posted February 27, 2016
Systemic Fragility in the Global Economy, Part 3 (Why Economists Get It Wrong)

In the preceding Part 1 of this series, which appeared in the December 2015 issue of this magazine, the growing unstable state of the global economy was described. Conditions in China, Japan, US, Europe and Emerging Markets as of October 2015 were reviewed, as was the collapse of global oil and commodities, the intensifying global currency wars, declining stock and corporate bond markets worldwide, as well as the simultaneous slowing in the real economy globally. Part 1 concluded by identifying nine key trends responsible for the growing instability and slowing economy worldwide.

Since late October 2015, nearly all the identified trends and conditions negatively impacting China, Japan, Europe, US and Emerging Market economies, have deteriorated further.

A Recapitulation

In Part 2 of this series, appearing in this magazine’s January 2016 issue, an explanation of the nine trends behind the growing global economic instability was provided, as well as an explanation how those trends are leading to another major crisis in the global economy—most likely in 2017 but possibly even sooner. The idea of ‘systemic fragility’ was suggested as central to understanding how the global economy has been growing increasingly unstable again and is approaching yet another major crisis—a crisis this time potentially more severe than that experienced in 2007-09.

At the core of the systemic fragility-global instability relationship, it was argued, is a fundamental and defining shift in global capitalism in the 21st century: a shift toward investing increasingly in financial assets and securities, which in turn has been responsible for growing financial instability (stocks, bonds, currency volatility, capital flight, deflation in oil, commodity and other markets) as well as a corresponding slowdown in real investment (infrastructure, buildings, equipment, machinery, and so on)—i.e. in ‘things’ that produce goods and services that create real jobs, lead to real wages and income gains, consumption, and therefore economic growth and stability. It was explained that the shift to financial asset investing is accelerating because such investing has become simply more profitable than making ‘things’. Capitalists are therefore progressively shifting their wealth to investing in financial assets and securities, at the expense of real investment. In turn, the financial asset investing shift is causing fragility and financial instability, while in parallel producing a slowdown of real investment that in turn leads to a lack of decent paying jobs, stagnating wage incomes, tepid consumption recovery, a drift toward deflation, and slower growth.

The vehicle for this relative shift to financial securities and financial asset investing, Part 2 explained, is the new finance capital elite that has arisen globally—i.e. around 200,000 of super wealthy investors whose decisions now increasingly drive the global economy. Accommodating their growth in numbers and their wealth expansion has been the growing global network of ‘shadow’ banks and financial institutions that carries out much of the new elite’s financial investing, enabled by an ever-growing system of liquid financial markets worldwide. To absorb the financial elite’s accelerating investment in these ever-expanding global financial markets, new financial securities of all types have been, and continue, to appear.

This new institutional framework of finance capital elite, shadow financial institutions, proliferating financial markets and securities together constitutes the real definition of financialization of the global economy that is the hallmark of 21st century global capitalist evolution.

There has been much confusion about what exactly is meant by financialization and the role of financial forces in capitalist instability today. Financialization is not simply measured by the share of profits or jobs going to banks or the ‘FIRE’ sector (finance, insurance, real estate) or the placement of bankers in key roles in government. Financialization is the rise of this new finance capital elite and the supporting institutional structure of markets, organizations, and new securities. It is that new finance capital elite and the restructuring of global finance that represents financialization. The financial investing shift is its symptomatic indicator.

At an even more fundamental level, however, it has been the explosion of money and debt that has been steadily provided by the US central bank, the Federal Reserve, and other central banks worldwide, that has enabled the shift itself.

The central banks’ money machine—as well as non-money forms of credit—is what has created the escalation of debt that has exploded to unsustainable levels ever since the collapse of the old Bretton Woods international monetary system in 1973. That money and debt creation has accelerated ever-faster in the 21st century, flowing largely into financial asset investing, creating financial asset market bubbles, accelerating capital incomes and thereby producing runaway income inequality in the process. As documented in Part 2, the total value of investible financial assets globally has nearly doubled since 2007, to roughly $180 trillion, the majority of which has been under the control of the new finance capital elite.

