We’re glad we brought out our old ‘Crash Alert’ flag last week. It looks like we may need it.
The Dow plunged 333 points yesterday, or nearly 2%.
Back to that in a minute…
‘Jorge,’ we asked our farm manager, ‘when was the last time you visited Marta Sandoval at Tacana?’
‘Oh… maybe two years ago. She was okay then. A little crazy, maybe.’
‘Don’t you have to go every year to count the animals?’
‘Not up there. It’s not worth it. She only has about five goats.’
The farm is a marvel of ambiguity. We own it. On paper. But about 100 people live on it…work it…and use it.
In fact, they control some of the best parts of it. They pay us ‘rent’ in the form of a percentage of their animals — about 1 in 20. But since their animals aren’t worth anything, we count, but we don’t bother to collect.
And so, they pay nothing. They — and their descendants — can stay as long as they want.
How long they will want to live in such harsh and lonely conditions is a subject of much conversation and speculation. But most show no signs of wanting to come down.
‘They were born there,’ says Jorge. ‘They want to die there too.’
‘Can I ride up to Tacana sometime?’
‘Yes. The trail is very rough. And you’d never find it on your own. I’ll take you.’
Back in the world of money, GDP, yields, Kim Kardashian YouTube clips, Netanyahu speeches and market crashes…
…to fully understand this strange world — and the strange events that brought us to negative bond yields, a phony recovery and multiple bubbles — we must go back once more, ab ovo, to whence today’s curious money system was hatched.
For that, we begin with two economists — one living, one dead.
As former IMF and World Bank economist Richard Duncan explains in his book The New Depression, a new system replaced capitalism after President Johnson asked Congress to end the gold reserve requirement against Federal Reserve notes (i.e., dollars) in 1968. After this, writes Duncan:
‘The production process ceased to be driven by saving and investment as it had been since before the Industrial Revolution.
‘Instead, borrowing and consumption began to drive the economic dynamic. Credit creation replaced capital accumulation as the vital force in the economic system.’
Duncan calls this new system ‘creditism’.
In free market capitalism, private companies and private persons own capital and decide how to invest it.
Typically, they invest in new projects — factories, industries, housing and technologies. They hope these will produce enough profit to repay the cost of capital…and then some.
When they are successful, this results in more capital. Thus does a society get rich.
This old system was limited — shackled to a golden ball and chain. You could only lend a certain multiple (set by stringent reserve ratios) of the money you had saved.
And you could only spend what you had earned or what you could pay back.
On a national basis, if a country spent more than it earned, its currency ended up in foreign hands. And when accounts were settled, the over-spender had to ship its gold to its creditors.
This left it with less money (gold) to spend and invest. As its money supply went down, the economy contracted…thus restoring balance.
During World War I, the US became the largest holder of gold in the world. It sold food, clothing and weapons to the Allied Powers and collected money (gold) in payment.
Arguably, the US entered the war on the side of the Allied Powers largely because they owed it so much money; it wanted to be sure to get paid.
This increase in America’s money supply led to a big expansion of credit in the ‘Roaring Twenties’, followed by a credit crunch and depression in the 1930s.
By the 1960s, the US was no longer collecting gold, but disbursing it. It was overspending in a big way, on the Great Society at home and the Vietnam War overseas.
By 1971 — when President Nixon ended the direct convertibility of dollars to gold — half of its trove of gold was called away by foreigners. This is why Nixon ‘closed the gold window’ and changed how the world’s money system worked.
Two years later, in March 1973, the G-10 countries ended their pegs to the US dollar in favour of floating exchange rates.
People didn’t know what that change meant then.
They still don’t…
We meditate. We pray. We drink heavily. And still, we struggle to understand it.
The obvious consequence of the new purely paper-money system was that it removed the restraints on lending.
Total US credit hit the $1 trillion mark in 1964. Today, it is near $60 trillion.
During that half-century, total US GDP summed to $477 trillion in 2009 dollars. So, you may infer that one out of every eight (477 / 60 = 8) shopping malls, highways, wars, healthcare costs, university football teams — all were bought on this new and expanded credit.
The old (gold) money disappeared with automobile fins and drive-in movie theatres. The new (credit) money was very different.
You didn’t have to earn it by the sweat of your brow or the diligence of your enterprise. Banks could simply create it, out of thin air, by making new loans.
And because their regulator, the Federal Reserve, had lowered the amount of reserves banks were required to hold against new loans to insignificant levels, they no longer provided any constraint on the amount of new money (loans) that banks could create.
Unlike capital — which the private sector earned, saved and directed — the Fed controlled the cost of credit.
And gradually more and more of it was sent in a new direction — toward consumption rather than production.
The old capitalists might have built a factory; they knew they had to make a profit to pay back the loan. The new ‘creditists’ would use loans to finance more housing, more automobiles, more student loans or more payments to old people.
And when the bills came due, they could refinance.
Economists of the era had it all wrong. They thought consumer spending was the key to boosting GDP and increasing prosperity. But it is production that gives consumers the wherewithal to spend, not the other way around.
Consumption does not create wealth; it consumes it. And as the driving force of the economy switched from capital to credit…and from production to consumption…growth rates declined.
From about a rate of 5% a year in the 1960s, US GDP growth fell to 2.4% last year. And it averaged just 2.2% between 2010 and 2013.
That is why real wage growth has been stalled for the last quarter of a century and why the typical American family has less real income today than it did in 2007.
It’s also why there are two million fewer ‘breadwinner’ jobs today than there were in December 2007.
How the new credit system reacts to stress is our subject for tomorrow. And for insight into that, we draw on one of our favourite dead economists, Milton Friedman.
for the Markets and Money Australia