posted January 10, 2018
A Theory of System Fragility: Part 2 (from Chapter 19 of ‘Systemic Fragility in the Global Economy’, Clarity Press, 2016

Excess Liquidity at the Root of Debt Accumulation

Systemic fragility is rooted first and foremost in the historically unprecedented explosion of liquidity on a global scale that has occurred since the 1970s. That liquidity has taken two basic forms: First, money provided by central banks to the private banking sector—i.e. ‘money liquidity’ as it will be called. Second, a corresponding explosion of forms of ‘inside credit’ by banks and shadow banks that allow these unregulated financial institutions to expand credit independent of, and beyond, the money credit provided by central banks—i.e. referred hereafter as ‘(inside) credit liquidity’ or just ‘credit liquidity’.

Centuries ago, when gold and other metals were the primary form of money, the problem was the actual and potential production of goods was greater than the availability of money (as gold, etc.) to finance the production and enable the circulation of those goods. Today, however, in the 21st century, the growing problem is the opposite: money and credit are being created far more easily and rapidly and in greater volume than is necessary to finance the production and circulation of real goods and services. Just as the development and expansion of currency and bank bills of credit forms of paper liquidity eventually rendered gold and metal forms of money less important in terms of total money creation, so too will new forms of money liquidity creation eventually surpass older forms of money creation now provided by institutions of central banks and the commercial banking system. Liquidity expansion will accelerate even faster.

Excess liquidity has therefore been a major and growing problem within the global capitalist economy and this will continue and grow as a problem in the foreseeable future. The problem, however, is not liquidity per se or even its excess; the problem is the transformation of that excess liquidity into debt, and the consequences of that debt for fragility and financial instability.

Money Liquidity

As earlier chapters noted, the collapse of the Bretton Woods system gave central banks the green light to embark upon generating their own particular form of excess ‘money liquidity’ creation. The decision by US and other advanced economy economic and political elites in the late 1970s and early 1980s to eliminate controls on global money capital flows enabled the liquidity explosion, engineered by the central banks, to disseminate globally. With the collapse of Bretton Woods in 1971-73, central banks were now responsible for ‘regulating’ and stabilizing currency exchange rate fluctuations in order to facilitate world trade and capital flows. That required injections of liquidity periodically to maintain stability for the world’s various currencies within an acceptable range of fluctuation against the US dollar and a few other key currencies. That currency stabilization task used to be done by the gold standard, and then the dollar-gold standard that was Bretton Woods system from 1944 to 1973. But all that changed with the 1971-73 collapse of the Bretton Woods system. Thereafter, currencies were free to fluctuate widely and volatilely, unless central banks intervened to maintain relative stability, which they began to do in the late 1970s.

The growing frequency of recessions and financial instability events in the 1980s and 1990s continued to destabilize economies, currencies, and banking systems, and in turn threaten world trade and economic growth for the many countries highly dependent on trade. That called for more liquidity injections to check the periodic recessions and financial instability events. So growth and severe disruptions to growth both called for and received more central bank liquidity injections, in addition to that needed for currency stabilization.

There was another factor. In response to the crisis of the 1970s, the US capitalist elite in the early 1980s decided to focus on expanding US capital more globally instead of focusing primarily on internal growth. This also called for the provision of more money capital, as US businesses accelerated their global expansion in that decade. With the collapse of the Soviet Union the opportunities for still more global expansion arose in the 1990s. More liquidity was necessary. With the integration of China into the global economy in the early 2000s, even more liquidity was necessary. With new digital technology and networking in the 1990, new industries and products appeared, requiring still more liquidity. Expanding free trade beginning in Europe and the US in the late 1980s, which accelerated throughout the 1990s and has done so ever since, demanded still more liquidity.

In short, the end of Bretton Woods, the globalization of money capital flows, the expansion of capitalist trade and economy both externally and internally, the growing frequency and magnitude of financial instability events and recessions, etc.,—i.e. all called for more money, more liquidity. And the central banks and private banking system provided it for more than a quarter century from the mid-1970s into the 21st century. Massive amounts more would be needed, however, to bail out the financial system when the general global financial crash occurred in 2007-09.

