Wednesday, June 16, 2010

Money For Nothing, or How the Banks Bought America and Then Destroyed It

Rebecca's thoughtful comment on my last post got me thinking about an aspect of ballooning money supplies I haven't yet posted on yet (I think.) What she observes is true -- the business cycle has a way of shuffling resources -- in her case, human talent -- from one market to another in a fairly capricious manner. This is one of those observations that should leave the free-market faithful economist scratching his head. Isn't the market supposed to allocate resources efficiently? Isn't it supposed to have foresight? If so, why do things seem to get flopped around so willy-nilly?

The business cycle itself is one reason, as you might have guessed, but there are other important effects that come creeping out of the same monetary meddling that drives the business cycle. Some might even be considered more sinister. The distortions and malinvestments of the business cycle cause plenty of trouble, but those effects are at least equal opportunity trouble. Some effects go beyond that, favoring particular groups and business structures which have a vested interest in the monetary jiggering.

Mo' Money and the Business Cycle

The Austrian business cycle theory holds that prices are distorted as new money enters the economy during the boom phase of the business cycle. For a most excellent review, if I do say so myself, see my series of posts on the creation and destruction of money. Or consult the even more excellent Wikipedia entry which Aaron provided some days ago.

The new money, as they say, is not 'neutral' in that it does not affect all prices equally. Prices become distorted as higher-order capital goods see their price increases outpace those of lower-order capital and consumer goods. This is because newly created money does not enter the entire economy all at the same time. Because of the way that it is created and introduced, it is first confined to certain markets before spreading through the rest of the system.

New money is first created as the central bank buys assets and deposits its payment as new reserves in the banking system. These reserves are then used to extend credit to borrowers, which typically borrow money for investing purposes more so than for direct consumption. 'New money' is typically 'invested' rather than 'spent,' so that monetary expansion of the FED tends to push up prices of capital goods long before it affects consumer goods. This price distortion leads to the irrational investment activity and economic behavior that is the origin of the business cycle, which is, ironically, precisely the phenomenon the FED is supposed to be preventing.

The Thieving Counterfeiters

That much is simple enough. There are other effects, however, of this cascade of events.

It might not be intuitively obvious that counterfeiters (e.g. those who create money 'from nothing,' licensed or not) would be responsible for the booms and busts of the business cycle, but it should be plain to everyone that there is more that results from counterfeiting than 'a general increase in price levels.' If that were all there was to it, nobody would go to the trouble. Who would spend time and energy to do that?

Obviously, the reason that anybody bothers to become a counterfeiter is to illicitly acquire things with the printed money. Despite the confusion inherent in the roundabout process described above, exactly the same thing happens with our banking system.

The banking system long ago noticed that, on average, deposits and withdrawals almost always balance out, as one customer's payment is merely transferred to the account of another. Specie (e.g. gold and silver) held on deposit rarely left the bank, it merely changed ownership within the system. It didn't take a genius to figure out the trick of lending out more money than the bank actually had in precious metal specie, so that interest could be collected on 'money' that was not supposed to exist. By doing so, the bank acquired illicit revenue streams and collateral powers over properties scot-free. For whatever reason, this dishonest practice was not condemned but granted legal sanction, and we have been dealing with the consequences ever since.

The same practice goes on today, but on a much larger scale. The FED itself gets property 'for free' when it makes a purchase, although some naïve persons will argue that it issues notes (i.e. dollars) against itself in return, as if the holder of that note wielded one lick of anything over the FED. And in creating new money by lending against deposits, which merely change hands within the system just as specie did in the old days, the banks acquire revenue streams and collateral obligations against their borrowers' properties.

The Benefits of Doing Business With the Cartel

As one might expect, the spender of new money created by a bank also gets a heck of a deal -- almost as good as the counterfeiter himself. He gets to spend the new money before its inflationary effect has taken hold. He trades the new money for goods at the old price. Those who get the money later than he will have to deal with already inflated prices. New money does them no good, and meanwhile, he has snapped up all the deals and they are left picking through the leftovers.

In the days of the gold rush, a new mine would attract resources from far and wide while it produced gold, driving up prices near the mine and depriving surrounding areas of their supplies. The well-placed in a 'boom town' often made out like bandits, not so much in proportion to any particularly noteworthy achievement or high level of productivity, but merely by being in the right place at the right time.

