans and stabilized by a military and commodity cartelization pact with Saudi Arabia:
The Fraying of the US Global Currency Reserve System
Since autumn of 2019, I've been bearish on the dollar, meaning I have a longish-term outlook towards a weaker dollar…
Hopefully I will not be tarred and feathered as a fiat apologist nocoiner shill for making the following observation, but I contend that this setup does not absolutely necessarily lead to catastrophe. If a central bank is run such that the moral hazard of its relationship to member banks and bankers is taken seriously; if banks are kept as small and as systemically unimportant as possible; if the pain of systemic deleveraging and the ecstasy of systemic leveraging are insulated from political interference; if retention of adequate reserves is mandated and is eaten into by bad credit; all with an eye towards faithful risk pricing and a healthy capital stock … then things might be okay. It should also be noted that money is a technology that has no platonic form, and that relative to most real-life alternatives, fiat has the dramatic advantage of vast payment reach and inexpensive settlement that count in its favor at all the times it isn’t imploding.
However, if the prevailing sentiment of those responsible for such a setup foolishly believe that economic health rests not on growing the capital stock, but rather on instantaneous magnitude of consumption, then slow motion disaster will be next to inevitable. Let us explore the mechanics of such a catastrophe.
Gradually, then Suddenly
To start with, the oversupply of debt forces the price of debt down to clear the market. The ranking of experimental viability that the market might have carried out to allocate scarce capital becomes irrelevant and all prospective experiments are carried out. This juncture is key. These experiments are, by their nature, uncertain. The price of the capital they would faithfully attract can hardly be better described than a crowd-sourced best guess as to their risk relative to the opportunity set. It is possible that these guesses are conservatively false and that all will succeed. But it is likely that more bad experiments will fail than would have otherwise, hence more debt will tend to mean more bad debt.
And not only this, but the experiments’ financial capital is all bidding against each other for real production capital — which cannot be artificially increased as can the debt to finance the experiments — hence the costs of running the experiments go up just as the cost of financing them goes down. The effect is akin to redistributing the mean risk created by the marginal risky experiment to the entire ensemble. We get more individually bad debt and more averagely bad debt.
It is highly likely many more of the experiments will fail than otherwise would have. This ought to lead to persistent lower later consumption to reflect the capital that has been destroyed, but in our brave new world, such politically incorrect outcomes are not to be tolerated. Consumption cannot slow! Consumption is wealth and wellbeing! The central bank will first buy the bad debts with newly created reserves, meaning banks are not forced to write down their own assets, as doing so would threaten the quality of their liabilities and the entire systemic functioning of money, causing consumption to collapse even further. Then, the central bank will lower the rate paid on its reserves, meaning banks must create more (probably bad) loans to maintain their profitability. It may combine both efforts and buy toxic credit assets on the open market, freeing up the balance sheets of capital market participants beyond just banks to take on these new loans.
By this series of machinations, we emerge with more financialization, borne not of the opportunity to create capital, but the necessity to stabilize money, and the desire to increase consumption. We get more dilutive equity and yet no redemptive deleveraging, as financialization cannot decelerate and any deflation, however transient and coincidental, is deemed bad and triggers further panicked intervention. We get short-term price increases in response to the crystallized value of financialization that become permanent inflation as no matched future value ever materializes. We get official proclamations that this inflation is good and ought to be targeted. And from the starting point of an oversupply of debt we get … an oversupply of debt.
Believe it or not, it gets even worse. It is possible, however unlikely, that the originally expanded set of experiments all work despite their risks being systemically mispriced. But if the nearly inevitable long-term inflationary features of such a system are widely enough appreciated, this will distort the incentives of those trying to create and preserve value. A risky entrepreneurial endeavor making a return below this inflation rate will no longer be creating wealth for its owners but losing it — not as fast as holding fungible pan-bank liabilities (money), admittedly, but then money is thought to have no risk. The point of the risk of entrepreneurship is to get a real return.
Hence all return-seeking capital assets are unnaturally incentivized to lever up to stay ahead of inflation. This will likely be how the market clearing of the debt oversupply is matched — unnatural supply met by unnatural demand. Of course, all that is really happening here is that by swapping equity for debt, the experiments themselves are forced to become riskier than they ought to be. They become more fragile, which creates more bad debt, which will eventually require permanentizing inflation. It also makes a corrective rate rise prohibitively systemically risky because more and more debt can only be sustained at progressively lower rates. If rates rise, debt fails, and if debt fails, money fails.