Central banks have been pumping increasing amounts of money liquidity into the economy through commercial banks since the 1970s and the collapse of the Bretton Woods system. However, central banks do not actually create money. They indirectly enable private banks to do so, by providing private banks excess reserves on hand that the banks can then lend, which does increase money liquidity in the economy when lending occurs.

But this too has been changing, resulting in even more liquidity injection into the system, as central banks’ recent revolutionary policy innovations like ‘quantitative easing’(QE) have been introduced since 2008. QE represents central bank direct money creation, not just the indirect liquidity injections through the commercial banking system. With QE, central banks print money (electronically) and use it to purchase back financial assets from private investors. The assets purchased are then registered on central banks’ balance sheets as debt (in effect transferring the debt from private banks and investors to the central banks’ balance sheets), and the printed money used to buy the assets from investors is injected into the economy, adding to the general liquidity.

As previously noted, since 2008 more than $9 trillion in QE liquidity has been injected into the global economy and more is likely to follow soon from Japan and the Eurozone. In addition, indirect central bank policies (name a few in brackets?) over the past quarter century have injected tens of trillions more, of which only a small proportion has been retracted. Traditional central bank policies since 2008, which have reduced bank interest rates to virtually zero in the advanced economies for seven years now, have injected an additional ten to fifteen trillion dollars as well.

While central banks have been responsible for the growth of both indirect and direct (QE) liquidity expansion, other new forms of money and credit were, and are, being created as well. For example, ‘digital currencies’ like bitcoins and other forms of digital money that are proliferating within the private economy. These forms are created neither by central banks, private commercial banks, or shadow banks. The new money forms remain outside the control of central banks and even the commercial banking system. Changes in technology under capitalism will almost certainly enable the expansion of additional new forms of money liquidity in years to come in increasing volume. All foregoing examples represent the creation of excess money liquidity that is likely to escalate from all the above sources. Central banks today have little control over the parallel trend of expanding non-money forms of inside credit liquidity. And credit liquidity generation is where the shadow banking system in particular has been playing a major role.

Inside Credit Liquidity

While shadow banks also extend credit in the form of money to their wealthy investor clients, the unregulated shadow banking sector also extends credit to investors where no money is involved, thus enabling their investor clients to purchase more financial assets and securities. This ‘credit liquidity’ is based simply on the price and value of previously purchased products. If the price of previous purchased securities rises, so does its value as collateral, on the basis of which further credit is extended to investors. No money in the traditional sense is necessary or provided. The credit is based on exchange values of existing securities, not on new money loaned to purchase more securities.

While credit liquidity may not expand in this way as frequently where real assets are concerned, it works especially well with financial securities and other financial assets. Credit is extended, and more financial assets are purchased, simply based on the rising price and market value of previously purchased securities. Margin buying of stocks is one such example of inside credit creation. Many forms of derivatives securities are purchased in this way. Corporations also obtain credit based on the value of their retained assets. And banks are extended credit in the form of ‘repurchase agreements’, or repos, for the short term based on the value of banks’ assets put up as collateral. It all works, until the value of the assets used as collateral for the additional credit begins to collapse. Then the inside credit extended has to be paid with real money. In the meantime, however, in periods of economic expansion and thus rising financial asset prices, technology and financial innovation continues to expand forms of (inside) credit liquidity which finances investment—especially in financial securities.

From Excess Liquidity to Excess Debt

Whether commercial, shadow, or deep shadow, banks provide credit to other businesses. By far the largest segment of debt growth in the US economy since 1980 has been business debt. According to the Bank of International Settlements, the fastest growing debt sector by far since 2008 globally has been the business sector—not government or households. This is in part due to the fact that business is able to ‘leverage’ investments with debt more easily and to a greater extent than households or government units. By leverage here is meant the ability to obtain credit from financial institutions and reinvest it, matching it with only a small fraction of their own money capital. For example, borrowing $9 of money and adding only $1 of their own capital, for a $10 total investment.