Likewise, today's money-spewing banking system draws resources and talent away from the rest of the economy and towards it. Those in close economic proximity to the banking system (financial companies, government, large corporations, etc.) see their share of the pie swell, while the rest of the economy withers in deprivation.

This is not merely a theoretical exercise or idle speculation. During the boom that began in the early 1980’s, the financial sector swelled, representing a steadily increasing share of total corporate profits in the US. Before 1980, rarely could the financial sector claim as much as 16%, but after 1985, their share rose steadily, comprising as much as 41% just a few years ago. Likewise, prior to the 1980’s boom, salaries in this market were comparable to other sectors. But again, as the boom got underway, salaries rose to as much as 181% of the average of other industries. Note that these are not measurements of raw increases, but increases relative to other sectors. Those other industries saw their profits and individual compensation rise as well, no doubt, but finance rose faster. Much faster, exactly as predicted in theory.

As debt levels and the money supply have exploded, the share of the economy devoted to finance exploded right along with it. The recent correction has only wrung out some of the excess, and the bailout of the big banks ensures that a large share of that ill-gotten bite will be permanent.

At everyone else's expense.

Corporate Malarky

For these reasons, I am led to believe that a great deal of what presently passes for conventional wisdom about corporations and their role in the structure of the economy is complete malarky. Here I am wandering off the Austrian reservation a bit, as I have never explicitly read these assertions in connection with this school of thought, but I'll relate them anyway because I think they are important and I believe the facts and theory support them.

Low interest rates result in an extension of the division of labor and capital accumulation. It does not matter whether the rates are naturally low or suppressed by monetary expansion. Both result in the devotion of resources to investment rather than consumption, the difference being that in the first case the investment is sound with respect to future patterns of consumption, while in the second it is not, resulting in the need to liquidate and redeploy these investments during a correction/recession.

But by existing in varying economic proximity to the banking system, it seems to me that this extension would naturally be more pronounced for some economic entities than others -- precisely those cases which see the most benefit of the expansion of the money supply. This is the obvious conclusion to draw, as the 'new money' was borrowed for the purpose of buying capital, and capital accumulation goes hand in hand with an extension of the division of labor.

It seems to me that a great deal of the business success of large corporations that one observes is not at all due to the inherent competitiveness of this business structure in comparison to, say, a mom-and-pop style small business, but is largely an artifact of being economically more proximate to Wall Street and the banking system. Mom and Pop can't take anywhere near the advantage of cheap lending that a Wal-Mart or a General Electric can, bailouts and legislative favoritism and regulatory obstructionism notwithstanding. By being cozy to the financial sector and operating at higher leverage, the monster corporations can make hay of their smaller competitors, despite the inherent inefficiency and confusion that comes with trying to coordinate the behavior of the disparate individuals that make up such behemoth organizations.

What is the advantage of a highly extended division of labor to, say, residential real estate and its associated business activities? Such markets are highly localized and require intimate knowledge of a geographical area for assessing risk in many separate, highly individualized, and relatively small transactions. How does an extended division of labor economize service of this market?

How does a headquarters in New York, complete with corporate leadership and centralized direction, help a mortgage lending branch held in Texas? I can't see that it does, yet that is precisely how the market was developing. Financial markets tried to turn real estate lending into a homogeneous national market, which it isn't at all, solely because it would be more suited to a corporate business structure than a highly localized and dispersed market. I conclude that the extended corporate structure was favored by markets anyway, not because it was the best tool for the job at hand, but because it was the best way to take advantage of an expanding money supply.

And it was a disaster.

It makes sense that some industries would naturally favor an expansive corporate structure. Heavy industries that really do have a lot of real capital, like chemical plants and refineries, or factories that make highly complex products would naturally have an extended division of labor. It also makes sense that there would be some rather large, specialized banks devoted to serving such customers. They would need to be sophisticated to assess the risks of lending in such an industry, and have the ability to lend large sums for such projects.

But for the most part, I think these instances are exceptions rather than the rule, most especially when it comes to banking and finance. These enterprises make use of very little actual, physical capital, and would not need much in the way of an extended division of labor to service it and keep it in operation.  And as noted before, intimate knowledge of individual transactions to asses risks seems more important than 'economy of scale' in lending, whatever that means.  A low division of labor almost seems preferred for these types of businesses.