Contrary to popular opinion, this financial wealth creation was hardly slowed by the 2008-09 crash, and has accelerated even faster ever since, adding $90 to $100 trillion in wealth to the 1% in less than a decade since 2007. But who among mainstream economists have even recognized, let alone addressed, this fundamental characteristic of 21st century global capitalism? Or explained how it has come about? Or considered its negative, destabilizing effects on the rest of the economy and billions of real people not among their ranks?

One would have to look very hard to find anything remotely similar to this kind of analysis among mainstream economists. As a group, they are typically loathe to identify actual capitalists, financial elite or otherwise, as centrally responsible for the growing global instability and slowdown.

Mainstream economists prefer to talk about ‘the markets’ as responsible for crises, as if there were no human beings behind them. ‘The markets said this’ or the ‘markets tell us that’ is how analysis is framed. Markets are also viewed as fundamentally stable. External shocks may temporarily knock the system off its otherwise stable economic pedestal, but the capitalist system is never ‘internally’ or fundamentally unstable. On the contrary, it is basically stable and is only occasionally disrupted by external supply and or demand shocks.

Given this fundamentally flawed view , mainstream economics is perplexed as to why certain long term trends in the global economy continue to develop—i.e. why real investment has been progressively slowing for some time now, why prices for real goods and services continue to drift toward deflation virtually everywhere today, why central banks cannot get goods and services inflation back up to a 2% annual rate anywhere despite having injected $25 trillion in money and liquidity since 2009, why income inequality is growing rapidly, why wage income growth remains stubbornly stagnant, why global oil and commodity prices continue to collapse, and why Japan has been having a recession every other year, Europe remains chronically stagnant, and China is headed for a hard landing.

The Global Slowdown Has Been Gathering Pace

To the failure of mainstream economists to understand or explain these longer term trends must be added their failure to explain why the deterioration of the global economy has been gaining momentum the last three months, from November 2015 through January 2016. Explaining short run events has been no more accurate than predicting longer term trends. Some of the more notable short term conditions and events it consistenltly has failed to explain why:

• Global oil and commodity prices resumed their collapse after November, with oil falling as low as $27/barrel and in some regions to $15;

• China’s real economy continues to slow according to a growing number of indicators, manufacturing activity continues to decline, investment slows rapidly, prices deflate, and risks of widespread default of industrial companies is rising;

• China’s stock market entered a ‘third leg’ down in December, this time pulling global stock markets with it. In January alone, in just one month, stock market values globally have fallen by 10% to 20%, and China’s has now fallen by roughly 50% in just the last six months—together wiping out more than $7 trillion in values worldwide;

• China effectively devalued its currency a second time in November following the IMF’s approval of it as a global trading reserve. Bets by investors are it will do so again soon. As a result of falling stocks and currency values, capital flight from China has exceeded more than $1 trillion, further destabilizing its stock market and currency. The view globally is that China policymakers are steadily losing control, and the prospect of that has deeply shaken markets, investors and governments worldwide;

• The US Federal Reserve raised short term interest rates in December, as the US dollar continued to rise, throwing US manufacturing exports and the sector into a contraction. The continuing collapse of the oil-gas sector in the US has destabilized corporate junk bond markets, led to hundreds of thousands of layoffs, and initiated a sharp decline in industrial production in the US;

• Currency wars ratcheted up further during this period, and especially in January, as Europe’s central bank signaled more QE money injection coming in March. Fearing more competition from Europe for the global economy’s shrinking exports pie, Japan’s central bank jumped the gun ahead of Europe, driving interest rates into negative territory and joining Europe where now nearly half of rates are negative. Central banks themselves are beginning to look like they are becoming desperate;