Leveraging is also more conducive to financial asset investing than physical or real asset investing. Since financial asset prices tend to rise more rapidly and higher compared to prices of goods and services, credit is more available for further purchases of financial assets. For example, an initial stock offering price per share may average $20-$30 on initial offering, but if successful may rise into the hundreds of dollars per share within a year. That is not how goods prices behave. A successful real product when introduced, like a smartphone for example, will almost never rise in price, but instead begin to decline within a year. That means the market value of financial assets may rise as rapidly as the price of the asset rises. That market value increase in turn enables more leveraging of debt in order to purchase more of the financial asset.

Excess liquidity not only translates into more debt for financial investing. It also means more credit is available for household consumption based on borrowing. The availability of cheap credit to households plays a role in wage income growth slowdown. Employers can afford not to raise wages as frequently, or not at all, since wage income households address their income shortfalls by accessing credit to offset the lack of wage growth. Standards of living are defended not by demanding higher wages, or organizing into unions to get wage increases, or demanding minimum wage increases. Debt instead is the vehicle for maintaining living standards that previously were supported by wage gains that reflected annual productivity.

The excess liquidity also contributes to rising total government debt, both federal and local, as well as agency and central bank. The excess liquidity means interest rates have been kept low. That provides an incentive for government to issue more debt. In the US, for example, that means at the state and local government level more issuance of municipal bond debt. At the agency level, the lower rates are reflected in more mortgage debt that is guaranteed and purchased by federal housing agencies like Fannie Mae and others. And by buying up mortgage bonds by means of its QE policies, the central bank in effect transfers private sector bad debt to its own central bank balance sheet.

The lion’s share of government debt occurs at the federal or national level, however. The US federal debt has now exceeded $18 trillion, most of which has been accumulated since 2000. Federal government debt accumulates in several ways. Deficit spending increases and tax cutting raises debt. That spending increase may be attributed either to social programs or defense spending. In the US example once again, defense spending has accelerated as the US has conducted wars in the 21st century for which it has not only not raised taxes, for the first time in its history, but actually cut them.. Estimates of the cost of wars thus far since 2000 for the US range from $3 to $7 trillion. And the 21st century wars are continuous, without end. Tax cuts amounted to nearly $4 trillion under George W. Bush, more than $2 trillion more under Obama’s first term, 2009-12, and another $4 trillion over the following decade, 2012-2022, as part of the ‘fiscal cliff’ legislation of January 2013.

On the social spending side, government spending on healthcare related programs has also soared, as the health insurance, private hospital chains, pharmaceutical companies, and health services sector has concentrated, established deep financing from Wall St. for acquisitions. This has raised prices at double digit annual levels for years since the mid-1990s. The consequence has been escalating costs in Medicare, Medicaid, and most recently the Affordable Care Act (Obamacare) programs. The passage in 2005 of Part D, the prescription drugs program, alone has added more than $500 billion to the US deficit and debt in the last decade, in part due to skyrocketing drug prices and also as a consequence of the US government refusing to pass a tax to pay for it, preferring to fund it totally out of deficits.

Government deficits and debt accumulation has also been due to cyclical causes, and not just the secular trends just noted. The growing frequency of financially induced real contractions of the economy has led to government bailout costs. While the federal reserve has been the source for bank bailouts that have raised its share of total government debt to approximately $4 trillion, parallel bailouts of non-bank companies impacted by the financial crashes since the 1980s has also raised government non-bank debt. This source of debt especially escalated after 2008.

All this increase in government debt could not have been possible, however, without the development of what is termed the ‘twin deficits’ solution, which has been described in more detail in chapter 15. Briefly once again, the ‘twin deficits’ is the neoliberal solution created in the 1980s in which the US allowed a trade deficit to develop so long as trading partners (Europe, Japan, petrodollar economies, and then China after 2000) agreed to recycle the dollars they accumulated from the trade deficit back to the US by buying US Treasury bonds in the trillions of dollars. That recycling allowed the US in turn to run a budget deficit of ever growing dimensions—resulting in the $18 trillion plus debt.