The slim possibility of all experiments miraculously working evaporates as experiments are forced to be bad and get worse. From the starting point of the widespread belief of systemically necessary inflation we get … the widespread belief of systemically necessary inflation.
Behavior and Incentives
“It is harder to ignore the enormous increase in indebtedness and overhead that has accompanied the enlargement of farm technology. Mr Billard quotes an Iowa banker: “In 1920 … $5,000 was a big loan, and people hesitated to borrow. Now a $40,000 loan is commonplace, and having mortgage after mortgage is an accepted thing. I occasionally wonder whether the average farmer will ever get out of debt.” …
… The Iowa banker’s statement, doubtful as it may seem out of context, is made in praise of credit. Nowhere is there a question of the advisability of basing so large on enterprise on credit, or of the influence of routine indebtedness on a people’s character. Nowhere is there a suspicion that there might be any worth in the old rural values of solvency and thrift.”
- Wendell Berry
What really matters in all of this — what the financial terminology ought to elucidate but can just as easily obscure — is what is happening to the incentives individuals face to devote their time and energy to economically useful behavior. Are they incentivized to grow the capital stock or not? I can think of four obvious changes in relative incentives, although I’m sure there are countless more.
First, there will be an incentive to find some asset other than money to save with. Likely candidates are real estate and equity and bond indices. Inflation in these asset classes will march upwards with the threat of inflation in general, distorting the price information they otherwise both create and rely on and further misdirecting capital to ends that are only as sustainable as the inflationary regime. Anybody who wants these assets for their actual economic function — somewhere to live, stable cash flows, whatever — ends up at the mercy of this regime: unable to own anything unless they lever up too, which of course just exacerbates the problem.
Second, those who hold return-seeking capital assets but who do not lever up are comparatively disadvantaged if their competitors do. And if they don’t get politically preferential access to the front of the queue for new loans, they may have to sell to those who do. The oldest company in the world, Kongō Gumi, was run by 50 generations of the same Japanese family before selling out to conglomerate Takamatsu in 2006, when it “succumbed to excess debt,” according to Bloomberg.
Third, this constant and pointless demand for financialization will create political and business opportunities to better facilitate it. Financial capital will increasingly be directed towards the very business of financialization at the expense of creating real productive capital. Those in on such schemes will do very well indeed, but this is clearly not economically useful. Here, Matt Stoller describes this process in equal parts entertainingly and depressingly, as industries as odd and diverse as portable toilets, prison phones, and dentistry are financialized to absolutely nobody’s benefit other than those orchestrating, “a form of legalized fraud shifting money from the pockets of investors and workers to the pockets of financiers.”
Fourth, this artificially expanded opportunity will favor general bigness and concentration in finance itself. Berry’s insight of the optimal organization of agriculture I think once again transcends his domain and is a valuable commentary on credit and capital:
“In a highly centralized and industrialized food-supply system there can be no small disaster. Whether it be a production “error” or a corn blight, the disaster is not foreseen until it exists; it is not recognized until it is widespread. By contrast, a highly diversified, small-farm agriculture combined with local marketing is literally crisscrossed with margins, and these margins work both to allow and encourage care and to contain damage.”
In other words, the financial system will tend towards a structure that makes crises all the more devastating when they inevitably occur.
And finally, an obvious consequence of all four is accelerating inequality between those who do and do not own capital, who are and are not able to get to front of the queue for artificial finance, and who do and do not malinvest in their own human capital on false price signals. Given the focus of this essay is to elucidate the dynamics of the capital stock, I will leave the connection at the following musing: if the popular reaction to such spiraling inequality and unaccountable overseeing of proliferating crises is to whip up anti-capitalist sentiment and/or demand compensatory money printing, will the incentives to channel time and energy towards growing the capital stock get better or worse?
The Uncapitalizing of America
Does it ever end? If so, where? When? How?