• Italian banks were revealed to have more than $350 billion in non-performing bank loans (businesses failing to pay interest or principal on debt). Euro-wide, it was revealed more than $1.5 trillion of bank loans are now non-performing loans (NPLs);

• China banks were revealed to have more than $2.5 trillion in NPLs, as China’s total debt rose to more than $30 trillion, a $25 trillion rise since 2007. Meanwhile, in the last six months, China has spent more than a half of trillion in dollars to stabilize its stock and currency markets, but has failed;

• Emerging market economies like Brazil, Venezuela, Nigeria, Argentina, South Africa, and others slipped even deeper into recession and financial instability in the past 90 days. The largest, Brazil, now experiencing its worst recession since the 1930s;

• Fourth quarter 2015 GDP growth rates tumbled in all the major global economies. Germany, France, UK, Japan, etc.—all recorded growth rates barely above zero. US GDP slowed rapidly in the fourth quarter 22015, registering a mere 0.7% annual rate even after GDP was redefined in 2013 to add $500 billion by questionable ‘paper’ recalculations. (Real adjusted US GDP is thus no more than 0.4% and virtually stagnant).

• The world economy is now experiencing a world-wide manufacturing contraction and recession, while global trade volumes keep falling and approach a zero growth scenario as well.

These facts conflict sharply with the scenarios that were painted by most mainstream economists last October 2015. Global oil prices were predicted to rise again by year end 2015, China would stabilize its currency and halt its stock decline, Japan-Europe QEs and currency wars were over, the US economy was robust enough to allow the Federal Reserve to raise interest rates in December and four more times in 2016, Japan and Eurozone central banks had successfully begun to reverse deflation and their economies and markets were on a path to recovery in 2016, China was successfully on the way to restructure from an export-government investment driven growth strategy to a more consumption-private investment driven economy and would experience a ‘soft landing’, the worst for emerging market economies was over, and so forth.

Obviously, none of these scenarios of just three months ago have been accurate. In nearly every case, conditions and events of the past 90 days, from November 2015 through January 2016, have proved to have been almost the opposite.

So why do mainstream economists continue to fail to predict the longer run trends while also consistently miss the mark with regard to even more recent short term events?

The reason is that their theories and models are fundamentally broken. They correspond conceptually and analytically to a framework based on a 1950s type US and global economy—not the 21st century global economy dominated by the new finance capital elite who are sucking dry the real economy in order to accelerate their wealth in financial asset investing.

Specifically, the theories and models of mainstream economists have no way of effectively integrating the destabilizing financial forces that are endogenous, i.e. intrinsic, to the capitalist system; financial forces that are now, once again as in the historical past, raising their destructive heads. Their forecasts and predictions fail because their models virtually ignore the role of financial asset investing and the new global finance capitalist elite who are the human agents who are the new global lynchpin in the 21st century capitalist economy, and who are responsible for the current drift toward yet another global economic crisis.

Hybrids and Retros

There are two major wings of mainstream economics. They are perhaps best identified as ‘Hybrids’ and ‘Retros’. They have differences, but share far more in common than not. The term ‘Hybrids’ refers to ‘Hybrid Keynesians’. Despite their claims, they are not really Keynesians. They borrow some of elements of Keynes’ theory but reject other key elements, and then add in views and propositions that preceded Keynes which he, Keynes, adamantly rejected. The ‘Retro’s refers to ‘Retro Classicalists’. They represent throwbacks to economic analysis before Keynes. They repackage the old worn out views of 19th century economics, what’s sometimes called neoclassical economics, creating old wine in new bottles. Both wings use the same conceptual apparatus for analysis and prediction, emphasizing real variables and de-emphasizing, and even ignoring, financial forces and variables. Retros see the economy as basically stable, so long as the government intervenes only minimally or not at all; Hybrids also see it as fundamentally stable, so long as the government intervenes when necessary to help the economy return to its natural, stable equilibrium state.