Much of the total government debt—both central bank, national government, and even local government—represents the transfer by various means of private sector debt onto government agency balance sheets. Thus, as private debt—primarily bank, corporate, and investor—has risen since the 1970s for reasons explained, government debt has followed. Without the State having thus absorbed the private debt, and continuing to do so, the financial instability and crashes to date would have been significantly more frequent and more serious. Action by the State has thus kept the global capitalist system afloat, and ensured the patient remains on ‘life support’ even as its condition continues to fundamentally deteriorate.

So in a host of ways, the excessive liquidity creation leads to more debt creation at all levels—i.e. financial institutional, households, and government debt in various forms. And excessive debt creation is an important component of fragility at all levels—business financial fragility, household consumption fragility, and government balance sheet fragility. Debt is just the mirrored reflection of excess liquidity, and together excessive debt/ liquidity drive the system toward systemic fragility and instability. The vehicle is escalating the trend toward financial asset investing, and its corresponding negative influence on real asset investment.
Debt and the Shift to Financial Asset Investing

Financial Asset v. Real Asset

Financial asset prices are far more volatile to the upside than goods prices, especially in a boom phase of a business cycle. With financial assets, ‘demand creates its own demand’, one might say, driving up prices while supply factors play a lesser role in dampening price swings. The more the price of the financial asset rises, the more buyers will enter the market to make further purchases of the financial asset, thereby driving its price still higher. Conversely, since the ‘cost of goods’ for making financial asset products is extremely small, rising supply costs do not discourage or lower the demand for the asset.

The opposite behavior occurs with goods prices, where demand plays a less volatile role and supply a more dampening role. Should the price rise, fewer buyers will purchase the product, unlike financial securities where rising prices attracts more buyers. That’s because goods themselves are not as highly liquid as financial securities. Goods cannot as easily or quickly be resold and, if they are, are almost never resold at a higher price but instead at a lower one. In other words, there is no profit from price appreciation with goods prices whereas for financial assets profits are mostly determined by price appreciation. That means there is significant potential for profit from price appreciation for financial assets, which is another feature attracting buyers.

There is also more profit potential related to production costs, since there is virtually no ‘cost of goods’ involved in producing financial securities—little raw materials required, no intermediate goods, very little in the way of labor costs, no transport costs since nothing is physically delivered to the buyer, no inventory carrying costs, and so on. Financial assets are electronic or paper entries created originally with a small team of ‘financial engineering’ experts. This lack of production and therefore supply costs makes financial assets more profitable to produce.

There is a third factor that also makes financial asset prices more profitable. Because they are sold online, by phone, or by some other communications media, a large and costly sales force is not needed. Distribution costs are negligible. Moreover, the potential market reach—i.e. what is called the addressable market in business jargon—is the worldwide network of financial investors who are generally ‘savvy’ enough to seek out the sellers, rather than having sellers ‘go to the buyers’. At most, minimal advertising costs are involved for the sellers of financial assets and securities.

In the simplest terms, then, financial assets have an advantage over the production of real goods—whether autos, clothing, food, machinery, or whatever—in all three categories of profit origination: price appreciation, cost minimization, and volume sales potential. They are simply more profitable—providing that prices are rising. In a contraction phase, the potential losses from falling financial asset prices are correspondingly greater compared to goods prices. But while the contraction may be steep in the short run, financial asset prices typically recover the losses much faster than goods prices in the recovery phase.

Another reason that financial assets are more attractive than real assets is that financial assets are traded (bought and sold) in highly liquid markets. That means an investment may be made and then quickly withdrawn (sold) if the asset price is not rising sufficiently or begins to fall. This is not possible with real investment and real goods. The real asset or company invested in must produce the good, and then sell it, over a longer cycle and time period. If costs rise and market prices fall in the meantime, the investor cannot withdraw to reduce losses as quickly. There is thus greater risk in real asset investing and goods production and sales. On the other hand, with financial assets, losses can be minimized faster as well as profit opportunities taken advantage of more quickly.