It is likely impossible to say because the impetus is politically variable, and there will always be the countervailing force of successful experiments propping the whole thing up. We can interpret their significance from multiple angles. By definition, they add to the capital stock and may or may not offset its natural rate of depletion. They contribute to deflation which may or may not offset the inflation caused by the perversity of the monetary regime. Most critically, they offer a means of natural deleveraging — even within the ideological obsession with consumption — because the lower later consumption that balances their financialization will be relatively less impactful.
But that the opportunity to deleverage exists does not mean it will be taken. Successful investment and capital creation may not pull hard enough and may only delay the inevitable. The never-ending march to greater and greater leverage will meet its final boss at the zero lower bound of interest. It is difficult to overstate the importance of appreciating the ZLB from first principles.
If you are offered a negative interest loan, what this means is that you can spend it on an investment project that loses money, and still make money yourself. This financialization allows you to crystallize future value that will never come to exist. In other words, it encourages not even the relative waste of capital, but its direct consumption. Imposing negative interest rates is strip-mining the capital stock. It is eating the seeds rather than planting them. It is utter insanity, but it is an insanity with no alternative if we can’t deleverage and yet we must consume.
Berry’s analysis of the tragic logic of the accelerating pillaging of the agricultural stock I think translates practically word for word. It may even be more accurate to say that it generalizes, as the agricultural stock is but one form of accumulated capital — the original:
“It is no doubt impossible to live without thought of the future; hope and vision can live nowhere else. But the only possible guarantee of the future is responsible behavior in the present. When supposed future needs are used to justify misbehavior in the present, as is the tendency with us, then we are both perverting the present and diminishing the future. But the most prolific source of justifications of exploitative behavior has been the future. The future is a time that cannot conceivably be reached except by industrial progress and economic growth. The future, so full of material blessings, is nevertheless threatened with dire shortages of food, energy, and security unless we exploit the earth even more “freely,” with greater speed and less caution. The obvious paradoxes involved in this — that we are using up future necessities in order to make a more abundant future; that final loss has been made a calculated strategy of annual gain — have so far been understood to no great effect. The great convenience of the future as a context of behavior is that nobody knows anything about it. No rational person can see how using up the topsoil or the fossil fuels as quickly as possible can provide greater security for the future, but if enough wealth and power can conjure up the audacity to say it can, then sheer fantasy is given the force of truth; the future becomes reckonable as even the past has never been.”
To say this sheer fantasy “ends” here is likely presumptuous. It gets abjectly worse here, but nobody knows when it ends. When all capital has been consumed? When leverage is infinite?
What about if or when savers revolt against the tax on their savings that negative rates require? Inflation may be a stealth tax that is unavoidable as far as they are concerned, but surely this obnoxiously direct tax can be avoided by removing deposits? Unfortunately, this will do little more than trigger a liquidity crisis that will have to be patched by long-term inflationary reserve creation, from which yet more short-term inflationary leverage will predictably metastasize. And if you think about it, this nuisance would be rather solved by simply banning cash such that fungible pan-bank liabilities are not liabilities against anything in particular, besides the loans that created them. It would be jolly good for banking stability to protect it from the animal spirits of the rabble. I wonder if anybody has considered this …
In Part One, Wittgenstein’s Money, I stressed that money is useful not because it fits some or other semantic scheme that holds up if and only if nothing in real life changes, but because real life does change, and money provides certainty in an uncertain world. But this is not to say that uncertainty is harmful. Capital formation is by necessity highly uncertain, but greatly beneficial. Money provides a means of socially scaling the embrace of this uncertainty, provided it gives us certainty in the first place. The more capital we create, the more complex the economic environment gets, and the more valuable the certainty of money becomes. Money emerges from uncertainty, capital emerges from money, and uncertainty emerges from capital.
This progression towards order and complexity can be reversed if perturbed with enough economic misinformation. If the value of money becomes increasingly uncertain, it will create increasingly worthless capital, which will mean money is less valuable anyway. If you break money, you break capital, and if you break capital, you break money. If you break money badly enough, you have to start strip mining capital to reclaim enough certainty to function at the level of civilizational complexity achieved to that point. But as this complexity depends on this capital, this is clearly not a sustainable proposition.
If we believe, or merely suspect, we are heading towards this outcome, can it be stopped? Can we opt out? Does anything …
… fix this?
What would it seem like if it did seem like we could fix this? Find out in Part Three.
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