(HYBRIDS)

A short summary why ‘Hybrids’ consistently fail to accurately predict trends and the general trajectory of the global economy today include:

• No distinction is made between financial asset investing and real asset investing or how the two investment forms negatively interact and impact each other. There is thus no explanation how financial cycles and real business cycles affect each other to destabilize the system. Financial variables and forces are of relatively minor import in the general economic picture.

• Central banks are considered the main determinant of real investment, through their influence on the money supply that in turn sets interest rates. That interest rates may have virtually no positive effect on real investment is ignored. So too rejected is the possibility that financial investing is diverting resources from real investment and thus causing the latter to slow.

• There is virtually no role for shadow banks or capital markets where businesses increasingly borrow, in the process bypassing traditional bank lending. Hybrids continue to adhere to the traditional view seeing central banks influencing commercial banks’ lending which, in turn, determines real investment.

• Central bank money injections influence credit. But there’s no role for autonomous and increasing growth and creation of ‘inside credit’ by the financial system—commercial and shadow bank alike—that occurs independent of central bank monetary policies. That credit need not be money is not considered.

• The negative role of debt is poorly understood. Debt is simply debt, and no distinction is made between business debt, household debt, and government debt, or how the forms of debt are capable of exacerbating each other and contribute thereby to rising fragility and instability.

• Increasing government debt is acceptable, so long as the economy is not at full employment. Nor does it matter how government debt is increased. More government deficits and debt help restore equilibrium.

• The ‘overhang’ of household and business debt since 2009 is holding back consumption spending. However, it is the magnitude of the debt overhang that matters, not the structure of the debt or the terms and conditions of debt repayment. How income and debt interact and cause system instability is insufficiently understood.

• Multiplier effects, that increase total government fiscal injections into the economy, are determined by the level of income . What form of income injected, and the timing, is relatively unimportant.

• Prices assist in the stabilization of the system. All prices behave the same, responding to supply and demand forces the same. That financial asset prices do not adjust as do prices for goods and services, and in fact lead to financial bubbles and financial instability, is not addressed. There is no theory of financial asset inflation.

• The major restructuring in financial markets and labor markets in recent decades is not integrated into analysis.

• The economy is fundamentally stable and returns to equilibrium, provided that government fiscal and monetary policies assist the process.

• There is no endogenous source of instability in the system. Recessions and depressions are caused by ‘external’ shocks to the system that divert the economy temporarily from its natural equilibrium.

• Depressions are basically recessions ‘writ large’. The difference is only quantitative. There are no fundamental qualitative differences between recessions and depressions.

(RETROS)

• Like Hybrids, Retros make no distinction between financial investment and real investment and how they may negatively affect each other, including how the former diverts money capital from the latter. Nor is there any framework for analyzing how financial cycles interact with real cycles.

• Also like Hybrids, there is no consideration of the fundamental institutional changes that have occurred with the restructuring of financial markets globally in recent decades—including the growth shadow banks, proliferating liquid financial markets and forms of financial securities.

• Even more so than Hybrids, Retros adopt a ‘money supply fetish’ and see growth and stability achievable simply by the central bank providing a proper supply of money. Even interest rates are often ruled unimportant. Money supply rules determine economic stability.

• Their view of inflation, whether financial asset or real goods and services inflation, is simply that inflation in whatever form is the consequence of too much money chasing too few goods. That the massive increase in money in recent decades has been accompanied by slowing and deflating goods prices is conveniently ignored.

• Declining and slowing real investment is caused not by a shift to financial asset investing, but is due to business costs remaining too high. Reduce business costs in whatever form, free up money capital thereby, and business will invest in real assets again. That record low interest rates and massive business tax reductions in recent years has been accompanied by slowing real investment is not explained.

• Financial instability is the consequence of individual ‘rogue behavior’, moral hazard, and asymmetrical information and has nothing to do with banking, shadow banks, or accelerating financial asset speculation.