The ability of investors to purchase financial securities by leveraging purchase with debt, the various ways financial assets are potentially more profitable, plus the greater flexibility in quickly moving investment around as new opportunities emerge, all together provide a significant incentive for investors to direct their money capital and available credit toward investment in financial assets.

Conversely, investing in real assets means less profitability potential, given that price appreciation is negligible and that costs of production tend to rise significantly over the boom phase of the cycle. It means an additional costly distribution channel where the seller of goods must ‘go to or seek out’ the buyer. And it means less flexibility to move one’s money capital around, to minimize losses and maximize gains. Why then would not the professional investor—i.e. the new finance capital elite—who cares only for short term, maximized capital gains not redirect his money capital from real asset into financial asset investing? He is not interested in building a company, becoming the biggest, gaining market share, acquiring and thus eliminating competitors. He is interested in short term, price appreciating capital gains. And for that financial asset investing is by far more attractive.

In short, because financial asset investing is typically more debt leveragable, because it is potentially more profitable in the shorter run, and because it is more liquid, flexible, and therefore less uncertain—investors can and do move in and out financial markets more easily and quickly. They take price appreciated capital gains profits in a short period, and then move on to other short term, liquid, financial asset market opportunities. Or, if prices fail to appreciate, move just as quickly out of the liquid markets and minimize losses. Within a given year, for example, an investor may move a given amount of money capital from stock investing in Asia, to shale gas junk bond debt in the US, to derivatives in the UK, to speculating in Euros and Swiss francs, and so on. Money capital is not tied up long term as in the case of real asset investment, nor with as great uncertainty of outcomes.

(Financial Asset Investing Shift)

To sum up: the greater opportunity to leverage with debt, the greater relatively profitability, the shorter investment cycle and therefore the less uncertainty that is associated with investing in highly liquid markets—all provide investors a much greater relative incentive to invest in financial assets and securities instead of real assets. Given all these advantages, it is not surprising that a relative shift toward financial asset investing has been taking place for decades now. The relative profitability potential is simply greater. And in a world economy in which professional investors have grown in number and now control an unprecedented volume of investible money capital, that shift to financial assets investing is not surprising. Keynes’ warning eighty years ago about the rise of the professional investor who prefers financial assets and securities, compared to the enterprise owner-investor who prefers real asset investing, has become the rule, not the exception.

The shift to financial assets does not mean that real asset investment disappears. Some of the explosion in excess liquidity and debt is directed to real asset investment and the production of real goods. And periodically major opportunities for real investment arise internally with the coming of new technologies like the internet, wireless communications, social networking, etc. Other external opportunities for real asset investing also emerge from time to time: the opening up of investment in Russia and east Europe in the 1990s; the significant real investment opportunities in China and emerging market commodities production that arose after 2000; or the North American shale gas and oil boom after 2008. But the time frame for profit generation from real asset investment is typically relatively short. Real asset investment becomes saturated after a few years, or after a half decade or so at most. Overproduction occurs. Costs rise and price increases are difficult to sustain. Competition provides more supply and dilutes demand. Sales peak and then decline. The boom is relatively short and the downside that follows is generally protracted.

In contrast, with financial asset investment the boom may extend and prices continue to rise over the longer term. So long as prices rise steadily and don’t over-accelerate, financial asset investing grows. There is no ‘overproduction’. As for the downside, while it may be deep on occasion, it is relatively short term. In 2008-09, for example, financial assets like stocks and bonds contracted sharply but then ‘snapped back’ quickly and attained new record levels in just months following the crisis. In contrast, prices and sales of real assets like homes and other goods contracted less initially, but have yet to attain prior levels of price and sales volumes six years after the recession ended. Prices for equities, bonds, and other financial securities have risen steadily since 2009, whereas prices for goods have been disinflating and even deflating throughout the advanced economies—and now in China and emerging markets—since 2009.