Excuses, excuses

I began reading Ludwig von Mises Bureaucracy some time ago, but decided to put it down a short way in. In it, he makes several good points about the bureaucratic organizational structure, the most important of which is that competition doesn't end with the death of the free market, it just takes a different form. Competition is alive and well and at work within bureaucracies just as much as anywhere else. But the makings of a successful competitor in this environment are very different, and the competition typically turns out to be a lot nastier and more personal.

I had to put the book down, however, when Mises begins trying to explain why corporate bureaucratism is different from bureaucratism in government because of the profit motive. In corporate bureaucratism, authority devolves down the chain of command, he says, because no person can handle the workload and decision-making responsibilities of all of his subordinate positions. Therefore, authority must be (and presumably is) delegated efficiently, and maintained through rigorous profit and loss calculations which are not present in government.

I think this is one of those nice sounding theories that breaks down in practice. To my knowledge, Mises never actually worked for a corporation and lived in a time and place such that he probably never experienced the particular flavor of social breakdown that is so apparent today, though he did see breakdowns of his own, of course. But it seems to me that the critical elements, the older assumptions and discipline over individual conduct, still prevailed in his time with almost none of today's multiculturalism and behavioral non-judgementalism. It seems to me that in his time, the West could afford a certain level of bureaucratism and still not feel too many immediate ill-effects, because the more craven human behaviors that tend to overrun such social structures were being held in check by other forces which have since been in decline. They also had better financial accountability in the form of harder money, so perhaps his profit-and-loss calculations also had more teeth.

In my experience, at least, few of his conjectures seem true anymore, though they may have appeared true in his day. I am more inclined towards such perspectives as are expressed in Dilbert and Office Space -- corporate bureaucratism tends toward the inane, wasteful, and duplicitous, with little to redeem it, at least in comaprison with non-bureaucratic enterprise. I do not think that supposed 'economies of scale' make up for the waste of human time and talent that bureaucratism is so famous for in the vast majority of cases. As noted before, there are probably some instances where the operation and maintenance of vast and complex physical capital make such structures necessary, but I suspect these are rare and do not remotely justify the observed level of bureacratic corporatist structures and the waste and headaches they cause.

And yet, for some reason the very properties of bureaucratic divisions of labor -- excessive complexity, obsession with status, waste, irresponsiveness to those they claim to serve, and resistance to individual accountability and reform -- so repulsive to the political right when observed in government, are nevertheless frequently defended when observed in corporations. Perhaps it is mere association with general 'business,' or perhaps they lean towards Mises' views. I don't know. But it seems to me naïve and that they waste their breathe and reputations defending behavior that in most cases really is wasteful, corrupt, and stupid, and obviously so.

But that just goes to show that there is no hope in politics, and that there probably never was anyway.

The Banks Are Killing the West

Thanks to monetary expansion and its effect on the growth of government and the economic sectors that profit disproportionately from the activities of the banking system, resources and talent get sucked into the black hole of bureaucracy that would be better employed elsewhere. These fused entites grow like a massive swollen tumor about the banking industry that hyperstimulates their growth with a perpetual ooze of fiat currency while the productive economy that supports them withers and dies.

Rather than wasting precious resources trying to force broken systems to work and building up parasitic economic entities, they could be better employed in smaller scale enterprise, real innovation, family, and yes, overseeing the finances of Rebecca's church, where efforts and investment might actually be worthwhile for human well-being. Instead, it takes a severe recession for the monetary fog to lift and make people desperate enough to do the things they probably should have been doing all along anyway. A pity. But while the money is flowing, the rewards of corporate participation are too compelling for most individuals, at least on paper, and it is almost impossible to resist.

The West, once a flourishing and innovative civilization, is slowly being transformed into something like an ancient Eastern bureaucratic society, where status supersedes merit and real achievement. Actually, I suppose it is where status is merit and the only recognized form of achievement. And yes, there are many other forces at working towards the same end, but I think this is one of the bigger ones.

All because a few smarty-pants thought they could do 'better than gold,' and people believed them.

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