• Central banks and improper policies are viewed as causing crises, and not bankers or investors. Crises occur as a result of bad central bank policy that fails to provide the correct amount of money to the real economy.

• Debt is good for investment and consumption, since it stimulates both. However, government debt is not good because it distorts markets and eventually reduces economic activity as government competes with private investors for access to money capital.

• All forms of government intervention are ineffective in restoring equilibrium from a recession or depression and generate more instability than they resolve. Discretionary fiscal policy is ineffective and destabilizing, as is central bank monetary policy except when focused on a steady and consistent growth of the money supply.

• Like Hybrids, there is no theory of financial asset price inflation, or bubbles, that destabilize the real economy. There is only ‘one price system fits all’, where supply and demand adjust prices and restore equilibrium and stability.

• Keynesian multiplier effects are over-estimated and ineffective, and both the level and other measures of income are considered unimportant for restoring equilibrium. The economy is self-correcting, without the need for even assistance or ‘nudging’ by government policy.

• Once again like their Hybrid cousins, recessions and depressions are caused by external supply and/or demand ‘shocks’, not fundamental endogenous forces that lead the system into instability. But if left alone by government policy makers, the system will self-correct.

Within the two wings, many economists have attempted to update and make the old approaches more relevant. However, unable to break thoroughly from the old conceptual framework, their efforts appear, then quickly dissipate and disappear, like cheap fireworks spinning off into the night sky. What remains is a kind of eclectic empiricism under the umbrella of the two wings, rendering mainstream economics more confusing than clarifying.

From the preceding it is clear that both Hybrid Keynesians and Retro-Classicalists together share a relative disregard for financial forces and variables. Financial asset bubbles are controllable either by central bank and government fiscal-monetary policy response, or better, by the market itself. There are no theories of how financial asset and real asset investment impact each other. The price mechanism will return instability back to equilibrium, with or without government ‘nudging’ or assistance. Debt is only a danger on the government side, and only given narrow, specific conditions. Debt is a positive contribution to real investment and consumption. The forms of debt do not have mutual effects on each other. Recessions and Depressions are due to external shocks, due to supply side or policy based demand side errors. The fundamental structural changes in global capitalism in recent decades require no revisions to basic neoclassical theory or policies. The propositions introduced by Keynes himself decades ago are only selectively relevant (and decreasingly so) or largely irrelevant. Neoclassical economics and its policy consequences are more appropriate today than ever before.

Global capitalism is not static. It is constantly changing. Periodically throughout history the agents of capitalism—i.e. their elite decision makers, the leaders of their political parties, and representatives in their governments and state institutions—recognize the need to undertake a major restructuring of their institutions and mutual relationships in order to address the periodic crises that inevitably occur. Major wars, depressions, financial crises, technology revolutions, and the rapid geographic expansion of capitalism itself precipitate the periodic major restructurings.

Mainstream economic analysis always lags behind these restructurings and changes. Its major concepts, propositions, theories and models do not change as quickly or in parallel in order to explain the new conditions. And that is the case at least since the late 1990s, and more likely since the 1970s. Not much has changed in terms of analysis to integrate the major restructurings that have occurred in recent decades in financial and labor markets.

Ideas are conservative, especially those that are heavily laden with justifications of the old order. As the global capitalist economy has undergone major restructuring of financial, labor, and other markets in recent decades, the old conceptual framework of Hybrids and Retros has become less able to explain the new changes and conditions. They therefore become less predictive. As the decline in their explanatory ability and predictive efficiency grows, new ideological arguments and analyses are increasingly overlaid on the old analyses. An ideological edifice of misrepresentations builds, rendering the old views increasingly ineffective in explaining the changed reality. This conceptual framework thus becomes even less adequate in explaining the new conditions. A fundamental conceptual breakthrough becomes necessary.

Jack Rasmus is author of the just published book, ‘Systemic Fragility in the Global Economy’, by Clarity Press, 2016. His website is: www.kyklosproductions.com and his blog, jackrasmus.com.

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