Despite the growing importance of financial compared to real asset investing, mainstream economic theory still does not recognize or give appropriate weight to this financial asset investing shift. Investment is measured in real terms, based on real data obtained from national income accounts. There’s little place for financial variables in their General Equilibrium Models. How financial variables impact and determine the trajectory of the real economy is not explained in sufficient detail. At the same time, Marxist economists also continue to dismiss financial assets, referring to them as merely ‘fictitious’ capital and considering their role even more irrelevant.
Both mainstream and Marxist make little distinction between financial asset investing and real asset investing, or how they mutually determine each other. Investment is investment, as indicated in the Gross or Net Private Domestic Investment category of the National Income Accounts. If GDP is a measure of the performance of the real economy, financial investment variables have no effect on GDP level outcomes. It is the real side that drives the economy, and financial instability in turn.

The view from both the mainstream and Marxist analysis is that other non-financial forces are responsible for the slowing of real asset investment. And because of that slowing, investors are turning more toward financial asset investing. The real side is what is driving the ‘financialization’ of the economy (which is usually defined narrowly, and incorrectly, as a rising share of total profits going to banking and finance). Mainstreamers argue what is causing the slowdown of real investment is slowing productivity, excessive benefits compensation, too high federal taxation, and other costs. Marxists argue it is the falling rate of profit due to a rising ratio of fixed to variable capital, workers resisting employer exploitation, or growing capitalist competition that is responsible.

Neither acknowledge that the shift to financial investing may be due to the easier and higher profits from such investing—an outcome of the financial sector restructuring that has occurred the past four decades. Neither accept the notion that perhaps the higher and more certain profitability from financial investing is what is driving available money and credit more toward the financial side of the global economy, reducing money and credit that otherwise would have gone to real asset investment.

While it is apparent that money and credit is flowing increasingly into financial assets and financial securities investing, their argument is that the decline in real investment is causing the rise in financial. But the observable correlation—with real investment slowing and financial investment accelerating—may have an alternative causal explanation. It may be that financial asset investing is ‘crowding out’ real asset investing simply because the former is more profitable than the latter. It may not be only an excess of liquidity that is driving financial investment; it may be that the financial side is not simply getting the excess available liquidity and debt left over after real investment occurs. It may be the greater attractiveness of financial investing is diverting money and credit from real investment to financial investment. It may be real investment is slowing—not because of slowing productivity, or rising compensation costs, or too high government taxes, but because financial side and financial investing is just more attractive and potentially profitable in 21st century global capitalism.

As a final comment on the financial investing shift, it should be noted that as the shift grows over a longer period following a crash of financial assets, financial investing tends to assume more of a speculative character. By ‘speculative’ here is meant investing in highly price volatile financial asset classes and for an even shorter term duration than average for financial asset investing in general. Speculative investing focuses on quick ‘in and out’ purchases of assets in highly liquid markets, in expectation of a fast price appreciation (or depreciation) and consequent capital gain profit. It may also employ a greater amount of debt leverage in the investing. Speculative investing appears as chasing ‘yield’—i.e. seeking higher returns than average by investing in more risky asset classes like corporate junk bond and leveraged loan debt, distressed sovereign debt, more ‘naked’ short selling of stocks where bets are placed on stock price declines and no actual purchases are made, or on the most unstable currencies in expectation of currency exchange swings.

Speculative investing not only tends to rely relatively more on debt leverage but is more likely to be incurred via inside credit. A good example in 2015 has been the growing reliance on margin buying of stocks in the China equity bubble of 2014-15. That was followed by shadow bank investors then taking advantage of the significant stock financial asset deflation by engaging in short selling of Chinese equities. In the case of margin buying, the heavy debt inflow drove up China equity prices faster and higher than could be sustained for long, while the short selling had the effect of driving those same asset prices down faster than otherwise would have occurred.
In summary, couched within the shift to financial asset investing is the more unstable element of financial speculation. This tendency toward the more speculative forms of financial asset investing is generally an indication of growing financial fragility within financial asset markets in general. However, in the Chinese example, neither the uncontrolled margin buying nor the subsequent short selling of equities could have been possible without the extraordinary run-up in liquidity and debt in China since 2008 that made the shift to financial asset investing possible, leading to the escalation of financial fragility within China to dangerous levels.

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